As predicted in our "The dawn of a new wave of internal models for Solvency II" post, we are observing an expansion of partial and full Internal Models to meet the pillar I capital requirements of Solvency II. The debate around its advantages vs its costs has resurfaced, with a special focus on the market and credit risk modules. Here, we provide our perspective on the main benefits of Internal Models based on proven enterprise solutions.
Accurately reflect the risk profile
The complexity of insurance portfolios has increased dramatically over the last few years, with investments in credit-intensive and illiquid assets made directly or through externally managed funds. Supervisors and stakeholders are urging insurance undertakings to capture exposures correctly, augment the granularity and the quality of the data, and improve the pricing to reduce the dispersion in some asset model outputs.
Putting in place a solution to accurately simulate securities is the first step toward an Internal Model, which permits insurers to better manage risk and reward, and often becomes the catalyst for more informed business decision-making processes. Register for our "Solvency II: A case for improving market and credit risk management" webinar, where we will further discuss these topics.
A relevant example is the correct set-up of a Risk Appetite Framework, where the need to monitor risk and exposures with the desired frequency and granularity is paramount. Well-designed Internal Models ensure the reliable application of risk tolerance and appetite mandates, as well as efficient use of capital. They ultimately help optimize the value of the business.
One of the consequences of precise projections of the risk-reward profile is that market and credit solvency capital figures calculated with Internal Models are (or tend to become) lower than Standard Formula ones in many cases.
Potential reduction in capital charges
Using an enterprise-class ERM platform helps identify the main sources of risk and take action to reduce and hedge them, with incremental improvements year after year. Between 2017 and 2018, for instance, a life insurance capital survey by PWC found that the average change in the ratio of Internal Model to Standard Formula SCR was -8.7%.
Capital relief can also derive directly from Monte Carlo VaR calculations. Internal models allow for full diversification benefits, with the possibility to implement complex codependent structures. In addition, Standard Formula is simply more onerous, on average, for certain asset classes (e.g., Equity Release Mortgages).
An Internal Model can incorporate the application of Dynamic Volatility Adjustment, which has been found to reduce spread risk by approximately 50% in a recent EIOPA report.1 Firms that apply the Matching Adjustment to some of their portfolios, on the other hand, can only benefit from full diversification—between those and the remaining part of the undertaking—under an Internal Model.
And finally, well-designed Internal Models are instrumental for Use Test compliance, because they can be incorporated into ALM and investment processes, empowering firms to assess the performance and decide the business strategy. In comparison, when the reported risk figures are imprecise or unreliable, as often happens with Standard Formulas, executives are forced to ignore them for business management purposes; regulators then intervene by imposing extra capital charges.
Written by Paolo Laureti
Product Manager, SS&C Algorithmics