Actuarial Notes

Earthquake Exposure Sound Practices

By Office of the Superintendent of Financial Institutions · 2013 · B-9

Study guide: Exam 6C

OSFI Guideline B-9 sets out expectations for the policies and procedures of P&C insurers that write business materially exposed to earthquake-related losses. Those policies should form part of an insurer's overall catastrophe risk management. The guideline also sets out common parameters and other factors for calculating probable maximum loss (PML), which, compared with the financial resources available, lets an insurer assess its capacity and financial preparedness to handle claims from a major earthquake, and it has insurers report earthquake exposure information to OSFI annually. It is dated February 2013.

On the syllabus

  • Exam 6C — objectives C1 and C5; the whole guideline.

I Purpose and Scope

  • Catastrophic losses from earthquakes may pose a significant threat to the financial wellbeing of many P&C insurers and reinsurers, who must measure, monitor and limit their exposures in accordance with a prudent risk appetite and risk tolerance.

II Key Principles

  • OSFI assesses an insurer's earthquake exposure risk management policy against the principles and may require remedial action; because catastrophe models carry significant uncertainty, governance, risk limits, risk transfer and risk avoidance matter as much as the models.
  • 1 Earthquake Exposure Risk Management
    • Policies & Procedures
      • Earthquake policies and procedures cover the risk appetite and risk tolerance for earthquake insurance, data management, exposure aggregation monitoring, the selection and use of models, PML factors, the financial resources available against the PML, and contingency plans.
    • Senior Management
      • Insurers should have a sound and comprehensive earthquake exposure risk management policy overseen by senior management (the Chief Agent for a foreign branch).
  • 2 Earthquake Exposure Data
    • Data Integrity
      • Earthquake exposure data needs to be appropriately captured and regularly tested for consistency, accuracy and completeness, and reviewed at least annually by individuals independent of its collection.
  • 3 Earthquake Models
    • Use of Earthquake Models
      • Earthquake models should be used with sound knowledge of their assumptions and methodologies and with a high degree of caution that reflects the significant uncertainty in their estimates.
    • Sound Earthquake Model Practices
      • Insurers should understand how model settings affect the PML, the handling of demand surge, fire following and business interruption, and modelled versus non-modelled losses, and explain materially different results from more than one model.
    • Model Versions
      • A material change in a commercial model is expected to be adopted within one year of its release, or the insurer explains why not.
    • Model Validation
      • Validation should show that, over a sufficient historical period, model-based losses are consistent with actual losses, or use a suitable prudent proxy.
  • 4 PML Estimates
    • PML estimates should properly reflect the total expected ultimate cost to the insurer, including considerations for data quality, non-modelled exposures, model uncertainty and exposures to multiple regions.
    • Data Quality
    • Non-Modelled Exposures and Risk Factors
    • Model Uncertainty
    • Exposures to Multiple Regions
      • PMLs historically based on the larger of the British Columbia or Quebec PML understate the PML for insurers exposed in both zones; PMLs should be based on Canada-wide exposure for foreign insurers and worldwide exposure for Canadian insurers.
  • 5 Financial Resources and Contingency Plans
    • Insurers need an adequate level of financial resources and appropriate contingency plans to manage through a major earthquake.
    • Financial Resources
      • Policies should outline how financial resources cover the gross PML; insurers refer to OSFI's MCT Guideline for the regulatory test of financial preparedness for earthquakes.
      • 1 Capital and Surplus
      • 2 Earthquake Reserves
      • 3 Reinsurance Coverage
        • Non-catastrophe reinsurance may count if the insurer considers per-event limits and other events that could exhaust it; letters of credit or guarantee facilities from a parent cannot support the gross PML.
      • 4 Capital Market Financing
        • Requires OSFI's prior approval before it can be recognized as a financial resource under the MCT.
    • Contingency Plans
      • Contingency plans address the key elements of claims management: emergency communications, claims and adjustment personnel, and off-site systems back-up including reinsurance records.

III Regulatory Reporting

  • All insurers file an annual Earthquake Exposure Data form with OSFI, or a letter stating they have no material earthquake exposure; exposure can arise under automobile and marine as well as property policies, and from fire following and tsunami.

IV Guideline Administration

  • Supervisory Information
    • OSFI expects the insurer's annual Financial Condition Testing to consider an earthquake event, or document the rationale for not including it.
  • Capital / Asset Requirements
    • If an insurer fails to meet the principles, OSFI may adjust its capital or asset requirements or target solvency ratios.
  • Reporting
    • A senior officer should regularly report to senior management on the earthquake exposure and how it is managed, including the PML and the financial resources that support it.
  • Implementation
    • Each insurer files an approved copy of its earthquake exposure risk management policy with its OSFI Relationship Manager.

V Description of Terms

  • Earthquake Insurance, Probable Maximum Loss (PML), Risk Appetite and Risk Tolerance.
  • PML is the threshold dollar value of losses beyond which losses caused by a major earthquake are unlikely; with probabilistic models it is the loss expected to be exceeded once in every X years. Gross PML is after deductibles but before reinsurance; net PML is after both.

VI Other OSFI Guidance

  • The Supervisory Framework, the Minimum Capital Test, the Corporate Governance Guideline, Guideline B-3 Sound Reinsurance Practices and Procedures, and Guideline E-17 on background checks on directors and senior management.

Related readings

  • OSFI MCT — the Minimum Capital Test, to which Principle 5 refers for the regulatory test of financial preparedness and the earthquake reserve requirements
  • OSFI Reinsurance — Guideline B-3, which Principle 5 says reinsurance programs should follow
  • OSFI Corporate Governance — referred to for OSFI's expectations of Boards (Principle 1) and listed in Section VI

Sources