Scenario-based Capital Requirements for the Interest Rate Risk of Insurance Companies

Insurance companies can substantially suffer from changing interest rates. Regulatory approaches, such as the Solvency-II-standard formula, measure interest rate risk based on scenarios. Backtesting against historical... [ view full abstract ]

Insurance companies can substantially suffer from changing interest rates. Regulatory approaches, such as the Solvency-II-standard formula, measure interest rate risk based on scenarios. Backtesting against historical movements indicates that the standard formula is too optimistic. Also, it neglects changes in the yield curve’s steepness and curvature. This paper starts from a stochastic model for interest rates, which builds on the dynamic version of the Nelson-Siegel model. We use a principal component analysis to translate the simulated yield curves into scenarios. Backtesting results indicate that four scenarios suffice to measure interest rate risk almost as exactly as a stochastic model.