Willis Re has commended a report produced by Standard & Poor’s proposing new criteria for assessing insurers’ economic capital models.

The reinsurer says S&P’s report incentivises insurers to adopt more sophisticated internal capital models by giving them the opportunity to use the modelling results to potentially reduce their capital requirements.

The new criteria offer insurers the possibility of reducing their rating agency capital requirement by replacing a proportion of S&P’s standard formula with their own internal capital calculation, that proportion depending upon the credibility that S&P places on the firm’s economic capital model. The Willis Re report discusses the structure of the new criteria and their relevance for insurers worldwide, with a particular focus on EU companies that will soon be subject to a parallel set of requirements under Solvency II.

Willis’ response to the work, Standard & Poor’s Economic Capital Model Review Promises Capital Rewards identifies the main features of the “ideal” economic capital model according to S&P and provides insights into how the agency is likely to apply its new methodology in practice.

Commenting on the new criteria, David Simmons, managing director, analytics and head of international & specialty enterprise risk management for Willis Re, said: “By at last offering the carrot of lower capital requirements to add to the stick of their existing ERM review, Standard & Poor’s has further increased the incentive for insurers to adopt tailored and more sophisticated capital models. But the bar is set quite high. Strong risk management remains key and only models embedded in business decision-making of companies judged to have strong ERM processes will be eligible for review.”

While S&P’s criteria resemble Solvency II conditions for supervisory approval of internal models, the report notes that there are differences. S&P does not approve models but rather weights their credibility. Willis Re says that it now looks likely that Solvency II implementation will be phased, assuming that the transition allowances recently set out in the Omnibus II Directive are followed. “Many companies, particularly in the London market, have invested heavily in their internal economic capital modelling, partially in expectation of gaining regulatory capital relief. This proposal promises a means to release real value from that investment by influencing their rating agency capital,” said Simmons.

Key findings in the report include:

•S&P’s review will have a markedly qualitative character. S&P will assign scores of “basic”, “good”, or “superior” to each component of an insurer’s economic capital model. These scores will then be aggregated into a comprehensive assessment summarised by a single number, the “M-factor”, which measures the model’s credibility in S&P’s view. The M-factor will be used to blend S&P’s capital model requirements with those from the insurer’s model. This is materially different from Solvency II, where approved internal models will fully replace the standard formula for the solvency capital requirement.

•Stochastic modelling per se may not be enough to obtain S&P’s approval and should be augmented by stress tests including, but not limited to, worst historical experience.

•S&P believes that capital fungibility should be explicitly and carefully modelled before taking any diversification benefits into account in the determination of economic capital – a crucial requirement for multi-national insurance groups.

•The immediate impact of the new criteria is likely to be relatively small, says Willis Re, as S&P will probably adopt a conservative attitude in deciding its M-factors. This is likely to change in the future, however, as insurers’ models increase in sophistication and S&P’s comfort in them grows.

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