A Strategic Decision-Making Model Executing the Use Test Under Solvency II

Abstract

Solvency II allows insurers to determine their own solvency capital requirements (SCR) under a one-year Value-at-Risk (VaR), and using internal models to quantify risks can therefore replace parts, or even all risks, of the standard formula. A major challenge for the industry is the use test under which companies will need to convince regulators that senior management understands, trusts and takes appropriate account of internal model outputs within its key decisions. This paper present a conceivable solution that linking capital allocation, pricing, performance and strategy together. The model presented will execute the use test under Solvency II and senior management provides with drivers to make strategic decisions based on the defined risk appetite and the internal model output. The model will be presented under the scope with a partial internal model for reserve risk, but could easily be extended to a full internal model environment. The model will be interpreted as a premium reserve model with intention to assess the ratio of the risk return of the SCR held.