The insurers are mandated to carry out their Own Risk and Solvency Assessments (ORSA) in line with their nature of business, scale and complexity of the risk profile it carries by the International Association of Insurance Supervisors (IAIS). There are also new regulatory, statutory and risk requirements that the insurers need to ensure regarding capital adequacy from different stakeholders' perspective. The insurance companies are addressing this by building internal models in line with their philosophy of the enterprise risk management framework, which then becomes embedded in the risk, capital management and operational process. This article discusses the various aspects of internal models, model construct and some of the practices being followed by the insurers.

International Association of Insurance Supervisors stipulates that all insurers should be undertaking their Own Risk and Solvency Assessments (ORSA) in line with their nature of business, and scale and complexity of the risk profile of its business. Insurers report to regulators with respect of solvency capital requirements, economic capital needs of the insurance enterprise, and capital requirements as per National GAAP and risk requirements for other internal strategic decision making. Insurance regulators have specified guidelines, model elements assessed, process for submission, evaluation of adequacy of capital based on the internal models of the insurance companies. They follow this with reviews that could vary from thematic review, on-site inspection, desk-based review and so on. While efforts are being made to converge the diverse requirements, in the interim, insurance companies need to have a strong risk assessment, monitoring, control and reporting framework.

Internal models provide an overall framework for forecasting, analyzing, quantifying, evaluating and monitoring of risk and capital management process in the insurance companies. It provides visibility in estimating the risk before the insurance company in accordance with its risk profile, underwriting practices and financial and investment management practices. Internal models are also being used in the areas of rate making, Asset Liability Management (ALM), reinsurance programs, strategic business decision, asset allocation, risk strategy, capital allocation, risk limit setting, performance analysis, pricing and market consistent technical provision, budgeting, evaluation of technical provision, product development, risk margin, and dividend payment.

While comparisons are often made with Basel II, there are some fundamental differences between the banking sector and the insurance sector. The material risks for insurance companies are catastrophe risk, underwriting risk, reserving risk, market risk, credit risk and operational risk. Of these catastrophe risks, underwriting risk and reserving risk are specific to insurance business and are termed as insurance risks. Market risk, credit risk and operational risks are common to all financial entities. Secondly, insurance companies have complex liabilities, different typical mixture of assets, different ALM relationships, time horizons, relative importance of different risk categories and organizational and legal structures. Thus, while Basel II provides a framework for managing risks in banks, the same could not be directly applied to insurance companies because of the insurance risks, which is not addressed in Basel II framework. However, the framework for credit, market and operations risks can be adapted for insurance companies keeping in mind the difference in business structure and realities.

Insurance Chronicle Magazine, Internal Risk Models, Insurance Companies, Credit Risk, Operational Risks, Financial Entities, Insurance Business, Banking Sector, Asset Liability Management, Capital Allocation, Strategic Business Decisions, Reinsurance Programs.