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Pillar I capital requirements: is an internal model still the right approach?

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The Solvency II directive requires all insurance firms to consider the most appropriate approach to meeting Pillar I capital requirements. Insurers can choose between developing an internal model, using the European Standard Formula or applying a hybrid of the two. In the UK, most firms based their decision on the outputs of the fifth Quantitative Impact Study (QIS5) for Solvency II (November 2010). 

Since this study was published, however, several changes have taken place. The European Standard Formula requirements have been revised, many firms' business models have altered and entry to the pre-application process has closed. Most importantly, implementation timelines for Solvency II have shifted again. As a result, many firms may find an internal model is no longer the right choice.

As national supervisory authorities work on developing interim capital regimes for use until Solvency II is implemented, insurers can take advantage of this period of stagnation to reassess whether the internal model is the still right for them. 

There are three key areas to focus on:

Reassess whether potential improvements in capital efficiency justify the cost of developing an internal model 

Use allocated regulatory resources to reconsider whether the potential improvement in the capital efficiency of your business justifies the cost of continuing to develop an internal model. We recommend taking into account the following points:

  • scaling back or withdrawing from certain portfolios/locations may be more cost-effective than developing an internal model

  • even though developing an internal model may improve capital efficiency, supervisory authorities are likely to require capital levels above a pre-determined economic 'floor'

  • in the UK, the ICAS regime is likely to be re-invigorated and is expected to permit the use of Solvency II internal models in development for this purpose. Re-running old ICAS models may be costly by comparison. 

Use the November 2011 Solvency II Level 2 Implementing Measures to re-evaluate the European Standard Formula

QIS5 took place over two years ago. Since then, your firm’s business profile may have changed significantly and, in the updated text, the make-up of the European Standard Formula changed too. Now is the time to review the formula in light of the following: 

  • reinsurance arrangements may have changed

  • with-profits business may no longer be relevant

  • a correlation matrix approach to aggregate risk may no longer be appropriate

  • account volatility may no longer be applicable. 

Consider whether the case for an internal model remains intact in light of your future business strategy

The costs associated with developing an internal model don’t stop when internal model approval is granted. The recommendation would be to make sure that the business case for an internal model takes into account the future costs associated with its maintenance and update, taking into particular consideration:

  • once internal model approval is granted, you cannot revert to using the European Standard Formula unless there are “duly justified circumstances” 

  • economic uncertainty is set to remain significant and your business strategy may evolve as a result 

  • IT hardware and licensing costs may continue well into the future.

Continuing with the development of an internal model and using this methodology during any interim regime, such as ICAS+ in the UK, may be the correct course of action for your business. However, it’s vital to base your decision on current market knowledge and the latest policy developments, not on historical analysis.

PA is in the unique position of supporting organisations right across the insurance industry, including a number of European regulators, with the implementation of Solvency II. Latest case studies include;

FSA - supporting delivery of the FSA's largest ever programme

Arch Insurance - delivering beyond expectation on Solvency II programme

To talk to one of our experts for independent advice on any aspect of your Solvency II programme, contact us now. 

David Troman
Financial Services
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Reiar Ness
Financial Services
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