Risk aggregation in non-life insurance: Standard models vs. internal models

Abstract

Standard models for capital requirements restrict the correlation between risk factors to the linear measure and disregard undertaking-specific parameters. We consider an alternative framework for risk aggregation in non-life insurance using vine copulas that allow non-linear dependence and are estimated with undertaking-specific parameters. We empirically compare our alternative risk model with three regulatory standard models (Korean risk-based capital, Solvency II, Swiss Solvency Test) and show that the standard models lead to more than 50% higher capital requirements on average. Half of the overestimation results from the uniform parameter selection imposed by regulations and the other half comes from the linear correlation assumption. The differences might distort competition when both standard models and internal risk models are used in a single market.