David LightfootGuy Carpenter - Instrat

Solvency II – The March Solvency II – The March Towards Economic Capital Towards Economic Capital ModelsModels

CAS Spring Meeting – June 19, 2007CAS Spring Meeting – June 19, 2007

2

Discussion

What is an Internal or Economic Capital Model (ECM)?

Why are EU Regulators and Companies Supporting Use of ECMs?

ECM Results as Full or Partial Replacement of the SCR Standard Formula

– How to Use– Regulatory Approval

3

Economic Capital ModelingDefinition of Economic Capital

Estimate of capital needed to support the enterprise given the possibility of decreasing assets, increasing liabilities or unexpected net losses resulting from the risks undertaken or inherent in the business

Assets

Liabilities

Capital

Assets

Liabilities

Capital Net Losses

Net Losses

4

Review of ECM Components

Capital Need forNon-Life Insurance

Company

Insurance Hazard Financial (Asset)Operational &

Strategic

Underwriting

Accumulation / Cat

Reserving

Credit

Market

Liquidity

People / Processes / Systems

External Events

Business Strategy

Quantitative Methods

• Factor / Scenario Based

• Simulation Based

Quantitative Challenges

• Data Availability / Resolution

• Correlation

• Treatment of Uncertainty

• Non-modeled Perils

• Operational Risk

5

Why Growing Support for this Development?

Regulators– Principal regulatory objectives

Better risk management Encouragement of innovation in risk management methodology Improved risk sensitivity in capital requirements

– Other stated benefits Higher competitiveness through lower cost of capital Better modeling of non-standard contracts Better, more informed and more consistent discussion with

regulators and rating agencies

Companies– Integral to ERM virtuous circle of risk identification, measurement,

and management– Organizational, reputation and operational benefits

6

ECM Results as Full or Partial Replacement of the SCR Standard Formula How to Use

Full Internal Model (long term goal)– Model and simulate all important aspects of the business – Take correlation between risks into account– Calculate Net Operating Income for each simulation– SCR = 1 in 200 year negative result

Partial Internal Model (valuable starting point)– Model and measure risk using Partial Internal Models– Clearly identify which componets of the SCR standard formula are

affected by the use of the ECM– Aggregate capital requirements to total capital requirement

Correlation needs to be considered

7

ECM Results as Full or Partial Replacement of the SCR Standard Formula Regulatory Approval

Actuarial Model

Internal Risk Management

Regulatory Capital Requirement

Test 1:

Statistical Quality

Test 2:

Use

Test 3:

Calibration

8

Key Message

The movement is well under way in Europe for better, transparent risk management supported by a clearer measurement of risk and ultimately how risk relates to capital