Analyzing the Impact of Time Horizon, Volatility and Profit Margins on Solvency Capital: Proposing a New Model for the Global Regulation of the Insurance Industry

Abstract

The European Solvency II regime requires a solvency capital covering risks with a given shortfall probability of 1/200=0.5% on a one-year time horizon, which is extremely short compared to the contractual terms in traditional life insurances, as well as the settlement periods of several decades in some casualty branches. This approach undermines the importance of a high return margin and, given a risk-averse approach to management, may lead to an overall riskier business strategy in the long run. In light of this, we cannot help but ask whether such a short time horizon is capable of providing a meaningful guideline for a sustainable business and risk management that has a long-term perspective. In response to this question, we present a new model for assessing the evolution of the equity of an insurance company and calculating the probability that the initial equity of an insurance company will be depleted during a given time period. This model demonstrates that insolvencies mostly do not occur in the first year. Therefore, if one only considers a one-year window, as is the case under Solvency II, the risk will be underestimated. Even more serious is that the business will be managed too cautiously without aiming for a suitably high profit margin, which significantly reduces the risk only in the long term.