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Prism’s Approach to Modeling Natural Catastrophe Risk. Casualty Actuarial Society November 12, 2007 Mark Rouck, CPA, CFA. Topics. Background on Prism . Prism’s Catastrophe Risk Component. What Does it Mean for Ratings? . Topics. Background on Prism. Prism’s Catastrophe Risk Component.

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Prism’s Approach to Modeling Natural Catastrophe Risk

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Prism’s Approach to Modeling Natural Catastrophe Risk

Casualty Actuarial Society

November 12, 2007

Mark Rouck, CPA, CFA


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Topics

Background on Prism

Prism’s Catastrophe Risk Component

What Does it Mean for Ratings?


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Topics

Background on Prism

Prism’s Catastrophe Risk Component

What Does it Mean for Ratings?


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Nov-2007

Fully Implemented

with “cure” period

Late 06-Early 07

2nd QUARTER, 2006

PRIOR TO 2006

The Road to Implementation US: November 2007

Prism

  • A robust, global, stochastic model for evaluating the capital adequacy of insurers

  • Represents a significant step forward from existing regulatory and rating agency methodologies

  • Beta Models tested and calibrated

  • Executive Summary of Methodology

  • Technical Document of Prism

  • Assessment of Insurer In-house Economic Capital Models

  • Defining Available Capital

  • Calibration to Rating Thresholds

  • Enterprise Risk Management

  • Commits to building a Global Economic Capital Model (September 2004)

  • Releases Variable Annuities Capital Model (August 2005)

  • Publishes Catastrophic Risk and Capital Requirements (November 2005) and New Catastrophe Risk Analysis Increases Capital Needs by 10%. (May 2006)


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Prism’s Unique Strengths and Features

  • Global yet local

    • Current list of countries: FR, GER, UK, US

    • Consistent assumptions and structure allows us to bolt on others

    • Recognizes country specific products and parameters

  • Integrated

    • Risks are modeled simultaneously – captures both diversification and compounding effects

    • Economic Scenario Generator / Correlated Random Numbers

  • Stochastic

    • 5,000 simulation scenarios

    • T-VaR approach considers “tail” events

    • Calibration based on historical default rates

    • Wave of the future – Solvency 2


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  • Credit Risk

  • Incorporates defaults, migration and spread volatility

  • Use common market indices to establish parameters for asset type and quality

  • Over 50 asset buckets.

  • Stochastically model reinsurer default risk

  • Underwriting Risk

  • Use a collective risk model of frequency and severity of losses.

  • Relies on ELR, Attachments, Limits

  • Factors one year of new business.

  • Reserve Risk

  • Incorporates reserve adequacy analysis

  • Use Mack Method to Estimate Volatility

  • Utilize several checks to ensure data integrity

  • Asbestos & Environmental Losses Evaluated Separately

  • Catastrophe Risk

  • Use Company Provided PMLs

  • Use AIR (Catrader) software.

  • Consideration of up to 1 in 10,000 event

  • ALM (Market) Risk

  • Incorporates risk-free yield curve (bonds, mortgages), real estate and equity returns (DAX, FTSE, CAC).

  • Use a proprietary, integrated scenario generator.

“Aggregator”

  • Consistent economic scenario set

  • Similar Cat event set

  • Correlated random numbers

Each Company will potentially have unique risk curves

Modeling Methods – Risk Elements Captured


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Two Core Outputs Determine Prism Scores

  • Available Capital or “AC”

    • Economic, not accounting based number

    • What is amount of liquid capital in a controlled run-off situation

  • Required Capital or “RC”

    • Distribution table produced by the simulation

    • RC is not a single number but a range of outcomes

    • Derived by applying the appropriate T-VaR against distribution

      Simulation calculates PV of cash inflows and outflows over 30 year balance sheet run-off (with one year of new business)

    • Cash outflows: claims and expenses

    • Cash inflows: investment earnings and premiums on new business

      Prism Score is point where AC intersects RC

    • The highest rating level at which that occurs is your Prism Score


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Capital “Score” Required vs. Available

Defined by Balance Sheet Assessment

Defined by Model Results


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Confirmed overall existing capital assessment of Fitch universe

Limited (~10% of group’s reviewed) Prism related rating actions

Certain sectors performed better than expected e.g. personal auto

Prism: 2006 US Non-Life Results


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Topics

Background on Prism

Prism’s Catastrophe Risk Component

What Does it Mean for Ratings?


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Prism’s Catastrophe Risk Component

  • Insurer provided modeled annual aggregate catastrophe losses at various return periods

    • Frequency / Severity Assumptions = Near-term

    • Demand Surge = Occurrence base

  • AIR Catrader models gross annual aggregate catastrophe losses at various return periods based on by state premium distribution and AIR event sets

  • Interpolation generates modeled annual aggregate gross loss distribution ranging from 20-10K year return periods


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Prism’s Catastrophe Risk Component (cont.)

  • Catastrophe reinsurance program applied against gross losses to create annual aggregate modeled net loss distribution

    • Alternatively will use insurers full net annual aggregate catastrophe loss distribution if provided

  • Alternatives to traditional reinsurance (i.e. catastrophe bonds, ILWs) added to catastrophe reinsurance program based on perils and attachment points


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Prism’s Catastrophe Risk Component (cont.)

  • Modeled net catastrophe losses combined with other risk components to determine each scenario’s additional capital needs


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Topics

Background on Prism

Prism’s Catastrophe Risk Component

What Does it Mean for Ratings?


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What Does this Mean for Ratings?

  • Capital required to support catastrophe risk varies by company and rating category

    • Fitch does not have single by rating category catastrophe exposure related capital requirements


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What Does this Mean for Ratings? (continued)

  • Catastrophe related “stress test” implicitly considered through

    • Use of annual aggregate modeled catastrophe losses

    • T-VaR approach applied to overall required capital distribution

    • In unique cases, modeled catastrophe results can also be stressed by shifting company supplied or CATRADER generated loss distributions upward


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Catastrophe Findings from 2005 Beta Testing

  • Insurers with large homeowners or coastal property coverages have tremendous capital exposure to extreme tail events

    • For these insurers required capital can materially exceed 100 year and 250 year PML used in factor based models

  • Others such as specialty liability underwriters have virtually no catastrophe exposure

  • For universe in aggregate, catastrophe related required capital was equal to 8.9% of aggregate exposure

  • Ignoring insurers without catastrophe exposure, range of required catastrophe capital / exposure was 6% - 37%


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Results of 2005 Beta Testing by Sector


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Takeaways

  • Fitch uses Prism to determine capital requirements for natural catastrophe risk

  • Prism considers modeled annual aggregate catastrophe loss distributions rather than select points along the distribution to develop capital requirements

  • Capital required to support catastrophe risk varies by insurer and by rating category

  • “Stress Tests” implicitly considered through annual aggregate and T-VaR approaches employed by Prism


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Dedicated Website: www.fitchratings.com/prism

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