Regulator Questions Modelling Use

The UK’s regulator has thrown into question the industry’s use of models to manage catastrophe exposures.

In a letter to re/insurance CEOs the Prudential Regulatory Authority’s (PR) Acting Director, Insurance Supervision, Gareth Truran has warned that the authority has concerns around the over reliance on and the accuracy of the models.

In his letter Mr Truran said recent natural catastrophes highlighted the need for underwriters to reassess the adequacy of its exposure management data and control along with their strategies for risk mitigation. He then questioned the validity of the industry’s models.

“We encourage firms to consider whether their historical information and models continue to represent current hazard and exposure trends,” said Truran. “Over the last year we have undertaken a series of exposure management review and we see a number of areas for improvement. We expect firms with material catastrophe risk exposures, or those planning to expand their exposure materially, to take these potential weaknesses into account when reviewing the appropriateness of their risk appetites and exposure management controls.”

Mr Truran added: “We remain concerned that some firms place excessive reliance on estimates of exposure which have been derived from complex models, especially when setting their exposure tolerances and reinsurance strategies. Such firms may experience losses which are much larger than expected if these model assumptions prove misplaced.”

He said firm should consider back-testing actual and near miss losses against modelled estimates “which can highlight firms’ potential for model error when assessing current hazard and exposure trends”.

In the letter Mr Truran revealed PRA’s Priority areas for the year ahead. These are reserve adequacy, underwriting disciplined underwriting strategy, exposure management, and internal culture in the wake of the damning Lloyd’s report into the London market and its behaviour.

“You can expect our supervisory focus over the next year to include discussions with you, your boards and management teams to understand how your firm is addressing these issues,” he added.

He said there were signs that reserving deficiencies were on the increase and that management at some firms were coming under pressure to deliver improved results that may see actuarial judgements around the level of necessary reserving being challenged.

He said the PRA would take a strong line on the issue and that if it suspected any under reserving it would not hesitate to consider launching a skilled persons review under section 166 of the Financial Services and Market Act.

The letter also highlighted concerns over the issue of exposure management. Having seen what, it described as “further notable large losses, some with unexpected risk characteristics, the PRA noted the premiums levels were beginning to harden.

However, Mr Truran added: “While some firms appear to have adapted their strategies and business plans others are still struggling to achieve underwriting profitability and have not yet complete remediation work to deal with potential under-pricing of risk.”

The letter said that the PRA’s work has also highlighted underwriting control weaknesses which affect firms’ “ability to understand profitability and exposures at a sufficiently granular level”.

On cultural change Mr Truran said firms needed to address the culture as it had an impact n its perceived performance.

“Recent reports relating to sexual harassment and bullying within the London market are of deep concern and it is clear some firms have more work to do to improve aspects of corporate culture and individual behaviour.”.

Mr Truran warned instances of nonfinancial misconduct “could speak to personal integrity and may have implications for our view of the fitness and propriety of individuals within our Senior Managers and Certification Regime”.

He added that the PRA will work with the FCA “to assess instances where inappropriate culture and behaviour within firms may impact compliance with regulatory expectations, standards and statutory objectives.”