Optimisation of limit systems for investment risks in accordance with Solvency II

Abstract

In order to satisfy the requirements of Solvency II (e.g. Framework directive on the EU Solvency II Project on Safety Measures and its implementation according to § 64a German Insurance Law)—insurance companies should implement an overall risk limit system. The starting point for developing this system is the entity’s risk strategy and risk bearing capital approach based on economic principles. For life insurance companies, the dominant risk category is investment risk. Therefore, the limit system should focus on such risks. In practice there are multiple interactions between the core life insurance business and the asset side. Because of these interactions, a limit system for investment risks cannot be separated from life business risks. There is a particular need to integrate the entity’s asset liability management approach into the risk limit system. The regulatory requirements call for consistent integration of a top-down view with a bottom-up risk management perspective in the investment department. In creating an adequate system, the first step is to categorise the individual types of risk and the corresponding risk management approaches. It is most important to get clear definitions of the bottom-up and the top-down views in the context of life insurance investment risks, and to integrate these into the entity’s overall solvency control regime. The current financial crisis has revealed problems of valuation and an enormous and unprecedented increase in volatility in the capital markets. It is clear that an ongoing and effective analysis of these market developments and their impact on asset allocation and portfolio optimisation is necessary. The crisis also implies the need to think in detail about how to manage model risk implications. In this paper we propose an integrated view of these issues as the basis for optimal design of the company’s risk limit system.