The Threat of Model Risk for Insurance Companies

Abstract

Insurance companies have increasingly used quantitative decision-making tools for a number of years. They have routinely taken advantage of models for a large number of business activities (underwriting policies, transferring risks, determining reserve adequacy, managing assets and liabilities, valuing risk exposures and financial instruments, .. ), but they now appeal to models for more ambitious ends like development of new products or strategic planning. Moreover, the new quantitative regulatory requirements of Solvency II, as well as various stakeholders' expectations (including rating agencies, analysts, financial markets, ... ) push companies to develop more and more sophisticated models, not only for more complex products, but also for improved enterprise risk management. The expanding use of models reflects the range to which models can improve business decisions. But they also can lead to wrong decisions and potential adverse consequences when they are incorrect or misused, which is known as model risk. An active management that addresses these consequences has to be organised by insurance companies. In this chapter, we first try to understand what model risk is. In a second part, we discuss several approaches to measure model risk. In a third part, we raise the problem of model risk management and present several procedures to mitigate it. In a last part, we discuss the issue of model risk for the new regulatory framework Solvency II.