Quantifying credit and market risk under Solvency II: Standard approach versus internal model

Even though insurers predominantly invest in bonds, credit risk associated with government and corporate bonds has long not been a focus in their risk management. After the crisis of several European countries, however, credit risk has recently been paid greater attention. Nevertheless, the latest version of the Solvency II standard model (QIS 5), provided by regulators for deriving solvency capital requirements, still does not require capital for credit risk inherent in, e.g., EEA issued government bonds from Greece or Spain. This paper aims to provide an alternative approach and compares the standard model with a partial internal risk model using a rating-based credit risk model that accounts for credit, equity, and interest rate risk inherent in a portfolio of stocks and bonds. The findings demonstrate that solvency capital requirements strongly depend on the quality and composition of an insurer's asset portfolio and that model risk in regard to model choice and calibration plays an important role in the quantification.

► We propose partial internal models for equity, interest rate and credit risk. ► We compare internal models with the regulators' standard model of Solvency II. ► The capital requirements strongly depend on the portfolio composition. ► Diversification effects are not adequately reflected in the standard model. ► Model risk plays an important role for quantifying the capital requirements.