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Are you ready for the T-Var?

Dear Friend,

Fitch has been pumping out some high quality research of late and yesterday outlined their latest attempt at making sense of the more esoteric end of the world of (re)insurance.

The work highlights the difficulty in trying to stress-test (re)insurers when looking at events that have a 1-in-100 or lower probability of recurring. As we all know, this task is ultimately as impossible as trying to nail jelly to a wall, as one man’s 1-in-250 is another’s 1-in-50, but Fitch deserve plaudits for giving it a go and trying out some a new method.

The general idea is to try and differentiate better between how low-probability events impact upon different (re)insurers. At the moment Fitch only looks at one point in the probability curve — the 1-in-100 year event — and this throws up inevitable distortions.

This is because the way that you structure your book and your reinsurance protections can have a huge effect on how less probable events hit you. Fitch cited the example of two notional companies that both suffer the same $100m loss from a 1-in-100 year event but a 1-in-500 year event might leave one with a $200m loss and the other with a whopping $1bn loss — five times as bad as his neighbour — ouch!

At the moment the two probably get identical ratings, which obviously can’t be right.

So quite rightly Fitch wants to try and take an average of the impact of all the less probable losses towards infinity, all the way down to 1-in-10,000 year events. And here comes that clever T-VaR bit — the T-VaR (or Tail value at risk) is the average of all the loss scenarios above a certain threshold.

Leaving the maths lesson aside for a minute, it doesn’t take a genius to see that if you start adding in 1-in-1,000 year scenarios, where you once measured only 1-in100s, the overall ratings effect is going to be negative and the industry is going to have to find more capital if it doesn’t want its ratings downgraded.

Anyway – be prepared — the new methodology and model is being bolted together over the next three to six months, when it will be let loose on ratings.

It’s surely another good reason to get down to Wall Street and join the queue for more capital now while stocks last!

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