GR-NEAM
SOLVENCY II: THE DILEMMA
As companies grapple with the implications of Solvency II and, specifically, how best to calculate Value-at-Risk, GR-NEAM’s Jim Bachman and Tobias Gummersbach weigh up the pros and cons of standard models versus bespoke models and a ‘rules-based’ and ‘principles-based’ approach.
A
t the risk of making a generalisation, the Solvency II framework is very specific with respect to its ultimate evaluation criterion: 99.5 percent Value-at-Risk (VaR). Companies can derive their
estimates of VaR using a standard model, as described in the European Insurance and Occupational Pensions Authority (EIOPA) Technical Specification papers, for example, or they can develop their own model. In a sense, these two options characterise the subtle difference between a ‘rules-based’ and ‘principles-based’ approach.
The standard model relies upon estimates of expected outcomes and
volatilities for underwriting and investment activities and correlations. It is essentially a standard normal multivariate framework. VaR is an end-of- period one year sum. The standard model does not focus upon extreme events in either distributional form or rigorous stress-testing. This is a curious approach given the view that the recent capital markets’ meltdown was anything but normal.
Individual companies can develop their own models, which are subject
to regulatory review and approval. But we believe companies are unlikely to sponsor internal models requiring greater levels of capital than they would choose to hold, or that the standard model would indicate. Accommodating extreme events and stress-testing increases capital requirements; it will rarely lessen them.
30 | INTELLIGENT INSURER | Spring 2012 Hence, the dilemma arises between balancing companies’ freedom to
develop models that are potentially less rigorous and the public policy need for adequate solvency margins. This places a great burden upon regulatory officials who must approve company-sponsored models. Additionally, company-developed models, predicated upon unique assumptions, will both confound transparency—an acknowledged deficiency of the international financial reporting standards (IFRS)—and render company comparisons impossible.
This article has three sections. The first describes several alternative
methodologies to calculate required capital. The second section presents the results of using each of these methods scaled to 2010 year-end balance sheet values of the US property/casualty industry. The third section summarises the impact of differences in methods upon the Solvency II 99.5 confidence level VaR and Tail Value-at-Risk (T-VaR) estimates.
ALTERNATIVE REQUIRED CAPITAL
CALCULATION METHODOLOGIES Similar to Solvency II, we rely upon a 99.5 VaR as the basis of
estimating capital adequacy. We estimate VaR and T-VaR using three different methods: Standard normal end-of-period (SNEOP), Diffusion
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