Introduction

Paolo Cadoni

Since the early 1990s, we have witnessed remarkable advances in financial engineering and financial innovation. These innovations in financial products have also given rise to some new challenges for market participants and their supervisors. Risk-sensitive capital standards, the development of improved risk management practices and the greater role that a firms’ own internal model for the measurement and management of risk in the definition of capital requirements – in both insurance and banking – are examples of this shift. More specifically, internal models have also been used increasingly for external purposes, such as in communicating information about an institution’s risks to creditors, shareholders, regulators and rating agencies.

The 2007–08 financial crisis has led to questions about the use of internal models for the calculation of regulatory capital both in banking, where they are widely used, and in the forthcoming European insurance regulatory regime that is Solvency II.¹¹ For further details, see European Parliament and the Council of the European Union (2009). The financial crisis exposed the limitations of banking models and the way they failed to measure