CRO Forum study released

Industry body the Chief Risk Officer (CRO) Forum, which consists of the chief risk officers of Europe's leading insurers, is advancing the case for the use of proprietary internal models under Solvency II with the publication of a new in-depth report. Principles for Regulatory Admissibility of Internal Models was published and presented to national regulators in June.

As discussions gather pace at a European level on the Solvency II prudential regime for insurers, the CRO Forum says it is strongly in favour of admissibility of internal models because they reflect the true risk profile and solvency position of companies, and provide an incentive for improved risk measurement and management.

"We are very strong advocates of being able to use our own internal models for the purposes of determining economically based capital requirements under Solvency II, and although it appears that that will certainly be an option, it was never finalised," says Tom Grondin, chief risk officer at Aegon and member of the CRO Forum. "We wanted to make it easier for the regulators to move along that path by removing some of the uncertainty and discomfort they may have had."

The group states that the aim of its study, which is based on research by University of Munich professors Damir Filipovic and Daniel Rost, is to provide a practical framework, building on current practices within the industry, for regulators to assess a company's internal model for Pillar 1, which covers capital requirements, and Pillar 2, which covers regulatory supervision.

The researchers interviewed the risk management groups of all 13 member companies of the Forum, which includes Allianz, Axa, Swiss Re, Aviva and other multinational insurers. "There are differences across companies, and what we provide in the study is a classification that captures these differences," says Filipovic. The report also assessed the approaches adopted by national regulators and the internal models framework of the International Actuarial Association (IAA), which has been endorsed by the International Association of Insurance Supervisors (IAIS).

To determine the level of assets required by insurers under Pillar 1, the Forum recommends using a solvency capital requirement (SCR), defined as a risk margin above the economic value of liabilities, set to ensure a standardised likelihood of economic loss to policyholders. This should be based on the insurer's risk profile, and should be independent of accounting liabilities. The CRO Forum also says that the minimum capital requirement - set as a trigger for regulatory intervention - should not interfere with the operation of the solvency figure.

The study then looks at how solvency should be defined. The Forum takes a "strong view" on basing this on available capital, defined as the difference between the economic, market-consistent value of assets and liabilities. This is an implicit criticism of regulatory capital regimes such as Germany, which shun economic valuation in favour of a book value accounting approach. The Forum recommends computing the SCR by taking the value-at-risk (VAR) of available capital over a one-year horizon, at a 99.5% confidence level. Modelling approaches based on longer, multi-year time horizons or other risk measures, such as TailVAR, should be admissible, they recommend, as long as the calibration approach used is consistent with an annualised 0.5% probability of economic insolvency.

The CRO Forum also recommends that all sources of market risk be modelled probabilistically, with embedded options and guarantees explicitly modelled through simulations. All sources of credit risk, including derivative and reinsurance counterparty risk, should also be modelled probabilistically and aligned with the principles of Basel II, taking account of default, migration and spread risk.

Likewise, operational risk should be aligned with Basel II, with a standardised Pillar 1 risk charge and advanced measurement approach. Insurance risk, where modelling approaches can vary significantly, should be tailored to the type and size of the risk. For risk aggregation, the CRO Forum says companies should explicitly account for inter-risk dependencies and concentrations, using parameters based on tail dependencies.

Regarding implementation, the CRO Forum suggests that full calculations with internal assessment and refining of internal models be done at least on an annual basis with quarterly updates. Accepting the need for regulatory review of internal models, the CRO Forum suggests that regulators lacking experience of this should outsource the job to consultants.