Premium and reserve risk (Solvency II)
The main sub-module of Solvency II non-life underwriting risk, measuring the possible loss on the coming year's future claims and on the inadequacy of reserves for claims already incurred.
A non-life insurer runs two distinct underwriting risks. Premium risk is that claims on the coming year's policies cost more than expected: the premiums collected are not enough. Reserve risk is that claims already incurred but not yet settled cost more than the reserves set up: the past turns out more expensive. In the Solvency II standard formula, both are grouped in a single sub-module. For each line of business, motor, fire, liability, credit, the formula takes a volume measure, expected premiums for premium risk, the best estimate of reserves for reserve risk, and applies a standard deviation set by regulation, higher for volatile lines. The segments are then aggregated with correlations, which brings out a diversification benefit, and a reduction is granted for geographic diversification. An insurer whose portfolio does not resemble the average European market may apply to use undertaking-specific parameters, based on its data, instead of the standard deviations. Catastrophe risk is treated in a separate sub-module. This split explains why a long-tailed, volatile line such as liability consumes a lot of capital even without an extreme event.
Hypothetical case: a professional liability specialist holds 800 million euros of reserves and expects 300 million of premiums. The standard formula imposes a high capital charge for reserve risk; showing, on fifteen years of data, lower volatility than the market, it is allowed to use its own parameters and cuts this requirement by a fifth.
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