Catastrophe Model “Common Flaws,” “Blind Spots” Questioned in IAIS Report

While the reinsurance industry may not post a systemic risk to the larger financial system, the use of “interdependent” catastrophe models may pose a systemic risk to the reinsurance industry, according to a report released by the International Association of Insurance Supervisors (IAIS) on Thursday.

“[Common] flaws in the catastrophe models produced by these firms may have a systematic impact on a large segment of the reinsurance market,” the IAIS report titled Reinsurance and Financial Stability said.

The IAIS report gave a general pass to the reinsurance industry in terms of being regulated by global watchdogs as “systemically important financial institutions,” or SIFIs. While not the final word on oversight, the report will hold sway over individual country regulators willingness to count reinsurers as SIFIs and force them to hold greater capital against cataclysmic financial losses.

But despite arguing reinsurers posed less of a threat to the world financial system, the IAIS did warn about the risks current catastrophe modeling practices within the reinsurance industry.

The IAIS raised concerns that reinsurers are served by three large industry vendors: Risk Management Solutions, AIR Worldwide and EQECAT. In particular, the report points out that because catastrophe experts typically move within the three modeling firms, the chances are greater that “common model flaws” could be transmitted from firm to firm and thus increase reserve, credit, market and operational risk among reinsurers .

“[The] larger reinsurance companies can afford the development and application of their own in-house catastrophe models that are an important additional and independent source to assess overall catastrophe risks,” the report states. “Although reinsurers tend to incorporate input from more than one vendor into the catastrophe modeling practices, the sector – with the exception of the largest companies – appears to be heavily dependent on three firms providing catastrophe modeling services”

The IAIS report also raised questions regarding the “patchiness” of catastrophe model in terms of perils and regions covered, citing the experience of insurers following earthquakes in Japan and New Zealand.

“The 2011 earthquakes have highlighted ”blind spots”, one being the damage arising from the tsunami that followed the Japanese earthquake in March 2011 and another being the damage caused by aftershocks from earthquakes, which can be larger than the original earthquake,” the report states.

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