Explain why an insurance company might use an internal model to assess its regulatory capital
requirements
-Under Solvency II an insurance company needs to either use a standard formula
model (prescribed by the regulator) or an internal model that will be built by an
insurance company [1/2]
-The main reason that the company will want to apply for an internal model is to
reduce the capital requirement of the company. This would provide various
advantages to the company eg ability to write more new business, pursue a less
restrictive investment policy, and so on. [1.5]
-The capital requirement will need to be reduced enough compared with the
money/time/resources that will need to have been invested. [1/2]
-Likely to be a feasible undertaking only for large(r) companies.[1/2]
-The internal model will reflect the company’s specific risk or business characteristics
rather than the standard model which may have inappropriate assumptions embedded
into the calculations based on an average company. [1½]
-In particular the standard formula may not include risk classes that are important to
the insurance company, which an internal model can take account of. [½]
-The company may have assumptions built of more appropriate experience which can
help assess both the assumptions and the relative stresses for its capital model. An
internal model could take this approach into account. [1]
-Using an internal model could also remove any approximations that a standard
formula approach may have taken into account. [1]
-The company could already be using the internal model for other metrics (e.g.
Economic Capital) and could be therefore more efficient to only run one model [1]
-The company may have spent a lot of time and money in building the model which it
therefore wants to exploit (eg use to reduce the capital requirement)