Partial Internal Model for Catastrophe Risk
An insurer uses a partial internal model for property catastrophe risk and the standard formula for all other risks. The board's risk appetite is a 99.5% one-year VaR and a capital coverage target of 1.8 times the required solvency margin; the current ratio is 1.85. The internal model gives catastrophe capital of ₹900 crore against ₹600 crore under the standard formula, after an excess-of-loss programme of ₹500 crore excess of ₹200 crore with one reinstatement. Model validation finds that the dependence between catastrophe and reserve risk was set at 0.1, while recent experience suggests 0.3. Correcting this raises the required capital by ₹250 crore. In addition, a reinsurer providing 30% of the cat cover has been downgraded by two notches, and the board wants to avoid a capital raise. The Appointed Actuary is asked to advise whether the partial model can be used for regulatory reporting next quarter.
1. Evaluate whether the partial internal model is appropriate for regulatory use next quarter.
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Partial model use. A partial internal model can be used only for the risks in its scope and only with supervisory approval; the rest must be calculated under the prescribed standard formula. The cat model's output (₹900 crore) is 50% above the standard-formula cat charge (₹600 crore), so the choice materially increases capital. Validation issues. The 0.1 dependence assumption is not supported: raising it to 0.3 adds ₹250 crore, which is a model limitation, not a smoothing adjustment. The model must be recalibrated, documented and approved before use. Reinsurance. The excess-of-loss cover reduces gross cat risk, but the model must reflect the ₹500 crore excess of ₹200 crore structure, the one reinstatement and the downgraded reinsurer. A two-notch downgrade increases counterparty credit risk and may reduce the recoverable or capital credit. Conclusion. Do not use the model for regulatory reporting next quarter unless the dependency and reinsurer credit issues are corrected and approved; otherwise use the standard formula or a conservative adjustment.
2. Advise the board on the actions needed to restore capital coverage and maintain credibility with the regulator.
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Actions for the board. First, update the dependence assumption and recalculate the capital requirement; the ₹250 crore increase should be treated as a real capital need, not delayed. Second, test the cat programme: price the one reinstatement, model a second event, and quantify the gap if the reinsurer defaults or disputes. Third, compare the resulting ratio with the 1.8× target and the 99.5% VaR appetite; if the ratio falls below target, options are additional reinsurance, capital raising, reduced cat appetite or a documented temporary breach. Governance. The board should approve the model changes, the use test and the plan for regulatory approval. Communication. Explain that the partial model is not a capital-saving device; it must be credible, validated and consistent with risk appetite. Avoid using the standard-formula result simply because it is lower.