The importance of internal models for reinsurance

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. The use of internal models in reinsurance is currently under the spotlight. Lutz Wilhelmy, Head Group Regulatory Risk Management, explains why Swiss Re advocates for the continued use of internal models in reinsurance.

Q: What are the benefits of using internal models to determine regulatory required capital for reinsurers?
Re/insurers build their internal model to assess the business they are considering to accept. We use them first and foremost internally: to calculate the risk and the capital requirements for the entire business cycle – from setting risk appetite, to business steering, underwriting and costing, as well as performance measurement and reserving. In insurance, this approach is necessary to understand and assess the profitability of the businesses. It also fosters good, transparent and conscious risk management. Using internal models also for regulatory purposes ensures that regulators have a realistic, unbiased view of the risk profile. Moreover, they enrich dialogue between supervisors and companies.

Q: Why is there currently a debate on the merits on internal models versus more standardised approaches?
The skepticism of internal models originated in the banking sector and spread to the re/insurance sector. However, banking and re/insurance use internal models in very different ways and Swiss Re believes that insurers’ use of internal capital models to determine regulatory required capital should be preserved and extended. This was on the table for discussion at the recent Eurofi High Level Seminar 2017 where Nina Arquint, Head Group Qualitative Risk Management, participated in a panel discussion entitled ''Consistent and reliable use of internal models in the insurance sector''.

Q: So, why are internal models so suited to insurance?
Banks use internal models mainly as a tool to calculate their regulatory capital. Often that is the sole purpose. Re/insurers use models in an integrated manner to assess their business throughout the business cycle. This is very different compared to banks. Insurers are incentivised to ensure that the model rightly reflects their business – otherwise steering would be pointless: If internal models do not realistically reflect the risks to which insurers are exposed, this results in real losses due to business mismanagement. It is in the interest of the insurer or reinsurer to get the internal model right and boards are accountable for ensuring this occurs. This is called the "use test".  Good insurance regulators embrace the fact that internal models provide an adequate, well-governed capital assessment. They can trust the model as it is a main input for steering the business of the company and the board fully owns it.

Internal models are inherently complex. This is inevitable to provide an accurate picture of an individual re/insurer's risk situation. Because standard models strive to be applicable to most re/insurers, they end up being unnecessarily complex for any individual re/insurer. However, this complexity has no benefits: standard models are imprecise. Particularly to obtain an adequate assessment for diversification, which is integral to insurance and reinsurance – there is no one-size-fits-all approach. This is why it is important to maintain the use of internal models for regulatory purposes in insurance.  

Q: Where are the challenges for ensuring effective supervision using internal models?
It's key to establish that regulators and other stakeholders can trust the results of the internal model. Regulators and investors need to understand how the model functions in order to trust in it, and re/insurers need to explain how their models work to these target audiences.

People express their concerns that the complexity of internal models makes it hard to compare the capital requirements of one insurer with another and argue for a straight, non-complex comparison. However, the capital requirements of companies are perfectly comparable, as long as they are right. To get it right requires complex internal models.  It is pointless to compare wrong results – even when produced using a straight and simple recipe.

Finally, the conflict of interest in using of internal models for determining regulatory required capital is mitigated through application of the use test referred to above and through strong internal governance around the model.

Eurofi Magazine
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