3.3 Allocating Risk Capital

Capital modelling is used when deciding how much capital should be priced and reserved to cover potential risks.52 The role of capital allocation modelling in the insurance industry is typically focused on ensuring capital requirements for regulatory purposes are met, without significantly impacting daily underwriting decisions.53 This is a method known as ‘Regulatory Risk Based Capital’. Under Solvency II pillar one, insurers are obligated to meet the Minimum Capital Requirement and Solvency Capital Requirement.54

To meet these requirements, insurers can either use a ‘one size fits all’ prescriptive model provided by the regulator, which uses a standard formula, or else develop an internal capital model (ICM).55 The use of partial or fully internal capital models goes beyond the scope of regulatory compliance by providing greater insight into a company’s risk profile and is essential for navigating towards efficient capital allocation.56

To validate a modelling process of capital allocation, insurers often develop scenarios to assess the resilience of these capital reserves to shock and trend risks. Scenario modelling is used to validate insurers decisions on the allocation of capital across lines of insurance by estimating their exposure to a disaster scenario.

Using clash aggregation modelling techniques, insurers can test their capital allocation reserves based on a disaster scenario that impacts multiple lines of insurance. Clash modelling allows insurers to better understand their potential losses across multiple lines of business and develops a narrative for capital requirements necessary to cover these losses.

Solvency II

In 2009, the European Union Insurance and Occupational Pensions Authority (EIOPA),57 a financial regulator body of the European Union, introduced the EU Solvency II Directive. The directive aims to homogenise EU insurance regulation and focuses on an enterprise risk management approach towards required capital standards.58 Solvency II is primarily concerned with the level of capital reserves insurance companies should hold to reduce the risks of insolvency.59 This legalisation was driven by the events of 2008, when the Financial Crisis and subsequent Great recession highlighted the necessity for insurance companies to manage their capital allocation to remain solvent. To ensure the solvency of EU insurance companies, the Solvency II program has three main areas, known as ‘pillars’:

Pillar 1: Financial Requirements

Pillar 2: Governance and supervision

Pillar 3: Reporting and Disclosure

Pillar 1, known as the ‘quantitative pillar’, puts demands on the required economic capital that insurance companies must hold.60 The pillar stipulates two thresholds that insurance companies must adhere too: Solvency Capital Requirement (SCR) and Minimum Capital Requirement (MCR). The SCR requires insurers to estimate the level of capital needed to meet quantifiable risks on their existing portfolios, including one year’s expected new business.61 MCR is the lower bound of the SCR and is the level of capital in which regulators would consider the insurer to be in significant danger of insolvency. The MCR is calibrated in the Solvency II regulations as 85% value-at-risk over one year from valuation date.62

Pillar 2 is known as the ‘qualitative pillar’ which sets out clear requirements regarding how the quantitative objectives of pillar 1 should be achieved. The pillar requires companies to design effective systems of governance which are proportionate to the nature, complexity and scale of operations.63 An insurer must have written internal policies in relation to risk management systems and internal controls of the organisation. Under the Own Risk and Solvency Assessment (ORSA) area Solvency II, insurers must action a significant self-assessment of the risk they are exposed to in the short and medium run.64 ORSA aims to go beyond the modelling requirements in pillar 1 and for the insurer to think about additional risks the insurer may be exposed to.

Pillar 3 outlines the reporting requirements of company’s risk with respect to which information should be disclosed such as risk exposure and concentration, and the frequency with which this information should be reported.65