CAS Spring Meeting – June 19, 2007
Solvency II – The March
Towards Economic Capital
Models
David Lightfoot
Guy Carpenter - Instrat
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
2
Economic Capital Modeling
Definition 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
Capital
Assets
Capital
Net
Losses
Assets
Liabilities
Liabilities
3
Review of ECM Components
Capital Need for
Non-Life Insurance
Company
Quantitative Methods
• Factor / Scenario Based
Insurance Hazard
Underwriting
Accumulation / Cat
Financial (Asset)
Credit
Market
Operational &
Strategic
People / Processes /
Systems
External Events
• Simulation Based
Quantitative
Challenges
• Data Availability /
Resolution
• Correlation
• Treatment of Uncertainty
• Non-modeled Perils
Reserving
Liquidity
Business Strategy
• Operational Risk
4
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
5
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
6
ECM Results as Full or Partial Replacement of the SCR Standard Formula
Regulatory Approval
Test 2:
Use
Test 1:
Statistical
Quality
Internal Risk
Management
Actuarial Model
Regulatory Capital
Requirement
Test 3:
Calibration
7
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
8