Partial internal models for a Norwegian life insurance company

Abstract

In this thesis we wish to explore and develop Solvency II-compliant computational tools that will provide arguments for the insurance company to employ internal models. Applying these tools we will replace some of the stress tests of the standard model (standard formula) with partial internal models when computing the solvency capital requirement (SCR). We will then compare the SCR numbers of the partial internal models with the SCR numbers of the corresponding stress tests. Since the standard model is meant to apply for all insurance companies in all countries subject to the EU regulations for insurance companies, it has to be an average model for a diverse universe of insurance companies. For an average model meant to guarantee solvency with a 99.5% probability for all “SCR compliant” insurance companies, it is our hypothesis in this thesis that the standard model will have to be calibrated quite conservatively. We will test this hypothesis. In this thesis we introduce multivariate simulation as an alternative to the standard model/formula. With this numerical method the insurance company may compute SCR estimates that are tailor-made to its actual balance sheet risk exposures. This way we aim to provide partial internal models that not only will compute SCR numbers that better reflect the actual risk exposures, they may also assist the insurance company with a better understanding of its own risks. This last part will come in handy when the insurance company is performing the mandatory “Own risk and solvency assessment” (ORSA) and “Forward looking assessment of own risks” (FLAOR). With such partial internal models the insurance company may be able to free up capital that in effect will provide an extra financial flexibility for the company. This freed up capital could for example be paid out as an extra dividende to the shareholders/owners, or it could be used as available SCR for an increase in the risk level from existing or additional insurance activities. Either way, assuming fiduciary responsibility of the insurance company, its expected return on investment is improved. In this thesis we will look at partial internal methods for a fictive Norwegian life insurance company, but the main priciples of the models apply to any insurance company subject to Solvency II. As we in particular look at balance sheet items exposed to market risk, the partial internal models developed in this thesis should to a large extent be applicable to other types of insurance companies as well, with the necessary modifications reflecting differences in insurance activites.