Internal Models and Solvency II

Paolo Cadoni, Christian Kerfriden

Since the early 1990s, there have been 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 firms’ own internal model for the measurement and management of risk are allowed to play in the definition of capital requirements – both in insurance and banking – are examples of this shift. More specifically, internal models have also been used increasingly for external purposes – for example, communicating information about an institution’s risks to creditors, shareholders, regulators and rating agencies.

EFFECTS OF THE FINANCIAL CRISIS

The 2007–08 financial crisis has called into question 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 (Solvency II). The financial crisis exposed the limitations of banking models and how they failed to measure extreme financial events, capture all risks to which firms

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