Regulatory Models and Internal Models for Risk Analysis - Solvency 2

Question 1

What is the Solvency 2 capital requirement?

Answer 1

Insurers to hold capital equivalent to a loss of a 1 in 200 year equivalent, expressed as 99.5% VaR over a 1 year time horizon.

Question 2

What are the ways that capital requirements can be calculated under Solvency 2?

Answer 2

1. Standard Formula - prescribed set of stress test and calculations.
2. Internal Model

Question 3

What risks are captured in the internal model for Solvency 2?

Answer 3

Insurance risk, credit risk, market risk and operational risk.

Question 4

What are the 6 tests that must be passed under Solvency 2 before a firm can use its own model?

Answer 4

1. Statistical quality standard - insurer to demonstrate methodology, assumptions and data underlying the model are sound.
2. Calibration standard - demonstrate that the model is calibrated to a level equivalent to the Standard Formula for the purpose of the SCR calculation.
3. Validation standard - Substantiating a sound control environment around the model.
4. Documentation - a 3rd party should be able to replicate the model using documentation.
5. Profit and Loss attribution - Demonstrate the ability to reconcile the sources of variance (profit and loss) in the results of the model with the risk included in the model.
6. Use Test - Demonstrating that the model is used for wider range of purposes in the business, other than the calculation of regulatory capital.

Question 5

What are the general principles of using an internal model?

Answer 5

1. Senior management understanding of model.
2. Model fits business model
3. Model is used to support and inform decision making.
4. Model is integrated into the risk management system and covers enough risk to make it useful.
5. The model is used to improve the firm’s risk management system.

Question 6

When should capital requirements be calculated under Solvency 2?

Answer 6

At least annually or when there are significant changes e.g. company risk profile changes.

Question 7

Under PRA rules for SCR, can future business be included in the SCR calculation?

Answer 7

Yes, up to upcoming 12 months.

Question 8

Under PRA rules what confidence level must be achieved for the SCR?

Answer 8

VaR for own basic funds up to a confidence level of 99.5% over a 1 year period.

Question 9

If an insurer wants to change its internal model, does it need PRA approval?

Answer 9

Yes

Question 10

Once using an internal model, can an insurer revert back to a Standard Formula?

Answer 10

No