Financial models are at the heart of Solvency II, but what do they involve and how do they work?

The standard way to produce financial models for insurance and reinsurance companies is through what is known as ‘stochastic’ analysis. This type of model enables you to test the financial robustness of your organization in any number of imaginary but possible situations, taking into account such factors as exceptional loss experience across a wide range of lines, stock market failure and reinsurance default. 

As well as helping to assess the company’s underlying strength, the resulting information from stochastic models can help senior management make key strategic decisions. It can lead to improvements in the following areas, amongst others:
• Capital adequacy and allocation
• Scenario testing;
• Reinsurance purchasing;
• Product and pricing strategy;
• Security ratings;
• Business expansion;
• Mergers and acquisitions. 

In practice a lot of senior insurance executives find stochastic modelling such a daunting prospect that they put off taking action. Yet it is not as difficult as some people imagine. You can always start by creating a few simple models and then becoming more ambitious as you grow in confidence and knowledge.
Although it can eventually become highly technical, it is fundamentally a part of an organisation’s risk management process. The first questions to be asked should always be strategic. Some of the main questions are below. 

What do we want to achieve?
Insurers and reinsurers sometimes come unstuck at the first hurdle, which is to agree on the overall objectives. These will ultimately determine the risks to be captured and quantified from the whole process. Management needs to have a shared understanding of the risk measures to be used and the company’s overall appetite for risk, something that many organisations do not explicitly consider or communicate at present.