Traditionally products were priced such that they would turn in a profit while prudent assumptions in the reserving aimed at ensuring that there was enough in the kitty to pay the policyholders what they were owed.

Solvency II is an attempt to make reserving more transparent, ensuring that reserves are calculated on a market consistent/best estimate basis and that all prudence is captured in an additional capital requirement. That capital requirement is intended to enable the insurer to still have more assets than reserves after an extreme shock.

But Solvency II goes much further, allowing companies to use their own capital models (internal models) to calculate the amount of capital they need to hold. Firms taking this internal model route are asking the regulators to trust that their internal model will correctly calculate the capital requirement. In return for this trust the firms asking to use internal models are required to jump through a lot of hoops (tests) to justify their models to the regulators.

This article was first published by FTadviser.com.