# LO 58.10: Compare the standardized approach and the Internal Models Approach

LO 58.10: Compare the standardized approach and the Internal Models Approach for calculating the SCR in Solvency II.
The two approaches an insurance firm can use to calculate the SCR under Solvency II are: 1. Standardized approach.
Internal models approach. 2. Standardized Approach. Analogous to Basel II, the standardized approach to calculating SCR under Solvency II is intended for less sophisticated insurance firms that cannot or do not want to develop their own firm-specific risk measurement model. It is intended to capture the risk profile of the average firm and is more cost efficient for smaller firms with less fully developed risk management functions.
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Internal Models Approach. This approach is similar to the IRB approach under Pillar 1 of Basel II. A VaR is calculated with a one-year time horizon and a 99.5% confidence level. There is a capital charge for the following three types of risk: 1. Underwriting risk, divided into risks arising from life insurance, non-life insurance (such
as property and casualty insurance), and health insurance.
2.
Investment risk divided into market risk and credit risk.
3. Operational risk. Regulators have implemented quantitative impact studies (QISs) to examine whether capital is sufficient to weather significant market events. For example, QISs have considered large declines (i.e., 32%) in global stock markets, large declines (20%) in real estate prices, large increases (10%) or decreases (25%) in mortality rates, and so on.
Internal models developed by insurance companies must satisfy the following three tests: 1. Statistical quality test: This tests the quality of the data and the methodology the firm
uses to calculate VaR.
2. Calibration test: This tests whether risks are measured in agreement with an industry
wide SCR standard.
3. Use test: This test determines if the model is relevant and used by risk managers.
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K e y Co n c e pt s
LO 58.1 Prior to 1988, bank capital regulations were inconsistent across countries and ignored the riskiness of individual banks. In 1988, the Basel Committee put forth its first guidance to set international risk-based capital adequacy standards known as Basel I.
Basel I was originally developed to cover credit risk capital requirements. It was amended in 1996 to also include market risk capital requirements. Basel II was introduced in 2004 and addressed not only credit and market risk capital but also operational risk capital.
LO 58.2 Under Basel I, banks calculated risk-weighted assets for on- and off-balance sheet items. Capital was required as a percentage of risk-weighted assets. For example, cash and Treasury securities received a 0% risk weight while commercial loans received a 100% risk weight. Off-balance sheet items were expressed as credit equivalent amounts and were converted into risk-weighted assets. Capital could be Tier 1 or Tier 2 but at least half of the capital requirement (4%) had to be met with Tier 1 capital (equity and non-cumulative perpetual preferred).
LO 58.3 Banks were required to measure market risk in addition to credit risk under the 1996 Amendment to the 1988 Basel Accord. The 1996 Amendment proposed two methods for calculating market risk including the standardized measurement method and the internal model-based approach. The standardized method assigns a capital charge separately to each of the items in the trading book. This method ignores correlations between the instruments. The internal model-based approach uses a formula specified in the amendment to calculate a value at risk (VaR) measure used to determine the capital requirement. Capital charges are generally lower using this method because it considers correlations between the instruments.
LO 58.4 According to the 1996 Amendment, the market risk VaR is calculated with a 10-trading-day time horizon and a 99% confidence level. The capital requirement for market risk is:
max(VaRt_1, mc x VaRavg) + SRC
where: VaRt _ j = previous days VaR VaRavg = the average VaR over the past 60 days mc SRC = specific risk charge = = multiplicative factor, minimum value of three
The 1996 Amendment requires banks to backtest the one-day, 99% VaR over the previous 250 days. If the actual loss is greater than the estimated loss, an exception is recorded. The
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multiplicative factor (mc) is set based on the number of exceptions. If, over the previous 250 days, the number of exceptions is: Less than 5, mc is usually set equal to three.
Greater than 10, mc is set equal to four. The bank supervisor has discretion regarding the multiplier.
5, 6, 7, 8, or 9, mc is set equal to 3.4, 3.5, 3.65, 3.75, and 3.85, respectively.
LO 58.5 Basel II improves on Basel I in at least two ways. First, counterparty credit ratings are considered in calculating risk-weighted assets. Second, a model of default correlation is included. Basel II specifies three approaches banks can use to measure credit risk, including the standardized approach, the foundation internal ratings based (IRB) approach, and the advanced IRB approach. The standardized approach is the least complicated and the risk weighting approach is similar to Basel I, although some risk weights were changed. Under the IRB approach, the capital requirement is based on a VaR calculated over a one-year time horizon and a 99.9% confidence level. The foundation IRB approach and the advanced IRB approach are similar. The key difference is who supplies the input variables. Banks supply their own estimates of probability of default (PD), loss given default (LGD), exposure at default (EAD), and the maturity adjustment (M) if using the advanced approach. Under the foundation approach, banks supply PD estimates, while the Basel Committee supplies the estimates of LGD, EAD, and M.
LO 58.6 Basel II requires banks to maintain capital for operational risks. Operational risks include failures of the banks procedures that result in loss (e.g., fraud, losses due to improper trading activities). External events that result in loss, such as a fire that destroys bank assets or information, are also considered operational risks. Under Basel II, there are three approaches banks may use to calculate capital for operational risk including the basic indicator approach (the simplest), the standardized approach (similar to the basic indicator approach but with different multipliers applied to different lines of business), and the advanced measurement approach (the most complex). The capital requirement for operational risk under the advanced measurement approach is based on an operational risk loss calculated over a one-year time horizon and a 99.9% confidence level (i.e., VaR). The approach has an advantage in that it allows banks to consider risk mitigating factors such as insurance contracts.
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LO 58.7 Basel II is an international standard, governing internationally active banks. There are three pillars under Basel II as follows: 1. Minimum capital requirements. This pillar involves calculating capital based on the
riskiness of the bank, taking into consideration credit risk, market risk, and operational risk.
2. Supervisory review. A primary goal of Basel II is to achieve overall consistency in the
application of the capital requirements across countries while, at the same time, giving supervisors discretion to consider market conditions in their own countries.
3. Market discipline. Banks are required to disclose more information about the risks they take and the capital allocated to those risks. According to Basel II, if banks must share more information with shareholders (and potential shareholders), they will make better risk management decisions.
LO 58.8 In the context of Basel II, the worst case probability of default (WCDR) is the amount the bank can be 99.9% certain the loss will not exceed (from a specific counterparty) in the coming year. The one-year probability of default (PD) is the probability that an obligor, given a large number of obligors, will default. The exposure at default (EAD) is the dollar amount a counterparty is expected to owe if it defaults. The loss given default (LGD) is the proportion of the EAD that is expected to be lost in the event the counterparty defaults. For example, if the bank expected to collect 40% in the event of default by a counterparty, the LGD is 60%.
LO 58.9 In Europe, Solvency I establishes capital requirements for the underwriting risks of insurance companies. Solvency II is expected to replace Solvency I and will consider operational and investment risks in addition to underwriting risks. Pillar 1 of Solvency II specifies: Minimum capital requirement (MCR). The repercussions for breaching the MCR will
likely include a prohibition from taking new business. Regulators may also force the insurance company into liquidation and transfer the companys insurance policies to another firm. Solvency capital requirement (SCR). Repercussions for breaching the SCR are less severe than if the firm breaches the MCR. If the SCR falls below the required level, the insurance company will likely be required to submit a plan for restoring the capital to the required amount.

LO 58.10 There are two approaches an insurance firm can use to calculate the SCR under Solvency II. They are the standardized approach and the internal models approach. The standardized approach is least complicated and is meant to capture the risk of the average firm. The internal models approach is similar to the IRB approach under Basel II. It involves calculating a VaR with a one-year time horizon and a 99.5% confidence level.
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C o n c e pt C h e c k e r s
1.
Michigan One Bank and Trust has entered a $200 million interest rate swap with a corporation. The remaining maturity of the swap is six years. The current value of the swap is$3.5 million. Using the table below to find the add-on factor for the interest rate swap, the equivalent risk-weighted assets (RWA) under Basel I is closest to:
Add-on Factors as a Percentage of Principal for Derivatives year 15 years Remaining M aturity in Years < 1 year 1 to 5 years > 5 years
Interest Rate
0.0 0.5 1.5
Equity 6.0 8.0 10.0
A. $3,000,000. B.$3,250,000. C. $3,500,000. D.$6,500,000.
2.
3.
4.
Saugatuck National Bank uses the internal model-based approach to set market risk capital as prescribed by the 1996 Amendment to the 1988 Basel Accord. The bank has backtested its 99%, one-day VaRs against the actual losses over the last 250 trading days. Based on the results of the backtesting, the bank recorded 11 exceptions. Based on these results, the multiplicative factor (mc) in the model should be set: A. less than 3. B. equal to 3. C. between 3.1 and 3.9. D. equal to 4.
Bank Macatawa has a $150 million exposure to Holland Metals Co. The exposure is secured by$125 million of collateral consisting of AA+-rated bonds. Holland Metals Co. is unrated. The collateral risk weight is 20%. Bank Macatawa assumes an adjustment to the exposure of + 15% to allow for possible increases in the exposure and allows for a 25% change in the value of the collateral. Risk-weighted assets for the exposure are closest to: A. $78.75 million. B.$93.75 million. C. $118.13 million. D.$172.50 million.
Which of the following accords first required banks to hold capital for operational risk? A. Basel I. B. The 1996 Amendment to Basel I. C. Basel II. D. Solvency II.
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5.
Which of the following statements is correct regarding capital requirements for insurance companies? A. Basel II includes the regulation of banks and insurance companies in the three
pillars.
B. The minimum capital requirement is likely to be higher than the solvency
capital requirement for insurance companies.
C. The repercussion for violating the solvency capital requirement is likely
liquidation and the transfer of company insurance policies to another firm.
D. The internal models approach to calculating the solvency capital requirement is similar to internal ratings based approach under Basel II in that the firm must calculate a VaR with a one-year time horizon.
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C o n c e pt C h e c k e r A n sw e r s
1. B The add-on factor is 1.5% of the interest rate swap principal for swaps with a maturity-
greater than five years.
credit equivalent amount = max(V,0) + a x L
where: V = current value of the derivative to the bank A = add-on factor L = principal amount
credit equivalent amount = $3.5 + (0.015 x$200) = $6,500,000 The risk-weight factor for a corporate counterparty under Basel I is 50% for derivatives and 100% for corporate loans. This means the risk-weighted assets (RWA) are: RWA= 0.50 x$6,500,000 = $3,250,000 2. D Saugatuck National Bank must compare the VaR calculated using its current method for each of the 250 trading days to the actual loss over the same period to determine the multiplicative factor. If the actual loss is greater than the estimated loss, an exception is recorded. If, over the previous 250 days, the number of exceptions is: Greater than 10, mc is set equal to four. Less than 5, mc is usually set equal to three. 5, 6, 7, 8, or 9, mc is set equal to 3.4, 3.5, 3.65, 3.75, and 3.85, respectively. Therefore, with 11 exceptions recorded, mc should be set equal to four. 3. A Exposure = (1.15 x 150) – (0.75 x 125) = 172.5 – 93.75 =$78.75
The risk weight for an unrated corporate counterparty based on Figure 3 in the topic is 100%. Applying the 100% risk weight, risk-weighted assets are:
risk-weighted assets = 1.0 x 78.75 = \$78.75 million
4. C Basel II requires banks to maintain capital for operational risks. Banks can use three methods
to measure operational risk. They are the basic indicator approach, the standardized approach, and the advanced measurement approach.
5. D Solvency II, not Basel II, establishes capital requirements for insurance companies. The
minimum capital requirement (MCR) is just that, a true floor and is thus likely to be lower than the solvency capital requirement (SCR). The repercussion for violating the MCR is likely the prohibition of taking new business and possible liquidation. The repercussion for violating the SCR is the requirement of a plan to remedy the situation and bring the capital back to the required level. The internal models approach is similar to the internal ratings based approach under Basel II in that the insurance company must calculate a one-year VaR with a 99.5% confidence level (versus 99.9% confidence for banks under Basel II).
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Ba s e l II.5, Ba s e l III, a n d O t h e r Po s t -C r i s i s C h a n g e s
Topic 59
E x a m F o c u s
Following the 2007-2009 financial crisis, the Basel Committee on Banking Supervision implemented reforms to shore up bank capital. This topic describes the measures taken in Basel II.5 and Basel III to increase capital and tighten the definition of what constitutes capital in normal periods, create buffers to protect banks against loss in stress periods, and encourage banks to better manage liquidity risks by requiring banks to maintain liquidity coverage and net stable funding ratios. It also describes the major reforms in the Dodd- Frank Act that impact banks and bank regulation. For the exam, know the major changes to capital regulation, including the incremental risk charge, the comprehensive risk measure, the stressed VaR, the capital conservation buffer, and the countercyclical buffer. Understand why banks may use less mainstream funding sources, such as contingent convertible bonds, as a result of higher capital requirements. In addition, be able to calculate the leverage ratio, liquidity coverage ratio, and net stable funding ratio given a banks balance sheet. Finally, be able to recognize and describe major changes imposed on U.S. banks by Dodd-Frank, including the creation of the Financial Stability Oversight Council, the Office of Financial Research, and the Bureau of Financial Protection.
S t r e s s e d Va R