Financial institutions often serve many different customers in many different sectors, including customers in sectors with higher inherent integrity risks. The sector in which a customer operates is one of the factors that a financial institution...Read more
Solvency II: Pillar 1
The first pillar of Solvency II concentrates on the economic balance sheet, the resulting actual own funds, and the required risk-based own funds. Required own funds are determined based on a Solvency II Standard Formula, or by means of an internal model.
The economic balance sheet takes market valuation as its starting point. Where market valuation is not straightforward, we seek to achieve this through model building. This applies in particular to the valuation of technical provisions.
Actual own funds break down into two components: core own funds (tier-one capital) and additional own funds (tier-two capital). Tier-one capital equals assets minus liabilities plus subordinated liabilities. Tier-two capital constitutes payable components to cover losses.
The standard model for risk-based required own funds has a modular set-up. Each module focuses on a specific group of risks, which is often refined at sub-module level. This primarily concerns the risks attached to the size and composition of the investment portfolio of an insurance company, and risks attached to the size and composition of the insurance portfolio. In addition to these, catastrophe risk, counterparty risk, and operational risk is included. An important component of the standard model is defining the cohesion between the various modules and sub modules by means of correlations. These correlations are part of an aggregation procedure that culminates in a single capital requirement.
Required own funds can also be calculated by means of an internal model that the insurance company will have to develop itself. Information from the institution's own data sets is necessary to support the parameters playing a role in this internal model. This applies to all parameters, not only to those for volatilities, but also those for correlations. The internal model is not only intended to establish the capital requirements, but also plays a part in other areas of operational management. Here you may think of premium setting, reinsurance policies, and remuneration policy.
The supervisory authority subjects the internal model to an application and an approval procedure. An internal model may not always be approved. A partial internal model focusing on a specific area of risk may also be developed.
The envisaged level of certainty of the capital requirement determined in this way was set at 99.5% over a one-year horizon. Roughly speaking, this means that a specific insurance company that meets the capital requirement exactly will run into trouble once every 200 years.