At the end of 2004, the Financial Services Authority (FSA) in the UK introduced new rules governing the amount of capital that insurance firms must hold.
A core component of the new rules is the requirement for insurance firms to undertake their own assessment of their capital needs, the so-called Internal Capital Assessment (ICA). The FSA will consider a firm’s ICA when setting Individual Capital Guidance (ICG) – the FSA’s view of the required capital.
As part of the ICA, firms are required to identify the major sources of risk, and where it is deemed appropriate to hold capital against these risks, to quantify this amount of capital. The FSA has specified that capital resources should be assessed that are consistent with a confidence level of 99.5% over a one-year timeframe, or possibly a lower confidence interval over a longer timeframe if appropriate to a firm’s business.
As a response to the new regulation, many firms have decided to build financial risk models of their business. In this way they are able to assess the impact of extreme scenarios, for example: severe levels of claims, poor asset performance, reinsurance failure, and quantify the amount of capital that should be held to protect the solvency of the firm under these scenarios.
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