Internal capital models provide a way for an entity to analyse and assess it’s inherent risks and formulate the required capital to sustain the entity and meet objectives. The key user of these models is generally the board who use it to decide how much capital the firm should hold. Other divisions can also make use of outputs from the model to fulfil their requirements.
In general insurance they are used in a number of applications:
- First and foremost they aid the insurer in setting the amount of capital held.
- They enhance the understanding of risk and provide an input into the risk management framework.
- They can be used to help set the Reinsurance programme.
- They can help business make key decisions.
They provide two key outputs:
- Required Regulatory Capital
- Economic capital
Required Regulatory Capital is the amount of capital the regulator requires insurers to hold. In Australia APRA requires insurers to maintain capital above the Prescribed Capital Amount (PCA). Insurers tend to hold what is often termed as Economic capital. This is the amount of capital the insurer will hold to meet it’s objectives. (e.g. RORBC, ROE, etc.) This is greater than the required regulatory capital.
Internal capital models model the following risks:
- Insurance Risk
- Credit Risk
- Asset Risk
- Operational Risk
- Interest Rate Risk
Dependancy structures are also modelled.