Skip to main content
Speeches

Challenges for board and management: Adequate catastrophe cover and meeting capital requirements

Tuesday 24 September 2013

Ian Laughlin, Deputy Chairman - Aon Benfield Hazards Conference

Good morning – it’s good to be here talking about such an important topic.

We all know that Australia is blessed with many positive attributes – from the weather to its natural resources. They all contribute to the Australian lifestyle, which by and large is an envious one.

It’s not all beer and skittles though, and one of the prices of our good fortune is the exposure we have to natural catastrophes.

These disasters, when they occur, don’t fall on our shoulders evenly. Rather, only a small part of the community generally is badly hit by any one event.

Here, of course, the insurance industry plays a very important role. It helps protect and it helps share the burden.

We have all seen the natural catastrophe figures from recent times so I won’t repeat them here. However, it is worth looking at our exposure from a different angle:

  • Of the total industry Prescribed Capital Amount (PCA) of $10.5 billion at 31 March 2013 (excluding LMIs), the Insurance Concentration Risk Charge (ICRC) was $1.5 billion.
  • Based on a subset of direct insurers who reported gross vertical Probable Maximum Loss (PML), without catastrophe reinsurance industry capital would need to increase by about 100 per cent just to meet PCA, or by about 300 per cent to broadly maintain current PCA coverage levels.

I’ve given you these figures just to highlight the significance of catastrophe risk management to the industry P&L and balance sheet, and hence its fundamental importance to the financial management of general insurers and the industry as a whole.

This begs a question: does the industry give catastrophe risk management the attention it deserves, given this significance?

I don’t think it does!

So why is this? Is it because there is something of a black box to the methods of determining catastrophe cover? Is it because it is too hard to understand, so a broad brush is applied? Or maybe it’s because there are experts and tools to produce the "answer".

Story

I’d like to tell you a story which might give us some insights into this.

The character is fictional but the company is a reasonable representation of what we might find in the Australian market – neither particularly good nor particularly bad.

The scene

David is watching TV. All the major channels are showing stories about a cyclone bearing down on south east Queensland, and he has been following progress closely. It is already raining heavily in Brisbane and flooding has started. The outlook is grim.

David is on the board of an Australian property insurer, with a significant exposure to the region. He is well-informed, industry-savvy and a very experienced board director. He has a keen interest in risk management and governance.

He chairs a sub-committee of the board risk committee which has particular responsibility for oversight of reinsurance arrangements.

He thinks about the chance of a cyclone hitting Brisbane and the Gold Coast directly. He goes to his computer and looks up the Bureau of Meteorology site to check on the cyclone’s progress. He finds quite a lot of information there about cyclones, and in particular some quite interesting historical records.

He decides to map all of the cyclones in the records – about 100 years worth. And he finds this picture:

He finds that a bit daunting, so he reduces the selection to cyclones that passed within 200 kilometres of Brisbane. This is what he finds:

It is clear that south east Queensland is no stranger to cyclones. He reflects on the fact that this is the history for about 100 years and that APRA’s minimum return period for capital purposes is 200 years.

This puts him in a pensive mood and he starts reflecting on how he found himself in this position.

A year ago he had been offered a board position with the company. He casts his mind back to that time.

A year ago

David has been offered a position on the board of an Australian property insurer. He is doing his due diligence before accepting the offer.

David comes from Queensland, and has family in Christchurch, and so is particularly conscious of catastrophe risks. He saw the consequences of a failed insurance company in Christchurch and this is preying on his mind.

He decides to review the company’s approach to catastrophe risks as a litmus test – that is, if governance and management of catastrophe risks is not done well, then he would know that the board was not for him.

David is thorough by nature and decides that he should look at this systematically.

He decides to make some notes about what he would expect to find in the company’s catastrophe risk management practices.

He starts by thinking through the issues of importance that need to be addressed.

He then draws up a check list of reference material that would be useful.

Here is his check list of material he would like to review (bearing in mind he is focusing on catastrophe risk):

As part of this process, he looks at the APRA website, and identifies some documents that may be of help:

  • GPS 116 and GPG 116 on Insurance Concentration Risk Charge
  • GPS 230 on Reinsurance Management
  • draft CPS 220 on Risk Management
  • GPS 310 on Appointed Auditor’s report

He then thinks who might play key roles in catastrophe risk management and governance and draws up the following list of parties:

He decides that when working through the reference material, he will pay close attention to the roles of these key people and how that compares with what he would expect. He notes that the APRA material assigns particular responsibilities to most of these key parties.

Catastrophe Risk – particular points

He then considers particular points that might help give him some insight about catastrophe risk management and governance. He draws up this list of matters he would like to learn more about.

He decides that all of that that should keep him busy for a while!

Due diligence

Now let’s walk through what he does to satisfy himself as to the quality of governance and management of catastrophe risk.

He decides to start with the level of catastrophe risk that the insurer is willing to bear. He wonders how the board has determined that risk and how it is expressed. So he picks up the Risk Appetite Statement (RAS) to see what he can find.

David considers that given the significance of catastrophe risk, it should be explicitly addressed in the RAS or in supporting documentation. The board’s attitude to catastrophe risk should be clear.

However he finds that catastrophe risk is not clearly and explicitly addressed!

He also is very interested to see if the return period adopted for the probable maximum loss (PML) is set at the APRA minimum of 200 years, or is more conservative. He finds they have indeed adopted the minimum. He wonders if the board chose this position only after a rigorous debate about their appetite for catastrophe risk, and decides to check papers and minutes from the relevant board and risk committee meetings when the decision was taken. He also checks the Reinsurance Management Strategy to see if it provides an explanation. He finds that this does not give him any great insight as to the board’s thinking, and this gives him pause for thought. He makes a note to discuss board engagement on catastrophe risk matters with the chairman.

The involvement of the CEO is also not clear from the papers and minutes. David expects to see clear leadership from the CEO on catastrophe risk management, given its fundamental importance to the management of the company. He makes a note to raise this with the chairman and to discuss catastrophe risk management with the CEO.

He then checks on APRA’s requirements and guidance in this area. Here are some of the things that he finds.

NOTE: In the following slides, mandatory requirements are in red; guidance in blue.

So it is not clear that APRA’s requirements about willingness to take on catastrophe risk have been met. Nor that APRA’s guidance has been followed in setting the return period. He makes a note to check the ICAAP Summary Statement and strategic plan to ensure they have a link back to the insurer’s catastrophe risk appetite as per APRA guidance.

Determining the PML

Having established that the chosen return period is 200 years, David turns his attention to how the insurer actually determines the PML. In doing this he reflects on the experience in Christchurch (as here it would appear an insurer underestimated the cat risk to which it was actually exposed, causing its failure).

He knows from his own experience that models can be wonderful tools, but they also have considerable weaknesses and deficiencies. For example, the model will not cover particular risks (as in Christchurch or Thailand), it may not be sophisticated enough to allow for various contingencies such as demand surge, it will have other technical deficiencies, its accuracy will be very dependent on the quality of exposure data used, its ability to replicate the real world limited, and so on. So he is very wary of undue reliance on model outputs. He is hoping to find recognition of the deficiencies of the model or models used, and that in setting reinsurance levels allowances have been made accordingly. He also wants to see commentary on the quality of the insurer’s exposure data (geo-coding, construction age and type, roofing materials, floor height etc) and recognition of non-modelled perils. Ideally the model output would show bounds of uncertainty for a given return period. He wants to see whose advice management and board obtained apart from the internal technical people, and in particular is hoping to find both broker and reinsurer involvement.

Lastly he wants to see clear evidence of stress testing and scenario analysis (e.g. the impact of a cyclone through southeast Queensland) being used to challenge and complement the modelling work. He then hopes to find some allowance for residual uncertainty in the chosen PML.

He decides to review the Reinsurance Management Strategy, the ICAAP Summary Statement, the Reinsurance Arrangements Statement and the relevant board committee papers to see what he can find. He is disappointed to find that there is no real evidence of the process he was expecting. Rather the output of a single model, increased by 5% as a general margin, has been used for the PML.

There is supporting commentary from the broker, but no recommendation. It appears that there has been no stress testing or scenario analysis to support the decision made. There is not even a back-test of model outputs against recent actual cat events. And there is no justification for the size of the 5% margin used.

There appears to be an over-reliance on work by the broker and little evidence of due diligence by the company. He then finds something that concerns him - a reference in the board papers to a proposal from the CEO to reduce the PML. A different model had been run by the broker and this produced a noticeably lower PML. The model was supposedly more up to date than the existing one, but there was no comprehensive comparison of the strengths and weaknesses of each model. Part of the difference was explained by less conservative assumptions in the new model. There was no indication of the uncertainty in the results produced by either model.

He concludes that the company lacks a strong understanding of catastrophe models and how they can best be used. There is a clear need to improve knowledge and skills in this area and in the use of other techniques to complement the model work.

David checks on APRA’s requirements in this area and finds some requirements and extensive guidance. Here is just some of what he finds:

So it seems very clear that APRA expects explicit recognition of the limitations of catastrophe risk models and considerable further work to complement the output of models. It also expects rigorous assessment by management and board.

It also seems clear that the insurer falls well short of APRA’s expectations.

Reinsurance

David has already reviewed the Reinsurance Management Strategy and ICAAP Summary Statement when looking at the PML. He decides he should take a closer look to see how they influence the reinsurance arrangements. He is also looking for consistency between the documents. He thinks together they should give real insight into how catastrophe risks are managed by the company.

David is aware the ICAAP Summary Statement is a newly crafted document and so expects it to be particularly informative. He wants to see a clear link to catastrophe risk appetite and to the Reinsurance Management Strategy. In particular, he thinks capital management plans should specifically address catastrophe risk (including the possibility of multiple events and their financial impact), given its significance in relation to capital. In the Reinsurance Management Strategy he hopes to find a clear explanation of the approach to catastrophe risk management.

He finds the ICAAP Summary Statement to be quite interesting and useful, reflecting strong engagement of senior management and board in its development. However, it does not address catastrophe risks and their impact on capital management in any detail, and he finds this disappointing. He looks for, but does not find, commentary on capital management in the circumstances of multiple catastrophe events, and the impact this might have on surplus assets. There is no mention of the El Nino/La Nina cycle.

The Reinsurance Management Strategy too he finds interesting. It sets out the objectives of the reinsurance arrangements, together with policies and procedures for the overall reinsurance management framework. The procedures for reinstatements management are also clear.

He is hoping to find a clear articulation of the thinking behind the catastrophe reinsurance arrangements. However the document does not provide him with any real insights into the rationale for what has been put in place. It does explain the management of the reinsurance framework quite well, including responsibilities.

He notes a reference in the Reinsurance Management Strategy which provides a clear link to the insurer’s risk management framework.

He reviews board minutes, seeking indication of board engagement in the final decisions on the reinsurance program. However, there is no real evidence of this.

He reviews APRA’s requirements for the Reinsurance Management Strategy and notes in particular:

He notes that both the ICAAP Summary Statement and Reinsurance Management Strategy could be improved based on the APRA requirements and guidance.

Reinsurance arrangements

David then decides he would like to see how all of this has been translated into actual reinsurance arrangements. He is hoping that this will be summarised in a simple form. He turns to the Reinsurance Arrangements Statement. He finds a very helpful diagram which gives him a good understanding of the catastrophe reinsurance that is in place. He notes the reinstatement arrangements appear to be quite sound.

He also sees references to drop-down cover for second and subsequent events (addressing the APRA "horizontal requirement") and makes a note to find out more about the rationale for this and how the drop-downs will actually work in practice.

He checks APRA requirements on reinstatements and finds they are met.

Actuarial Review

David decides to review the Financial Condition Report by the Appointed Actuary. He is expecting to find specific reference to catastrophe risks. In particular, he hopes to see commentary on these matters:

David finds no mention of any particular concerns, such as the quality of exposure data.

He finds no reference to environmental developments that might affect catastrophe risk e.g. urban development on flood-prone land or development of levees.

David is quite interested in geographic concentration, given the failure of an insurer with a heavy concentration in Christchurch in that city’s recent earthquakes. He finds a table showing sums insured by CRESTA zone, highlighting exposure in the largest zone. Those zones considered most exposed to cycone risk are highlighted also. He wonders if more attention could be given to this.

David finds a mention that prices include an appropriate allowance for catastrophe risks. However there is no specific reference to the allowance for the newly introduced flood risk cover, which surprises him, given the difficulty with flood risk information.

The FCR states that the PML is based on model output supplied by a broker. There is no mention of non-modelled risks, which model was used or its strengths and weaknesses, nor the implications of key assumptions made by the broker. Nor is there comment on the process that was followed by management and board to set the amount of catastrophe cover. He finds this disappointing, given the issues with sole reliance on such a model discussed earlier.

The catastrophe risk reinsurance coverage is summarised, showing retention and top of cover. There is no information on counterparties, other than a comment that the reinsurance is almost entirely with APRA-authorised reinsurers. There is no commentary on the number of reinstatements, cost of reinstatements etc.

There is discussion on surplus assets, with some reverse stress testing outcomes, including the number of major events that the insurer could withstand.

He checks on APRA’s requirements and guidance for the Appointed Actuary.

He concludes that the FCR is a useful document, but that it does not give him the degree of insight into the insurer’s catastrophe risk management that he would expect. He makes a note to raise this with the appointed actuary.

Given the significance of cat risks to the insurer, David wants to understand how those risks are captured by the insurer’s overall risk management framework. He has already worked through the risk appetite aspects so now looks for specific mention of cat risk in the insurer’s Risk Management Strategy. He also expects that cat risks would feature quite heavily in the regular board risk management reports.

He checks the documents and is reasonably satisfied with what he finds and notes that they are consistent with APRA’s requirements.

He makes a note to talk to the CRO about the part the CRO plays in the oversight of cat risk management.

To see how well embedded cat risk management is within the company, David reads the strategic plan. He is hoping to find a clear link to the ICAAP Summary Statement and to Reinsurance Management Strategy.

He finds some commentary on geographic exposures and the implications for cat risk, but there is not the strong link that he was expecting.

He finds APRA also expects a clear link.

Reviews by Auditors

David is keen to see what the auditors have to say about the cat risk processes and arrangements in their capacity as third line of defence.

In the reference material he has, there is nothing specific from the internal auditor on cat risks. However, he would expect that this would be an area of review from time to time. He also expects that cat risks would be captured in broader risk management reviews by the internal auditor. He makes a note to speak to the internal auditor about this.

The ICRC is an important component of the regulatory capital balance sheet, and the PML and associated reinsurance arrangements important aspects of the insurer’s financial management.

David expects, therefore, that the external auditor will pay specific attention to these matters. In particular, he is hoping to find that the external auditor does not just accept the figures produced by the cat model process and go no further. He expects that they will have reviewed the processes (use of model(s), stress testing and scenario planning, advice from experts etc.) that the insurer has put in place to determine PML and whether those processes have been followed. He makes a note to check.

David also checks APRA’s requirements.

David’s Conclusion

So that has been a fairly exhaustive process. David draws together all that he has found and reviews the notes he has made to talk to various people to help his understanding. He considers his level of comfort with what he has found and what decision he might make about joining the board.

So, does David accept the board position?

He is uncomfortable with quite a lot of what he has found, and he wavers initially. However, he follows up the extra information he wants, and has further conversations with the chairman, CEO, CRO and appointed actuary. He is particularly heartened by their keen interest in improving their practices and the Chairman’s view that David could help with this. So this gives him the comfort he needs and he joins the board.

Because of his background and keen interest, he is made a member of the board risk committee and put in charge of a sub-committee to review catastrophe risk management and reinsurance arrangements.

David immediately initiates a review of the PML and associated catastrophe reinsurance.

Over subsequent months the committee oversees a management review of models available in the market. They talk to brokers and model suppliers about the models, their strengths and weaknesses, and uncertainty in the model outputs. They ask for multiple model runs and seek to understand the reasons for the different answers. They are provided with much information and analysis.

The next two slides illustrate some of the insights provided about model uncertainty.

The first comes from a Guy Carpenter paper which provides a very good explanation of model uncertainty.

Note just how wide the band of uncertainty is in this illustrative example.

The second comes from a presentation from the model supplier, RMS, which highlights the issue of model uncertainty:

This helps them form a view on how they will make best use of the models and the weight they will give to the model output. They obtain advice from management about the quality of exposure data fed into the models and try to understand the implications of approximations etc.

They also seek input from climate specialists.

They conduct scenario analyses, including the possibility of a major cyclone in SE Queensland. This includes some thoroughly interesting and challenging workshops run by management with external support.

They review their risk appetite for catastrophe risk in light of all of this information, and decide that the APRA minimum return period of two hundred years is too low.

The end result is a comprehensive review of their catastrophe reinsurance. The level of catastrophe reinsurance for a major event is increased significantly.

Finally, they gain approval from the board for the changes and arrange implementation of the new reinsurance arrangements.

Back to the Present

David stops his introspection and brings his mind back to the present.

He has a sense of foreboding about the damage and losses to come from the cyclone. But he is confident that the board has done all it could to understand the risks the insurer now faces and their reinsurance protection is appropriate.

Conclusion

That is the end of the story.

The story contains a few messages, but note the following points in particular.

APRA wants each insurer to challenge itself about its governance and management of catastrophe reinsurance arrangements and to adopt very good practice. We particularly want the insurer to understand the strengths and weaknesses of any models it uses, and the degree of uncertainty in the results produced. And we want model outputs to be complemented by significant further analysis. Lastly we want the insurer to satisfy itself that the residual risk is truly within its appetite.

We are absolutely intent on seeing industry practice improve.

I hope this story helps in that process.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding $6 trillion in assets for Australian depositors, policyholders and superannuation fund members.