Reinsurers urge regulators not to overlook the benefits of internal risk models

Global reinsurers have a long history of managing society's most complex risks. To do this successfully requires the use of internal models for sound risk management, business steering and solvency purposes. Recent discussions in the International Association of Insurance Supervisors (IAIS) about the use of internal models to determine regulatory solvency and the possibility of supervisory overlays in Europe put progress at risk. A new publication by the Reinsurance Advisory Board (RAB) – Internal models: a reinsurance perspective – outlines why internal models remain the most accurate measure of risk for reinsurers and the best driver for good risk management.

The global risk landscape is rapidly changing. The negative effects of the financial crisis still ripple through Europe. Climate change is increasing the frequency of extreme weather events. Society is under pressure to respond to the risks posed by aging populations. And technological advances have exposed people and businesses to cyber risk. Adapting to this changing risk landscape and identifying emerging risks is at the heart of reinsurers' business models.

The large variety, complex interdependencies and joint impact of risks require correspondingly sophisticated models. Over the last 20 years, global reinsurers have invested significantly in the development of their own internal models, which have proven crucial for sound risk management and steering.

Important role of internal models under threat

Internal models have a number of benefits, making the risk profile of companies more transparent and enriching dialogue between the supervisor and the company. They also model risk more granularly, closely reflecting a company's risk profile.

But in the wake of the financial crisis, there has been significant debate on the merits of internal models versus more standardised approaches. Until recently, supervisors in Europe had accepted the important role that internal models play in advanced solvency frameworks with both Solvency II and the Swiss Solvency Test allowing for the use of internal models to calculate solvency for regulatory purposes. However, recent discussions amongst national supervisors within the IAIS on the allowance of models and at European Insurance and the Occupational Pensions Authority (EIOPA) on supervisory overlays to internal models – in the form of benchmarks, appropriateness indicators and standard formula corridors and scope limitations (e.g. partial models) – put this progress at risk and fail to recognise the benefits of internal models.

A common interest in closing the protection gap

The changing global risk landscape is only expected to increase the demand for insurance. As a result, a corresponding increase in the demand for reinsurance is expected. Regulators and companies have a common interest in embracing these developments in order to close the protection gap. But to do so in a sound manner, regulatory frameworks must be sufficiently flexible so that they can be easily tailored to local specificities and capture the changing risk profile of global reinsurers. In this context, internal models are sufficiently adaptable to be able to reflect the evolving risk landscape and local specificities.

So, what is the future for internal model use?

The RAB's answer to this question is outlined in the publication: Advanced regulatory frameworks must recognise that standardised approaches have significant limitations for internationally active reinsurers. Internal models are crucial to the IAIS's objective of a globally comparable International Capital Standard (ICS) and must be included in the first iteration (ICS 1.0). The RAB encourages EIOPA and national supervisors to refrain from supervisory overlays and maintain a dialogue on the experiences within national markets in relation to internal model approval and use. This, they note, will prove invaluable in improving the supervisory dialogue between companies and their supervisors and making sure discussions focus on the real issues at risk.

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