Backtesting the Solvency Capital Requirement for Longevity risk.

Purpose - The determination of the capital requirements represents the first Pillar of Solvency II. The main purpose of the new solvency regulation is to obtain more realistic modelling and assessment of the different risks insurance companies are exposed to in a balance–sheet perspective. In this context the Solvency Capital Requiremennt standard calculation is based on a modular approach where the overall risk is split into several modules and submodules. In Solvency II standard formula longevity risk is explicitly considered. Design/methodology/approach - It suggests a multiperiod approach for correctly calculating the Solvency Capital Requirement in a risk management perspective, in the sense that the amount of capital necessary to meet company future obligations year by year till the contract will be in force has to be assessed. The backtesting approach for measuring the consistency of SCR calculations for life insurance policies represents the main contribution of the research. In fact this kind of model performance is generally specified in the VaR validation analysis. in this paper, this approach is considered for testing the ex post performance of SCR calculation methodology. Findings - The backtesting framework is able to measure from time to time if the insurer has allocate more or less capital to support his in-force business, with adverse effects on free reserves and profitability or solvency. Research limitations/implications - In the Solvency II context, the insurance companies put aside the capital as regards the different kind of risk recognised by the QIS5. In particular, in the regulation framework , SCR is intended to be "the amount of capital that an insurer needs in order to remain viable in the market and maintain its default probability below a certain level"7. Nevertheless the balance-sheet approach prescribed by the new international guidelines could not adequately catch the effective impact of the longevity risk in the risk management valuations, given its specificity and incidence on long term portfolios. In this paper a multiperiod approach for correctly calculating the SCRs is proposed. The multiperiod perspective is in the sense that the amount of capital necessary to meet company future obligations year by year till the contract will be in force has to be assessed. In this setting, the aim of the research is to set out a backtesting framework for measuring the consistency of Solvency Capital Requirement calculation methodologies for life insurance portfolios. In this order of ideas, it is relevant to represent accurately the future mortality trend, as well as to consider the "right" tools to test the effectiveness of the formula or model which it is implemented to calculate the SCR. A backtesting framework to evaluate the ex post performance of SCRlong calculation methodology is set out. Practical implications - Indeed the forecasting performance is an important aspect to assess the effectiveness of the model, a poor performance corresponding to a biased allocation of capital. Originality/value - The backtesting approach for measuring the consistency of SCR calculations for life insurance policies represents the main contribution of the research. In fact this kind of model performance is generally specified in the VaR validation analysis. Recently Dowd et al. 2010 have proposed it for verifying the goodness of mortality models and now, in this paper, this approach is considered for testing the ex post performance of SCR calculation methodology