S&P’s criteria for assessing economic capital models provide incentives: Willis Re

Standard & Poor’s new criteria for assessing insurers’ economic capital models incites insurers to adopt more sophisticated internal capital models by giving them the opportunity to use the modelling results to potentially reduce their capital requirements, according to Willis Re.
In its report, Standard & Poor’s Economic Capital Model Review Promises Capital Rewards, Willis Re identifies the main features of the “ideal” economic capital model according to S&P’s and offers insights into how the agency is likely to apply its new methodology in practice.
Key findings of the report include:
• S&P’s review will have a markedly qualitative character. S&P’s will assign scores of ‘basic,’ ‘good,’ or ‘superior’ to each component of an insurer’s economic capital model. These scores will then be aggregated into a comprehensive assessment summarised by a single number, the “M-factor,” which measures the model’s credibility in S&P’s view. This differs from Solvency II, where approved internal models will fully replace the standard formula for the solvency capital requirement;
• stochastic modelling per se may not be enough to obtain S&P’s approval and should be augmented by stress tests, including but not limited to, worst historical experience; and
• capital fungibility should be explicitly and carefully modelled before taking any diversification benefits into account in the determination of economic capital – a crucial requirement for multi-national insurance groups.
“By at last offering the carrot of lower capital requirements to add to the stick of their existing ERM review, Standard & Poor’s has further increased the incentive for insurers to adopt tailored and more sophisticated capital models,” said David Simmons, managing director of Analytics and head of International & Specialty Enterprise Risk Management for Willis Re.
“But, the bar is set quite high. Strong risk management remains key and only models embedded in business decision-making of companies judged to have strong ERM processes will be eligible for review.”