In the summer of 2021, an area of low pressure brought heavy rains to western Germany causing devastating damage and costing many people their lives. According to experts, global warming is expected to result in an increase in extreme weather events in future. In other words, the risk of natural catastrophes is increasing. German primary insurers and reinsurers are able to guard against the cumulative losses that often follow from natural catastrophes. This was the finding of a recent survey by BaFin. However, the costs of reinsurance are rising, as are premium prices for policyholders.

For its analysis, BaFin surveyed 176 primary insurers and reinsurers that are exposed to natural catastrophe risk from their insurance contracts. The analysis covered the reinsurance structure in addition to the impact on pricing of the heavy rainfall in summer 2021. In addition, BaFin examined whether assessments of natural catastrophe risks in procedures used by insurers to calculate the solvency capital requirement are still appropriate.

These procedures include the predefined standard formula under Solvency II and the (partial) internal models developed by insurers. BaFin also examined the extent to which insurers consider the quantitative and qualitative aspects of these risks in their Own Risk and Solvency Assessment (ORSA).

Outward reinsurance largely appropriate

The survey showed that, with only a few exceptions, primary insurers and reinsurers consider their outward reinsurance, taking the increased regional damage following the heavy rainfalls in 2021 into account, to be appropriate. At the same time, a significant portion of primary insurers and reinsurers have adjusted their reinsurance structure or are planning adjustments, primarily in order to achieve greater reinsurance protection against accumulation losses.

The costs of reinsurance protection for primary insurers and reinsurers have increased significantly, with increases ranging from 20 to more than 70 percent. This is due to increased demand for reinsurance protection, particularly flood coverage, and the concurrent withdrawal of some reinsurers from specific natural catastrophe coverage, as well as inflation. The increase in reinsurance costs was slightly lower for reinsurers than for primary insurers.

Many primary insurers reported that they had increased prices in the affected insurance classes or planned to do so since premiums were no longer sufficient in light of future expected claims and the increased costs of reinsurance protection. Supervisory provisions require insurers in all insurance classes to set risk-appropriate premium rates. This can result in higher prices for policyholders. However, price increases that have been planned or implemented so far are lower than the cost increases described for reinsurance protection.

All in all, the responses provided by the insurers surveyed show that there is sufficient capacity in the primary insurance and reinsurance markets for insurers to protect themselves against the cumulative losses that often follow natural catastrophes – provided they are willing to accept and can pay the higher prices.

Standard formula: adequate risk capital requirements in the market as a whole

BaFin’s analysis also showed that, considering the market as a whole, the amount of risk capital to be held in accordance with the standard formula was adequate. At a few insurers, however, net claims expenditure was higher than the required risk capital. The 1-in-200 year gross loss estimated as at 31 December 2020 for all insurers that use the standard formula amounted to almost 16 billion euros. From a statistical perspective, the 1-in-200 year loss is deemed likely to occur no more than once every 200 years. This figure is used to determine the solvency capital requirement. It was therefore almost double the actual gross loss incurred as a result of the heavy rainfall in 2021. For primary insurers and reinsurers (users of the standard formula), actual losses amounted to almost 7 billion euros.

This result was confirmed at the level of individual insurers. The (net) claims incurred by the majority of insurers affected by the flood disaster were lower – in some cases by a significant margin – than the regulatory capital requirement for a 1-in-200 year loss for flood risk. One explanation for this is that the insurance portfolios of many German insurers are very well diversified geographically. This is essential if the standard formula is to appropriately reflect natural catastrophe risks.

At a small number of affected insurers, however, the opposite was true: their estimated net claims expenditures from the heavy rainfall in 2021 was higher than the regulatory capital requirement for flood risk. Some of these insurers’ portfolios were concentrated in certain affected regions. In other words, they were not well diversified geographically. Those insurers might be failing to meet an important implicit assumption under the standard formula and should therefore pay particular attention to the following section of this article:

Standard formula insurers in the ORSA: own natural catastrophe models widespread

More than 40 percent of non-life insurers that use the standard formula make use of their own natural catastrophe model in the ORSA in order to model natural catastrophe risks in a risk-sensitive manner. They also make use of this model as part of their corporate management.

In future, BaFin will look more closely into insurers’ individual natural catastrophe models in the ORSA. The goal is to ensure that insurance undertakings appropriately manage their natural catastrophe risks. In general, all standard-formula users must, as part of the ORSA process, evaluate whether and to what extent the standard formula risk assessments are appropriate to their own risks. This applies above all to insurers with low geographical diversification.

BaFin expects affected insurers to analyse their natural catastrophe risk using their own suitably calibrated natural catastrophe model in order to identify possible deviations from the standard formula. If there is significant deviation between the assumptions in the standard formula and the actual individual risk calculated, insurers must take action. This is because the regulatory capital requirements must correspond to the insurer’s actual risk.

Options for reducing risk

To reduce risk, insurers can increase their geographical diversification or product variety, or they can use a (partial) internal model. They also have the option of taking further measures to reduce their own risk, such as adjusting their reinsurance structure.

If an insurance undertaking is unable to reduce a significant deviation between the standard formula and its actual risk, BaFin can impose risk capital add-ons. This is based on section 301 (1) no. 1 of the Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) in conjunction with Article 279 of Commission Delegated Regulation (EU) 2015/35.

It is essential that the standard formula is regularly reviewed for all natural catastrophe risks, particularly in view of climate change and the increase in (local) natural catastrophe events. In accordance with the upcoming amendment to the Solvency II Framework Directive, such reviews are to be carried out every five years.

Representation of flood risk in internal models

In light of the heavy rainfall in summer 2021, BaFin also examined how the natural catastrophe risk of flooding in Germany is reflected by insurers that make use of an internal model. For this, insurers had to present the model they used at the time of the flood disaster. They were requested to demonstrate the strengths and weaknesses of their models and to report on changes to the model that they either considered necessary or had already implemented in the aftermath of the event. In addition, insurers were asked to provide selected risk metrics from the model and to assess trends in flood risk and claims – in particular those associated with anthropogenic climate change.

The results showed that the precipitation characteristics of the event did not impact on the general suitability of the models. All models used were able to cover the loss potential observed. Losses from heavy rainfall events can be deemed, in general, to be adequately reflected in the various models. At the same time, the insurers also acknowledge that state-of-the-art modelling reflects the effects of precipitation in detail.

Nonetheless, the insurers surveyed see room for improvement with regard to certain event characteristics observed. For example, improvements are deemed necessary in the modelling of flood waves with high flow velocities, which can quickly develop in narrow river valleys.

BaFin expects all insurers to regularly review their models and to fully comply with their own validation guidelines. They must demonstrate in detail that the climate states represented in their models are up to date. Further discussions are needed with selected insurers on this matter.