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Developing Internal Models

SCOR
Solvency II Seminar
2
What is Solvency about?
risk
e
a
r
n
i
n
g
s
2
1
0
2 destroys value
1 adds value
2 adds value
1 destroys value
RoRAC
1
2
0
3
What is Solvency about?
risk
0
RoRAC
0
insurance
reinsurance
e
a
r
n
i
n
g
s
4
Solvency II
Uses of an internal model
Components of an internal model
Validation of an internal model
Agenda
5
3 Pillars
quantitative qualitative transparency
6
What belongs to whom?
investments
assets liabilities
reserves
equity
belongs to the policyholders
belongs to the shareholders
7
What happens with it?
balance sheet
1 Jan. 2013
P&L
1 Jan. 2013 31 Dec. 2013
balance sheet
31 Dec. 2013
8
What happens with it?
balance sheet
1 Jan. 2013
P&L
1 Jan. 2013 31 Dec. 2013
balance sheet
31 Dec. 2013
9
What happens with it?
balance sheet
1 Jan. 2013
P&L
1 Jan. 2013 31 Dec. 2013
balance sheet
31 Dec. 2013
10
How much is left after one year?
today in 1 year time
e
q
u
i
t
y
pandemics
stock markets
inflation
possible scenarios

0
earthquakes
possible portfolios
in 1 year

11
capital
SCR
free surplus
Economic Balance Sheet
investments
reserves
R
T
C
RTC = Risk Taking Capital
= economic value of the company
= assets reserves
assets
market consistent / mark-to-market
reserves
best estimate + risk margin / mark-to-
model
SCR = Solvency Capital Requirement
= risk adjusted capital
= risk statistic of the RTC
free surplus 0
RTC SCR
assets liabilities
12
RTC & SCR
R
T
C
simulated scenarios
RTC probability density
possible scenarios
possible portfolios
in 1 year
pandemics
stock markets
inflation

earthquakes
today in 1 year time
13
0.5% 99.5%
RTC & SCR
RTC
RTC probability density
best estimate
Value at Risk = VaR SCR
14
RTC & SCR (SST)
RTC
1% 99%
Tail VaR = TVaR SCR
best estimate
RTC probability density
Value at Risk = VaR SCR
0.5% 99.5%
15
Differences S II & SST
S II SST
start 2017 ? 2006 - 2008
required capital VaR(99.5%) SCR TVaR(99%) SCR
risk horizon 1 year 1 year
insurance risk

market risk

credit risk

operational risk

deterministic scenarios

internal model ? % market players 50% market players
16
Standard Models
Reserves
Different models depending on
data availability / quality
line of business / market
processes / claims mgmt

actuarial judgment
1
st
moment of a distribution
standard reserving model
Capital
Different models depending on
data availability / quality
line of business / market
processes / products

actuarial judgment
n
th
moment of a distribution
standard solvency model
17
17
Solvency II
Uses of an internal model
Components of an internal model
Validation of an internal model
Agenda
18
Uses
Portfolio management
Reinsurance optimization
Capital allocation
Pricing
Underwriting limits
Product development
Mergers & acquisitions
Incentive & remuneration policy

19
Uses
Portfolio management
Reinsurance optimization
Capital allocation
Pricing
Underwriting limits
Product development
Mergers & acquisitions
Incentive & remuneration policy

20
l
i
a
b
i
l
i
t
y
f
i
r
e
e
a
r
t
h
q
u
a
k
e
r
e
i
n
s
u
r
a
n
c
e
i
n
d
i
v
.

l
i
f
e
m
o
t
o
r
g
r
o
u
p

l
i
f
e
g
o
v
.

b
o
n
d
s
c
o
r
p
.

b
o
n
d
s
s
t
o
c
k
s
d
e
r
i
v
a
t
i
v
e
s
100%
100%
100%
strategy A
strategy B
strategy C
portfolio today
Portfolio management
21
Portfolio management
R
T
C
today in 1 year time
company today
22
Portfolio management
R
T
C
SCR
strategy A
strategy B
strategy C
company today
23
Uses
Portfolio management
Reinsurance optimization
Capital allocation
Pricing
Underwriting limits
Product development
Mergers & acquisitions
Incentive & remuneration policy

24
Reinsurance optimization
0
20
40
60
80
100
120
0 200 400 600 800 1000
Economic Capital
N
e
t

R
e
t
u
r
n
r
e
t
e
n
t
i
o
n
c
e
s
s
i
o
n
r
e
t
e
n
t
i
o
n
c
e
s
s
i
o
n
r
e
t
e
n
t
i
o
n
excess
of loss
25
Uses
Portfolio management
Reinsurance optimization
Capital allocation
Pricing
Underwriting limits
Product development
Mergers & acquisitions
Incentive & remuneration policy

26
general
insurance
Capital allocation
EC
1
EC
2
EC
3
EC
1
EC
2
EC
3
life
insurance
investments
27
Capital allocation
EC
1
EC
2
EC
3
AC
1
AC
2
AC
3
AC
1
AC
2
AC
3
diversified
allocation
proportional
allocation
EC
company
28
proportional expected shortfall
formula
fairness
/
diversification
/
simplicity
/
communication
/
EC
EC
EC
AC
j
j
i
i
=

| | ) ( VaR X X X E AC
i i o
> =
Capital allocation
29
Uses
Portfolio management
Reinsurance optimization
Capital allocation
Pricing
Underwriting limits
Product development
Mergers & acquisitions
Incentive & remuneration policy

30
SCR
R
T
C
company today
add a policy
infinitesimal change of the portfolio
RoRAC
Pricing
31
company today
RoRAC
portfolio today
+
new policy
Pricing
32
Solvency II
Uses of an internal model
Components of an internal model
Validation of an internal model
Agenda
33
Major Risk Models
Insurance
risk
General
insurance
Reserves
Underwriting
Attritional
losses
Large claims
Catastrophic
losses
Life
insurance
Biometry
Options &
guarantees
Market risk
Fixed income
Variable
income
Exotic
instruments
Credit risk
Operational
risk
Aggregation
Convergence
Dependences
CRTIs
Meta-risks
Economic
scenarios
Stress
scenarios
Parameters
Risk margin
Liquidity
34
Major Risk Models
Insurance
risk
General
insurance
Reserves
Underwriting
Attritional
losses
Large claims
Catastrophic
losses
Life
insurance
Biometry
Options &
guarantees
Market risk
Fixed income
Variable
income
Exotic
instruments
Credit risk
Operational
risk
Aggregation
Convergence
Dependences
CRTIs
Meta-risks
Economic
scenarios
Stress
scenarios
Parameters
Risk margin
Liquidity
35
Components of the SCR
500
400
300
200
100
300
200
50
100
50
400
600
0 100 200 300 400 500 600 700 800 900 1000
reserves
life
P&C
earthquake
reinsurance
market
credit
diversification
operational
risk margin
SCR
RTC
36
Major Risk Models
Insurance
risk
General
insurance
Reserves
Underwriting
Attritional
losses
Large claims
Catastrophic
losses
Life
insurance
Biometry
Options &
guarantees
Market risk
Fixed income
Variable
income
Exotic
instruments
Credit risk
Operational
risk
Aggregation
Convergence
Dependences
CRTIs
Meta-risks
Economic
scenarios
Stress
scenarios
Parameters
Risk margin
Liquidity
37
Model Risk
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
Augyy Mayyy Janyy Octyy Julyy Apryy Janyy Octyy Julyy Apryy
MXN/USD
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0.50 0.40 0.30 0.20 0.10 0.00 0.10 0.20
logreturnMXN/USD
modelo
_
2
/ dof = 0.6

normal Models
38
Major Risk Models
Insurance
risk
General
insurance
Reserves
Underwriting
Attritional
losses
Large claims
Catastrophic
losses
Life
insurance
Biometry
Options &
guarantees
Market risk
Fixed income
Variable
income
Exotic
instruments
Credit risk
Operational
risk
Aggregation
Convergence
Dependences
CRTIs
Meta-risks
Economic
scenarios
Stress
scenarios
Parameters
Risk margin
Liquidity
39
Deterministic Stress Scenarios
0.01%
0.10%
1.00%
10.00%
100.00%
100'000'000 150'000'000 200'000'000 250'000'000 300'000'000
p
r
o
b
a
b
i
l
i
t
y
RBC t=1
RBC distribution
RBC shifted
mean
VaR
tVaR
occurrence probability distribution w/o scenarios
RTC shift
| | | | x RTC P p x RTC P
s
S
s
s
s A + = s

=
0
0
distribution w/ scenarios
40
Solvency II
Uses of an internal model
Components of an internal model
Validation of an internal model
Agenda
41
Methodological Framework
Risk categories
reserves risk
attritional losses
large claims
catastrophe risk
biometric risk
options & guarantees
economic scenarios
fixed income risk
variable income risk
exotic financial instruments
credit risk
operational risk
Monte Carlo convergence
dependencies
CRTI
stress scenarios
parameter risk
risk margin
liquidity
Model components
methodology
data
parameters
calculations
platform
governance
use test
Validation procedures
agreed upon procedures
market benchmarks
methodology assessments
implementation tests
source codes checks
plausibilisations
reconciliations
input tests
sensitivity analysis
backtesting
emulations
process walkthroughs
e.g.
e.g.
42
Procedural Framework
Tests
Draftreport
Documentationanalysis&interviews
Specifications
feedback
Final
report
43
43
Solvency II
Uses of an internal model
Components of an internal model
Validation of an internal model
Agenda
44
Trust is good... Modelling is better
45
Transmutation of Junk into AAA
46
Theres more to Solvency II
than just satisfying the regulator
It is an opportunity to
optimize your reinsurance
But only with an internal model
Conclusions
47
Frank Cuypers
+41 (41) 725 32 94
frank.cuypers@prs-zug.com
Speakers Coordinates
48
A Model for Variable Income Risk
Value of the asset
Return of the asset
Wiener process
( ) o , ~ ln
1
N
S
S
t
t

1 t
t
S
S
t
S
49
A Model for Variable Income
Value of the asset
Return of the asset
Wiener process
Deterministic stress scenarios
( ) o , ~ ln
1
N
S
S
t
t

1 t
t
S
S
t
S
50
Major Risk Models
Insurance
risk
General
insurance
Reserves
Underwriting
Attritional
losses
Large claims
Catastrophic
losses
Life
insurance
Biometry
Options &
guarantees
Market risk
Fixed income
Variable
income
Exotic
instruments
Credit risk
Operational
risk
Aggregation
Convergence
Dependences
CRTIs
Meta-risks
Economic
scenarios
Stress
scenarios
Parameters
Risk margin
Liquidity
51
Life Options & Guarantees
fix interest rate
yield curve
stochastic yield curve
stochastic cash flow
| | ( ) | | r D E X E


( ) r D X S

= ( ) r D X


( ) | | r D E X


( ) | | r D X E

cash flow
depends on
interest rates

MCV
cash flow
52
RTC & SCR
R
T
C
simulated scenarios
RTC
probability
density
time today in 1 year

possible portfolios
in 1 year
earthquake
pandemia
yields
inflation
MCV
MCV
53
Replicating Portfolios
Life insurance options & guarantees intimately weave
market and insurance risk together
SCR = RBC statistic over (real world) economic scenarios
RBC = average over (risk neutral) economic scenarios
Monte Carlo of Monte Carlo
Standard solution: replicating portfolio = RBC closed form
estimate
approximation of an approximation
54
Replication Quality in the Bulk
-20'000'000'000
-10'000'000'000
0
10'000'000'000
20'000'000'000
0 25'000'000'000 50'000'000'000 75'000'000'000
r
e
s
i
d
u
a
l
replicated BEL
r
e
s
i
d
u
a
l
replicated BEL
55
Replicating Portfolios
Life insurance options & guarantees intimately weave
market and insurance risk together
SCR = RBC statistic over (real world) economic scenarios
RBC = average over (risk neutral) economic scenarios
Monte Carlo of Monte Carlo
Standard solution: replicating portfolio = RBC closed form
estimate
approximation of an approximation
Other solution = Monte Carlo of Monte Carlo
with variance reduction
techniques
56
Variance Reduction
( ) ? = =
}
x f dx I
( ) known
~ ~
= =
}
x f dx I
( ) ( ) | | ( )
I f dx
x f dx x f x f dx I
~
~ ~
+ A =
+ =
}
} }
Monte Carlo
Monte Carlo
57
Major Risk Models
Insurance
risk
General
insurance
Reserves
Underwriting
Attritional
losses
Large claims
Catastrophic
losses
Life
insurance
Biometry
Options &
guarantees
Market risk
Fixed income
Variable
income
Exotic
instruments
Credit risk
Operational
risk
Aggregation
Convergence
Dependences
CRTIs
Meta-risks
Economic
scenarios
Stress
scenarios
Parameters
Risk margin
Liquidity
58
r
i
e
s
g
o

2
riesgo 1
best estimate
50% confidence level
70% confidence level
90% confidence level
Dependences
Kobe EQ
property
burglary
Barings Bank
September 11
aviation
property
BI
life
market

59
0
5'000
10'000
15'000
20'000
0 5'000 10'000 15'000 20'000
r
i
e
s
g
o

l
o
g
n
o
r
m
a
l
riesgo Pareto
0
5'000
10'000
15'000
20'000
0 5'000 10'000 15'000 20'000
r
i
e
s
g
o

l
o
g
n
o
r
m
a
l
riesgo Pareto
cpula
de Clayton
Dependences
cpula
independiente
60
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
GAUSS
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
CLAYTON
Use copulas, but with a realistic tail dependence
Dependences
61
Economys Complex Phenomenology
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0.0 0.2 0.4 0.6 0.8 1.0
t
a
i
l

d
e
p
e
n
d
e
n
c
e
limit process variable
observaciones
escenarios
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
l
o
g

r
e
t
u
r
n

E
Q

(
U
S
D
)

r
a
n
k
log return EQ (EUR) rank
observaciones
escenarios
| | c c
c
s s
=
u v P | lim
0

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