UK regulators insurance stress test to produce telling results for ILS

The UK’s city and financial regulator, the Prudential Regulation Authority unit of the Bank of England, has launched a series of robust stress tests for general insurers which could produce telling and interesting results for reinsurance, ILS and catastrophe bonds.

The PRA is seeking to stress test general insurers capital adequacy, reserves and reinsurance or risk transfer arrangements, with a series of tests designed to create worst case loss scenarios. The tests range from a year with three major hurricane’s to a coordinated multi-city terrorist attack.

As part of the test, insurers will be expected to detail their expected reinsurance recoveries under each scenario as well as the split across reinsurers they use. Any reinsurer where expected recoveries would be more than 2% of the loss should be detailed, which likely means that some ILS players, with their growing line sizes, would be highlighted.

With that level of granularity expected to be produced from the stress test reports, the results are likely to demonstrate any exposure that would be passed on to the insurance-linked securities (ILS) or catastrophe bond market.

With ILS fund managers participating in many of the UK general insurers reinsurance programs, there are a number of scenarios in particular which are likely to result in some losses to ILS players and their collateralised reinsurance products.

The scenarios that will be stress tested are a two European windstorm hit with a major UK flood event resulting, a multiple U.S. hurricane year (the Katrina, Rita, Wilma scenario), a coordinated terrorist attack, across London, New York and European cities, a motor liability shock and a major economic shock scenario.

Additionally, the general insurers will be tested for how their capital, reserves and reinsurance provisions will respond to supply chain disturbance, a liability or reserve stress, solar flare and geomagnetic storms, a major cyber loss, their own 1 in 200 year worst case modelled event and an insurer specific reverse stress test.

The stress tests have been designed to be comprehensive and to really put the capital models of UK general insurers to the test, in advance of the approaching Solvency II regulatory regime.

The events being tested for are major catastrophic scenarios of the kind that insurers fear and reinsurers typically end up shouldering a significant portion of the industry loss from. As a result it’s reasonable to expect that ILS players would shoulder their proportion of losses from some of these scenarios in particular.

The two European windstorm event (a £10bn and a £15.9bn event), which includes a major UK flood (a £4.8bn event), is likely one event that would impact on some collateralised reinsurance layers provided by ILS fund managers.

The three U.S. hurricane stress test is almost assured to result in an impact to the insurance-linked securities market and also some catastrophe bonds.

The first hurricane is a Katrina re-run, causing a $56bn industry loss. This is followed by a north-east hurricane, causing an industry loss of $24.4 billion and later in the season a Florida and east coast storm causing a $37.7 billion loss. All three hurricanes occur within the same treaty year, which would bring any aggregate exposures to light as well.

Such a U.S. hurricane season scenario would almost certainly cause some catastrophe bond losses, how much is hard to tell. Aggregate cat bonds covering U.S. named storms could become total losses, in some cases, under such a stress test. If Amlin is participating in these stress tests, its Tramline Re 2014 cat bonds would likely face some exposure to this scenario and maybe the European windstorm one as well, although its difficult to tell whether it would be triggered.

The exposure collateralised reinsurance and reinsurance sidecars would have to this U.S. hurricane scenario could also be significant. The results from this one could be telling, although of course the results are only going to be from UK general insurers who do not have many cat bonds in force and where only a portion of the collateralised market would be exposed. A fuller, global insurer stress test would provide a quite significant hit to the ILS market, we’d assume.

The terrorism scenario, which features a London city bomb, synchronised with a New York city bomb, followed by another major world city, could also have some impact on ILS players, given a number participate in some terrorism reinsurance layers.

The other stress tests would have lesser impact for ILS players as they are typically not areas of the insurance market where ILS markets are providing any significant capacity.

The impact to retrocessional markets is unlikely to be really highlighted by these stress tests, as they target insurers rather than reinsurers. However it’s safe to assume that the scenario set could cause a significant impact to that market as well.

Again, it has to be noted that this stress test is only for UK general insurers, therefore much of the ILS exposure won’t be considered, as it will be to other insurers from the U.S. and beyond. However the stress tests could highlight some ILS losses and therefore the results could be interesting, however it’s not clear what level of granularity the PRA will make available in any results.

You can access a copy of the stress test scenarios here (in PDF format).