Economic capital
Besides the determination of regulatory capital or solvency margin that insurers do have to hold by law, it is of paramount importance for insurers to determine the economic capital they need.
The economic capital may be viewed as the minimum amount of capital to be maintained in the firm by its shareholders to ensure the ongoing operations of the insurer. It must be sufficient to gain the necessary confidence of the marketplace, the policyholders, the investors and the supervisors, but it is also the interest of the insurer to keep it as reduced as possible and to maintain actual capital as close as possible to economic capital in order to maximise return on equity.
One trend in the development of solvency systems by insurance supervisors throughout the world is towards the allowance given to insurers to possibly use models similar to the ones developed for the determination of economic capital to determine their regulatory capital (cfr. the development of scenarios-based and probabilistic approaches referred to before). Differences in the models used and in the results obtained for the two purposes may subsist in most cases, for example because objectives, risk measures or confidence levels may differ. But notwithstanding these differences, the development of a predictive financial model is required in both cases and, if well designed, an important part of the development may serve both purposes.
The development of such models is further discussed hereafter.