CP1: Practice Questions - Solutions

(i) Define the Minimum Capital Requirement and the Solvency Capital Requirement under the Solvency II regime. [2]

(ii) Explain why an insurance company might use an internal model to assess its regulatory capital requirements. [4]

[Total 6]

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Solutions:

(i) Minimum Capital Requirement (MCR) and Solvency Capital Requirement (SCR) under Solvency II:

Minimum Capital Requirement (MCR):

The Minimum Capital Requirement (MCR) is the minimum amount of capital that an insurance company is required to hold to ensure that it can meet its obligations to policyholders and other creditors even in adverse circumstances. It is designed to provide a basic level of financial security for policyholders.

Solvency Capital Requirement (SCR):

The Solvency Capital Requirement (SCR) is a more comprehensive measure of capital adequacy. It represents the amount of capital that an insurance company needs to cover its risks with a high degree of confidence over a one-year time horizon. The SCR is calculated based on a risk-based approach, considering various risks such as underwriting risk, market risk, credit risk, operational risk, and other risks that the insurer may face.

In summary, MCR ensures a minimum level of financial security, while SCR provides a more sophisticated and risk-sensitive measure to ensure that insurers have adequate capital to withstand various risks they might encounter.

(ii) Why an Insurance Company Might Use an Internal Model:

Tailored Risk Assessment:

An insurance company might use an internal model to assess regulatory capital requirements because it allows for a more tailored and company-specific assessment of risks. Internal models can reflect the unique risk profile, business model, and risk management practices of the insurer.

Accurate Risk Measurement:

Internal models enable insurers to more accurately measure and quantify the various risks they face, including underwriting risk, market risk, and operational risk. This can result in a more precise determination of the Solvency Capital Requirement (SCR) based on the company's specific risk exposures.

Enhanced Risk Management:

The use of internal models encourages insurers to enhance their risk management capabilities. By understanding their risk exposures in greater detail, companies can implement more effective risk mitigation strategies and improve overall risk governance.

Incorporation of Company-Specific Factors:

Internal models allow insurers to incorporate company-specific factors and data that may not be captured adequately by the standard formula used for calculating the SCR. This flexibility enables a more nuanced and accurate assessment of the capital needed to cover specific risks.

Stakeholder Confidence:

Developing and using an internal model demonstrates a commitment to a robust risk management framework. This can enhance confidence among stakeholders, including policyholders, regulators, and investors, in the insurer's ability to manage risks effectively.

Strategic Decision-Making:

Internal models provide insurers with a tool for strategic decision-making. By understanding the impact of different business strategies on their capital position, companies can make more informed decisions about product offerings, pricing, and overall business direction.

Continuous Improvement:

The process of developing and using internal models promotes a culture of continuous improvement. Insurers can refine and update their models as they gather more data and as the business environment evolves, ensuring that their risk management practices stay current.

In summary, an insurance company might use an internal model to assess regulatory capital requirements because it offers a more tailored, accurate, and company-specific approach to measuring risks and ensuring capital adequacy under the Solvency II regime.

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