Draft revisions to Earthquake Financial Resource Formula and Earthquake Data Collection Form for Consultation

Document Properties

• Type of Publication: Memorandum
• Date: July 2013
• Audiences: P&C

Purpose

This memorandum sets out a revised proposal regarding the methodology for the measurement of earthquake exposure and earthquake financial resource formula. In addition, the memorandum presents a proposed revision to the annual Earthquake Exposure Data Form.

Background

In February 2013, OSFI published Guideline B-9 (Earthquake Exposure Sound Practices), which expects companies^{Footnote 1} to account for risk that may result from exposures to more than one region. As outlined in the cover letter to Guideline B-9, OSFI agreed to continue discussions with the industry to finalize the methodology to measure earthquake exposure.

Earthquake Probable Maximum Losses (PMLs) have historically been based on the larger of the British Columbia (BC) or Quebec (QC) PMLs. The historical approach understates the PML for insurers with significant exposures in both earthquake zones. OSFI has been conducting consultations and revising relevant guidance to ensure that earthquake PML is being appropriately measured and accounted for in its guidelines and expectations.

To continue these discussions, OSFI formed a working group that included the British Columbia Financial Institutions Commission (FICOM), Québec’s Autorité des marchés financiers (AMF) and the Insurance Bureau of Canada (IBC). This working group was tasked to find appropriate alternative earthquake PML measures. The working group agreed that the financial resource requirements for earthquake exposures should take into account a company’s actual level of earthquake exposure, whether in one or more regions.

The working group used the following evaluation criteria when considering alternative measures:

1. The proposed measure would be at least as large as current one.

2. Financial resources for a company with country-wide exposure would reflect their higher exposures compared to a regional company.

3. The methodology would be simple enough to be auditable.

4. The proposed measure for a Canada-wide risk would be less than the sum of the required regions, effectively recognizing diversification assuming the earthquake risks from multiple regions are independent.

Proposal

The formula arrived at by the working group is as follows:

The formula was selected because it fulfills the working group’s mandate and meets or exceeds all evaluation criteria outlined above. The parameter 1.5 is chosen from a range of one to two as being appropriate at the current time.

• It builds on the current, well-understood regional PML measure (Eastern and Western), expanding to account for risk exposure across Canada, and provides continuity with the current approach.

• It is a sub-additive, one of characteristics of a coherent risk measure.

• It is based on transparent mathematical formula and well-known risk measures.

• It does not require any changes to modelling software or estimation technology.

• It is simple to interpret and explain to senior management and Boards of Directors.

• It is an internationally recognised and tested approach.

OSFI will continue to monitor earthquake models, and, if models change significantly, will consider changes to this formula at that time. Draft wording for the Minimum Capital Test (MCT) Guideline with the formula is attached in the appendix A.

Analysis

OSFI used earthquake filing data to study the overall impact of the formula. Detailed analysis is attached as Appendix C.

• The overall PML regulatory requirement for the year 2022 will increase by $2.8 billion or 8.9% from the current $31.3 billion to $34.1 billion. The changes have the largest impact on the national writers where their BC and QC exposure are similar. Foreign companies, companies without personal property or large-sized companies (i.e. those with equity^{Footnote 2} greater than $500 million) are more likely to have a greater than 15% increase in PML.

• More than half of the affected companies already have financial resources related to earthquake risk at a level higher than the proposed 2022 regulatory requirement. Therefore, only $1.5 billion out of $2.8 billion will require additional financial resources. Further, the annual cost of an additional reinsurance requirement of $1.4 billion is likely to be less than $50 million.

• The additional requirements, like the current requirements, will be fully phased in by 2022. Given the phase in period and a marketplace where more than half of the companies already meet the proposed requirement, OSFI expects the impact of the additional reinsurance cost will be manageable on an industry-wide basis.

Consultation Period

All federally regulated P&C companies are required to file an Earthquake Exposure Data Form with OSFI annually. Appendix B - the proposed Earthquake Exposure Data Form – is provided for your comments.

OSFI anticipates both the revised MCT guideline (Appendix A) and Earthquake Exposure Data Form (Appendix B) to become effective January 1, 2015. OSFI would appreciate receiving comments on both the proposed changes on or before August 31, 2013.

Questions concerning this memorandum should be addressed to your OSFI Relationship Manager or to Kun Zhang, Actuarial Division, by email at kun.zhang@osfi-bsif.gc.ca.

Questions with respect to the draft MCT guideline section may also be addressed to Judith Roberge, Capital Division, by email at Judith.Roberge@osfi-bsif.gc.ca.

Appendix A: Wording for the Minimum Capital Test (MCT) Guideline

4.6. Catastrophes

4.6.1 Earthquake Risk Exposure

Insurers must refer to OSFI’s Guideline B-9 (Earthquake Exposure Sound Practices) for details on OSFI’s expectations relating to P&C insurers’ earthquake exposure risk management. The MCT Guideline outlines the framework for quantifying the earthquake risk exposure for regulatory capital purposes and assessing insurers’ capacity and financial preparedness to meet contractual obligations that may arise from a major earthquake.

Earthquake Reserves Formula:

The amount of earthquake reserves includes Earthquake Premium Reserve (EPR) and Earthquake Reserve Component (ERC) and is added to total capital requirements for the purposes of the MCT/BAAT as capital/margin required at the target level.

where

4.6.1.1 Measurement of Earthquake Risk Exposure

The earthquake Probable Maximum Loss (PML) is the threshold dollar value of losses beyond which losses caused by a major earthquake are unlikely. Gross PML, which is the PML amount after deductibles but before catastrophic and other reinsurance protection, is used for calculating earthquake exposure for regulatory purposes. In this section, PML refers to a dollar amount^{Footnote 3} that includes adjustments for data quality, non-modelled exposures and model uncertainty as outlined in Guideline B-9 (Earthquake Exposure Sound Practices).

Model approach

P&C insurers with material exposure to earthquake risk are required to use models to estimate their PML. Earthquake models include models licensed from various commercial vendors and maintained in-house or run by third parties on behalf of the insurer or can be an internal estimation technique or model developed by the insurer to OSFI’s satisfaction.

OSFI requires that P&C insurers continue to progress to a 500 year PML from earthquakes by 2022. Consequently, OSFI expects an insurer to meet a test of financial preparedness for a 500 year return period country-wide earthquake event by no later than the end of fiscal year 2022.

where

East Canada PML500

is a one in 500 year Eastern Canada event, which represents the 99.8^th percentile of the exceeding probability curve plus appropriate adjustments for data quality, model uncertainty, non-modelled business etc., using exceeding probability curves based only on earthquake exposure in Eastern Canada.

West Canada PML500

is a one in 500 year Western Canada event, which represents the 99.8^th percentile of the exceeding probability curve plus appropriate adjustments for data quality, model uncertainty, non-modelled business etc., using exceeding probability curves based only on earthquake exposure in Western Canada.

Recognizing the impact resulting from the new country-wide PML500 requirement, insurers may continue to phase-in their increased earthquake risk exposure until 2022 using the following formula:

where

Year

is the current reporting year (subject to a maximum of 2022)

East Canada PML420

is a one in 420 year Eastern Canada event, which represents the 99.76^th percentile of the exceeding probability curve plus appropriate adjustments for data quality, model uncertainty, non-modelled business etc., using exceeding probability curves based only on earthquake exposure in Eastern Canada.

West Canada PML420

is a one in 420 year Western Canada event, which represents the 99.76^th percentile of the exceeding probability curve plus appropriate adjustments for data quality, model uncertainty, non-modelled business etc., using exceeding probability curves based only on earthquake exposure in Western Canada.

Standard approach

P&C insurers should use the following standard formula for calculating their PML if;

• The insurer does not use an earthquake model for calculating its PML, or
• An earthquake risk exposure estimation technique is not to OSFI’s satisfaction

where

PTIV

is the property total insured value for earthquake exposure, which includes building, contents, outbuilding, additional living expenses and business interruption.

4.6.1.2 Financial Resources

An insurer must have adequate financial resources to cover its earthquake exposure calculated in section 4.6.1.1. Financial resources that can be used to support the insurer’s earthquake exposure include:

• capital & surplus;
• earthquake reserves:
  • earthquake premium reserve,
  • earthquake reserve component;
• reinsurance coverage; and
• capital market financing.

Capital and Surplus

Insurers can count up to a maximum of 10% of capital and surplus as part of their financial resources to cover their earthquake risk exposure. This maximum limit is subject to supervisory discretion and can be lowered to an amount less than 10% of capital and surplus.

For Canadian P&C insurers, capital and surplus corresponds to a maximum of 10% of total equity as reported in the most recent P&C-1 return.

A Canadian branch of a foreign P&C insurer may use up to 10% of its worldwide capital and surplus to cover its earthquake exposure; however, it must be able to demonstrate that after an event, at least 10% of the worldwide capital and surplus is still available to meet its obligations to Canadian policyholders. The amount of worldwide capital and surplus corresponds to the Canadian dollars amount reported in the most recent P&C-2 return.

Earthquake Reserves

Earthquake Premium Reserve (EPR) is the voluntary accumulation of earthquake premiums. This amount must not exceed the country-wide PML500^{Footnote 4}.

• In the case of catastrophic reinsurance coverage not specific to earthquake risk, an allocation of the premium amount must be made. Companies should be able to demonstrate the reasonableness of their ratemaking.

• Any earthquake premium contributed to the EPR must remain in the EPR unless there is a material decrease in the exposure.

• Should an earthquake occur and trigger claims, companies would establish an unpaid claims provision as well as a provision for claims adjustment expenses. The EPR component would be reduced by an amount equal to the claims reserves.

• Any reduction in EPR should be brought back into unappropriated surplus immediately.

• The EPR is a component of the reserves amount reported on the balance sheet.

Earthquake Reserve Component (ERC) is an additional component used to cover an insurer’s earthquake exposure not covered by the other financial resources. The ERC must always be greater than or equal to 0 and is equal to:

• Should an earthquake occur and trigger claims, companies would establish an unpaid claims provision as well as a provision for claims adjustment expenses. The ERC component would be reduced after the EPR, by an amount equal to the claims reserves.

• Any reduction in ERC should be brought back into unappropriated surplus immediately.

• The ERC is a component of the reserves amount reported on the balance sheet.

Reinsurance Coverage

Estimated reinsurance coverage available should be based on reinsurance policies in force on the day immediately following the end of the financial reporting period (e.g., policies in force on July 1 for MCT calculations as of June 30).

Capital Market Financing

Prior approval from OSFI is required before these instruments can be recognized as a financial resource in the calculation of the earthquake risk formula.

Refer to Guideline B-9 (Earthquake Exposure Sound Practices) for additional information.

Appendix B: OSFI Earthquake Filing Form

Name of Company^{Footnote 5}(s): Line to fill out ______________________________________

Date (January 1, 201X): Line to fill out _______________________________________

1. Materiality

1.1. Check the appropriate response.

1. No exposure to earthquake risk to this company.

   If your answer is a., please disregard the remainder of the form.

2. Non-material exposure to earthquake risk to this company and we will not be using a model to estimate our earthquake exposure, therefore we will use the standard approach formula outlined in the MCT Guideline.

   If your answer is b., please complete section 1 and 2.

3. For all other companies using an EQ model^{Footnote 6}, please complete the remainder of the form.

1.2. Describe how materiality was determined for earthquake risk.

1.3. If your answer is b, complete the following table:

Date of data	Region	Total Earthquake Exposed Insured Value	Policyholders’ Deductibles
	East Canada
	West Canada

2. Elements of the Reserving Formula

2.1. Complete the following table based on the requirement in MCT guideline.

	Max (East, West) PML420	Country-Wide PML(Year)	Country-Wide PML500
PMLFootnote 7 (Total, all perils)
Catastrophe treaty collectable	Shaded cell
Other reinsurance collectable	Shaded cell
Retention	Shaded cell

10% of Capital & Surplus
Capital market financing
Voluntary EPR
Required ERC
Earthquake Reserves

Annual renewal date for - catastrophe program

3. Model selection

3.1. If you have determined that earthquake risk is material for your company, you are required to use a model (external or internal) to determine your earthquake exposure. What models are used and who operates them for your company? Check as many as apply.

Model Information			Operated By
Provider	Model Name	Model Version	Internal Staff	Outsourced
				Reinsurance Broker	Others
RMS
AIR
EQE
Internal Model (please describe in 3.2)				Shaded cell	Shaded cell

3.2. Internal models can vary significantly in sophistication (and simple approaches may be appropriate for some insurers). Please briefly describe your internal estimation technique or model approach.

4. Non-modeled perils and model operations

4.1. Indicate whether the following risks are considered in modeling the PML. If yes, describe the assumptions used in the loss estimation.

Risk	Included in PML	If yes, briefly describe the assumptions
	Yes/No
Exposure growth		Footnote 8
Business interruption
Claims handling expenses
Adequacy of insurance to value
Guaranteed replacement cost
Debris removal
Increased seismicity after a large event
Blanket coverage
Coverage extensions or clauses

4.2. Supplemental perils and model options:

	Included in PML
	Yes/No
Tsunami
Secondary uncertainty
Time dependencyFootnote 9

4.3. Other adjustments information:

	Yes/No	Dollar Amount ('000s)
Adjustments for exposure data quality:
Adjustments for model deficiencies-severity:
Adjustments for model deficiencies-frequency:
Adjustments for demand surge:
Other factors for prudence:

5. Data quality control

5.1. Describe the company’s quality control processes around data collection and entry including materiality standards.

5.2. Describe the company’s review processes independent of those responsible for data collection and data quality (e.g. internal or external review).

6. Model results for Primary Insurer

6.1. Complete the following table with the range of modeled output

	Personal Property			Commercial Property			Auto	Total
West Canada	Shake (1)	Fire (2)	Other (3)	Shake (4)	Fire (5)	Other (6)	All Perils (7)	Sum (1) to (7)
TIVFootnote 10 ($ Millions)							n/a	n/a
PML 250 ('000s)
PML 500 ('000s)

	Personal Property			Commercial Property			Auto	Total
East Canada	Shake (1)	Fire (2)	Other (3)	Shake (4)	Fire (5)	Other (6)	All Perils (7)	Sum (1) to (7)
TIV ($ Millions)							n/a	n/a
PML 250 ('000s)
PML 500 ('000s)

	Personal Property			Commercial Property			Auto	Total
WorldwideFootnote 11	Shake (1)	Fire (2)	Other (3)	Shake (4)	Fire (5)	Other (6)	All Perils (7)	Sum (1) to (7)
TIV ($ Millions)							n/a	n/a
PML 500 ('000s)

6.2. Complete the following table in regard to Average Annual Loss (AAL)^{Footnote 12} as produced by your model:

Top 3 forward sorting area (FSA) in terms of AAL	AAL (‘000s)
1.
2.
3.
Overall AAL

6.3. Divide the worldwide PML at the reserving level for the current year-end into the following categories:

World-wide PML	('000s)
Primary risks
Assumed risks

6.4. Divide the reinsurance coverage used to cover the PML for the end of relevant period of exposure into the following categories:

Reinsurance coverage	('000s)
Canadian companies
Foreign companies (branches)
Lloyd's
Non-registered affiliates
Other non-registered
Total reinsurance coverage

6.5. Complete the following table as to the level of detail to which data is coded

	% of TIV
	Personal Property	Comm. Property
Geocoding
Exact street address
6-digit postal code
FSA
Other

7. Model results for Reinsurer

7.1. Complete the following table with the range of modeled output

	Excess of Loss		Proportional		Facultative		Total sum (1) to (6)
West Canada	Catastrophe (1)	Per Risk (2)	Proportional (3)	Other (4)	XOL (5)	Proportional (6)
TIV ($ Millions)
PML 250 ('000s)
PML 500 ('000s)

	Excess of Loss		Proportional		Facultative		Total sum (1) to (6)
East Canada	Catastrophe (1)	Per Risk (2)	Proportional (3)	Other (4)	XOL (5)	Proportional (6)
TIV ($ Millions)
PML 250 ('000s)
PML 500 ('000s)

	Excess of Loss		Proportional		Facultative		Total sum (1) to (6)
Worldwide	Catastrophe (1)	Per Risk (2)	Proportional (3)	Other (4)	XOL (5)	Proportional (6)
TIV ($ Millions)
PML 500 ('000s)

7.2. Complete the following table in regard to Average Annual Loss (AAL) as produced by your model.

Top 3 cedents in terms of AAL	AAL (‘000s)
1.
2.
3.
Overall AAL

7.3. Complete the following table in regard to your catastrophe-excess of loss coverage (Cat XOL).

Top 3 cedents in terms of Cat XOL	Limit Provided
1.
2.
3.
Overall catastrophe excess of loss

7.4. Divide the reinsurance coverage used to cover the PML for the current year-end into the following categories:

Reinsurance Coverage	('000s)
Canadian companies
Foreign companies (branches)
Lloyd's
Non-registered affiliates
Other non-registered
Total reinsurance coverage

Appendix C – Data study

The proposed approximation formula to the country-wide (CW) 500 year PML is based on an adjustment to the well-known “square root of sum of squares”. The square root of sum of squares is appropriate for normal loss distribution^{Footnote 13}. However, for the earthquake peril with heavy-tailed loss distribution, the parameter 1.5 is chosen from a range of one to two as being appropriate at the current time. OSFI studied the proposed impact using data from 2012 Earthquake Data Filings and Appointed Actuarial Reports.

1. Summary of the companies used in analysis:

• There were 82 companies used in the analysis.

• There are 10 companies that do not have earthquake (EQ) exposure but share reinsurance with other affiliated companies of the same group, so they are included within the capital adequacy study.

• There are 57 companies excluded due to a lack of EQ exposure in BC or QC.

• There are 18 (out of 167) companies excluded due to EQ data error in their filings.

Table1: Summary of Data (*Net earned premium is from all lines combined.)

$ in Million	BC Net Earned Premium	QC Net Earned Premium	Total Equity	# of companies
companies used in analysis	2,742	4,047	29,216	82
companies no EQ exposure but share reinsurance	90	42	878	10
companies excluded due to lack of EQ exposure	172	136	7,027	57
companies excluded due to EQ data error	224	704	3,361	18
Total	3,228	4,929	40,482	167
companies excluded due to EQ data error (% of total)	7%	14%	8%	11%

2. Overall PML Movement

• The overall PML regulatory requirement for the year 2022 will increase by $2.8 billion (1.5 + 1.3) or 8.9% from the current $31.3 billion to $34.1 billion.

• More than half of the affected companies already have financial resources related to earthquake risk at a level higher than the proposed 2022 regulatory requirement. Therefore only $1.5 billion out of $2.8 billion will require additional financial resources.

Graph 1: the overall movement of PML

Table2: The Overall Movement of PML ($ in Million)

Count of Companies	BC PML500	QC PML500	2012 Current PML	2022 Max (BC500, QC500)	2022 CW PML500
82	30,974	7,882	26,668	31,338	34,103
Incremental increase				4,670	2,765
Cumulative increase				4,670	7,435

3. Impact of CW PML500 to Max PML500

• Impact = CW PML500 / Max PML500 − 1

• Roughly 90% of the market (measured by exposure to earthquake) will have increases in minimum requirements of less than 15%.

• Foreign companies, companies without personal property or large-sized companies (i.e. those with equity^{Footnote 14} greater than $500 million) are more likely to have a greater than 15% increase in PML.

Graph2: Impact in PML by Characteristics of Companies

4. Financial Resource Adequacy (group level) (in ‘000)

Financial Resource Available = Reinsurance Collectable + 10% Capital and Surplus + Earthquake Reserves

• If the Catastrophe limit and deductible are available in Appointed Actuary Report, these data points were used to calculate financial resource available. Otherwise, the reinsurance collectable from EQ filing is used.

• If the company did not have EQ exposure, its capital was still included in financial resource available for the overall insurance group. There are 10 such companies in this category.

• Additional reinsurance required is $1.4 billion. The additional annual industry aggregate reinsurance cost is estimated to likely be less than $50 million (assuming rate on line (ROL) is 3%).

Table3: Financial Resource Adequacy & Reinsurance Cost ($ in Million)

Meet 2022 CW PML Requirement	2022 Max(BC500, QC500)	2022 CW PML 500	Finance Resource Available	Equity	Addi. Reins. Required	Reins. Cost 3% ROL	Reins. Cost To Equity Ratio
no	14,395	15,856	13,746	9,156	1,393	41.8	0.46%
yes	16,943	18,247	37,786	20,938
Total	31,338	34,103	51,532	30,093	1,393	41.8	0.14%

Graph3: Financial Adequacy by Characteristics of Companies