## Getting used to Solvency II

Insurers and reinsurers throughout the EU are facing up to the implementation of Solvency II, a radical overhaul of regulatory standards for insurance business.  Recently we explored how much Solvency II demands stochastic models.  Another feature of Solvency II is the so-called "use test", which has been described as follows:

"Are the insurance firm's internal risk measurement systems closely integrated into its day-to-day risk management processes? [...] Put simply, the "use test" refers to the need for the risk-measurement judgements to play a key role in the management of a firm before they will be accepted also for regulatory purposes."

Source: John Tiner, then Chief Executive, FSA, speech on 6 April 2006.

The quote is a little old, as the chief executive has since changed. However, the regulator's view of the use test is unlikely to have changed much. The key theme is that in order for a Solvency II model to be acceptable to the regulators, there has to be evidence that it is used in the day-to-day management of the business.  In other words, there can be no artificial distinction between models used for valuation purposes and those used for business management.

One question is how frequently you need to run these models to satisfy the use test?  We asked the actuaries of some life offices and reinsurers and got the following responses:

"We intend running full balance sheets quarterly, using roll forwards to monitor daily solvency."
"Given the practicalities of actually running these models, a frequency higher than quarterly is entirely out of the question."
"We produce a realistic balance sheet monthly and also use realistic estimates as part of pricing and I think that this satisfies the 'use' test."
"[...] the process should allow the undertaking to do it at any moment, under request of the supervisor or in case of a substantial change in the portfolio. In practice, I believe it will be done once a year for most companies."
"I would have to plump for "weekly" based on risk management processes here but I can see arguments for other frequencies."
"[...] its application is wide-ranging, e.g. from solvency assessments [...] through business planning, through new business pricing, and more [...] I don't think you need to produce a full economic balance sheet to satisfy the use test, so I'm not sure the question is capable of being answered. "

So, quite a bit of variety in opinion!  The sample is small and biased towards UK insurers, but most respondents have plumped for at least quarterly realistic balance sheets as a means of satisfying the use test.

Assume we have a random variable, $$X$$, with expected value ... Read more