Why an internal model?

The Solvency II Directive gives insurers the option of submitting regulatory capital requirements using the standard formula or an internal model.

While the standard formula is, by definition, more general and straightforward, we are firmly of the view that an internal model offers far wider business benefits. We are not alone in this opinion. According to the Chief Risk Officers Forum: “Risk management without risk modelling is not an option: the complexity of the insurance business model requires sophisticated techniques to measure and manage risk exposures.”

63% of the respondents to QIS4 across Europe have already shown interest in pursuing the internal model route for calculating solvency capital. The fact that regulators will require the insurer to pass seven ‘tests’, including the ‘use test’ to demonstrate that the model is not just used for calculating solvency capital, but is embedded within the business and used to assist in strategic decision-making, is indicative of the impact that they believe internal models can have. So what are the major advantages?

Reduce regulatory capital – internal models track risk more accurately and, virtually without exception, will result in the need to hold less regulatory capital.

Improved wider risk management – Firms that invest time and resources in internal models are investing in an understanding of the risks themselves at a more fundamental level. They can manage their business better as a result.

Operational effectiveness – internal models help drive business efficiencies in areas like reinsurance strategy, catastrophe cover and asset management. The reach of internal models goes far beyond regulatory submissions. Business performance dashboards developed in models can be valuable strategic decision making support tools for senior management.

Stakeholder assurance – a demonstrably robust approach to risk management is increasingly important for relations with rating agencies and in helping to raise new business funds.

Build a more risk aware business culture – when used wisely and fully embedded in a company, internal models help make people aware of the impact of their decisions on the wider business.

EMB’s Briefing Paper – ‘An Insurance Conundrum’ explores the decision framework for internal models in more detail.

Read more about building internal models.