Standard models for determining minimum capital requirements face challenges: S&P’s

Standard models used by insurers to compute their solvency capital required (SCR) have the potential to produce excessive or inadequate capital requirements, said Standard & Poor’s.
In its report, Standard & Poor’s Highlights Differences in Capital Adequacy Between its Methodology and Europe’s Solvency II Framework, the ratings agency says standard models face a particular challenge because they should be easy to use for a wide range of insurers.
Under the Solvency II framework, insurers can choose between using a standard model or a model developed internally and approved by a supervisor.
“In our opinion, [standard models] need a relatively simple structure and a relatively limited range of required stresses, otherwise the model will become too burdensome,” the report said.
“However, many risks are considerably heterogeneous, which makes it difficult to find a pragmatic choice of risk factors appropriate for a diverse range of insurance profiles.”
To simplify the stresses, model designers usually derive their standard stresses and capital requirements with reference to a ‘typcial insurer,’ S&P’s said.
“Inevitably, this may produce capital requirements that are excessive or inadequate for some insurers,” it continued.
“Also, some insurance markets have considerable different characteristics from the average [insurer]. The standard model may consistently overstate or understate required capital across all insurers operating in particular countries when insurers apply the same stresses internationally.”