Internal model for insurers: possibilities and issues

Abstract

Purpose – solvency II framework regulates how much capital the European Union insurance companies must hold. The amount of necessary capital can be calculated using a standard formula or an internal model. On the basis of the review of other authors’ empirical research, the present paper aim at identifying factors that influence necessary capital and propos-ing necessary areas of improvement for the methodology of an internal capital model. Research methodology – to conduct the paper, the authors have used the extended literature review. Analytical methods and comparative methods have been used for the Baltic non-life insurance market analysis. Findings – the Baltic market does not use an internal model even for a major risk – premium and reserve risks. A review of the current literature findings shows that the main weakness of the standard formula is risk aggregation. Research limitations – identified factors apply to non-life insurance companies under the Solvency II framework with a focus on reserve risk. Practical implications – factors are identified that should be implemented in the internal model methodology. The paper will help avoid using internal models as only a modern risk management tool and improve risk profile accuracy. Originality/Value – improvements of the internal model methodology are proposed based on a literature review. The au-thors have identified the main directions, issues and improvement possibilities for reaching modern risk management.