For non-life underwriting risks, contracts with annual aggregate limits (AAL) provide risk mitigation when the cumulated amount of losses in a given year, or the loss ratio in a given year, goes above a certain predefined level (say EUR 10m, or an 80% loss ratio). The most common contract of such type is the stop loss reinsurance. But you may also have quota share agreements with an annual loss ratio cap (inward reinsurance) or attachment point (outward reinsurance), or you may have (re)insurance contracts (inward) that provide for a maximum annual indemnity in combination with a maximum each and every loss indemnity.

This type of cover has an impact on losses that may arise within premium risk and catastrophe risk of the non-life underwriting risk module of the SCR standard formula, either as a limit on the maximum inward exposure underwritten by the company, or as a risk mitigation technique limiting the maximum net exposure of the company.

In case of non-life contracts that provide for an AAL on losses, may we apply that limit across the premium risk and the catastrophe risk calculation, and deduct the expected loss ratio that is already captured in the best estimate of premiums, to ensure that those expected losses are not double counted at the level of the SCR standard formula calculation?

In our view, the capital charge computed for the premium risk and the catastrophe risk should be capped to the potential maximum shock that may happen with a 99.5% confidence level over a one-year horizon on the net asset value.

Hence, with regard to calculating the mitigating effect of these contracts for the premium risk and the catastrophe risk, we believe that it should be allowed to compute the maximum possible deterioration of losses under these contracts as [Annual aggregate limit – Expected losses already deducted from best estimate of premiums], considering that:

- the SCR is measuring the maximum loss on the net asset value of the balance sheet with a 99.5% confidence level, over a one-year period.

- claims that have already occurred are reflected in the best estimate of claims (+risk margin) which are deducted from asset value to determine net asset value

- claims that are expected over the next 12 months are reflected in the best estimate of premiums as a deduction, so that only the expected profit over and above the expected losses is contributing to the net asset value

As an example, if expected loss ratio reflected in the best estimate of premiums is 75%, and a risk mitigation contract limits the net exposure of the company to a maximum possible loss ratio of 80% in the annual aggregate, then the maximum possible further deterioration of net losses to be considered in premium risk and in catastrophe risk, after cession to the reinsurer, should only be a 5% deterioration in loss ratio [= 80% AAL – 75% loss ratio already factored in the BE of premiums].

Likewise, if expected losses over the next 12 months deducted within the BE of premiums are EUR 4m, and the inward contract limits the exposure of the company to a maximum possible loss of EUR 10m in the annual aggregate, then the maximum possible further deterioration of losses to be considered in premium risk and in catastrophe risk should only be EUR 6m [= EUR 10m AAL – EUR 4m losses already factored in the BE of premiums].

Obviously the calculation does apply independently on the premium risk within the premium and reserve risk sub-module and on the catastrophe risk sub-module. Aggregation to SCR non-life then takes place as per standard formula.