Internal models: how EIOPA is using comparative studies as a supervisory tool

What are internal models?

The Solvency II framework requires insurance companies to hold enough capital to cover unexpected losses, which are driven by the risks companies are exposed to. To measure these risks, companies can use either a standardised approach set by regulators or their own internal model.

Under the standardised approach, companies apply standard risk measures. Internal models, on the other hand, allow companies to estimate the risk themselves. The more risk an insurance company bears, the more capital it needs.

Internal models are statistical tools that use available historical data, such as the company’s own business experience or market information, to simulate future financial outcomes. The models are tailored to the individual risk profile of the company and therefore allow a more accurate measurement of the risk.

Companies use internal models:

• To calculate their solvency capital requirements and to allocate their capital resources more efficiently.
• As a risk management tool, for day-to-day decision-making and for forward looking risk management (e.g. purchase of reinsurance, pricing of policies, investment portfolio allocation, etc.).

Companies that decide to use internal models are subject to initial approval following prescribed processes from supervisory authorities. After approval, supervisors continue to monitor the appropriateness of the model.

Comparative studies: EU-wide supervisory tools

To analyse whether models appropriately reflect the underlying risk, EIOPA, together with national supervisors, run European-wide comparative studies. They come as a complement to individual internal model analysis and national studies.

The objective is to compare internal model outputs efficiently, and have an up-to-date overview of the modelling approaches, as well as to further develop supervisory tools and foster common supervisory practices.

Participating undertakings receive preliminary and final feedback on the results of the study via individual feedback sessions to understand their relative position in the European sample. Results of comparative studies have already led to model improvements via model changes. The comparative studies are also used in assessing new internal model applications.

EIOPA is currently running four comparative studies on:

• Market and credit risk modelling,
• Non-life underwriting risk modelling,
• Diversification and,
• Life risk modelling

The Market and credit risk comparative study (MCRCS) runs on an annual basis and compares modelling approaches for a selection of predefined asset portfolios. Overall, it aims at enhancing transparency of internal models by analysing the outcomes of different market and credit risk models.

EIOPA recently published the 2022 MCRCS report based on year-end 2021 data.

Download the report

The Non-life underwriting risk modelling (NLCS) study aims to provide a fair evaluation of non-life underwriting risks and their development over a five-year time horizon.

The study on Diversification aims to gain an overview of current market approaches and on best effort basis, analyse and compare the levels of diversifications.

The findings of these studies will be published in the third quarter of 2023.

Finally, in 2023 a new comparative study on life risk modelling has started.

Learn more about internal models at EIOPA