Risk modelling and risk measures

Swiss Re uses an internal risk model to determine the economic capital required to support the risks on the company’s books, as well as to allocate risk-taking capacity to the different lines of business. The Group’s integrated risk model provides a meaningful assessment of the risks to which the company is exposed and is an important tool for managing the business. It is used for determining capital requirements for internal purposes as well as for regulatory reporting under the Swiss Solvency Test (SST) and Solvency II for Swiss Re’s subsidiaries in Continental Europe. The model also provides the basis for capital cost allocation in Swiss Re’s Economic Value Management framework, which is used for pricing, profitability evaluation and compensation decisions.

Swiss Re’s internal model is based on two important principles. First, it applies an asset-liability management approach, which measures the net impact of risk on the economic value of both assets and liabilities. Second, it adopts an integrated perspective, recognising that a single risk factor can affect different sub-portfolios and that different risk factors can have mutual dependencies.

The model generates a probability distribution for economic profit and loss, specifying the likelihood that the outcome will fall within a given range. Risk measures derived from the model are expressed as economic loss severities taken from the total economic profit and loss distribution.

In line with the SST, the Group measures its economic risk capital requirement at the 99% shortfall (or tail value at risk) level. This represents an estimate of the average annual loss likely to occur with a frequency of less than once in one hundred years, thus capturing the potential for severe, but rare, aggregate losses.

Risk modelling and risk measures (graphic)

In addition, the model is used to calculate value at risk (VaR) measures including 99.5% VaR, which is used in other regulatory regimes such as Solvency II. 99.5% VaR represents the loss likely to be exceeded in only one year out of two hundred and is thus more severe than the 99% VaR measure, which estimates the loss likely to be exceeded in one year out of one hundred. For Swiss Re’s loss distribution, the 99% shortfall (tail VaR) measure is generally significantly larger than the 99.5% VaR measure.

In order to assess the risk and provide solvency information for individual financial reporting entities within a network of entities, it is necessary to consider the impact of intra-group relationships. For this purpose, the Group’s internal risk model takes the following items into account:

  • Intra-group transactions (including loans, guarantees and retrocessions)
  • Intra-group credit risk and (for SST) potential limited liability toward subsidiaries
  • Secondary effects resulting from the potential insolvency of other reporting entities

Swiss Re’s risk model assesses the potential economic loss at a specific confidence level. There is thus a possibility that actual losses may exceed the selected threshold. In addition, the reliability of the model may be limited when future conditions are difficult to predict. For this reason, the model and its parameters are continuously reviewed and updated to reflect changes in the risk environment and current best practice. In addition, Swiss Re complements its risk models by ensuring a sound understanding of the underlying risks within the company and by applying robust internal controls.

The Group risk model is used to determine regulatory capital requirements in Switzerland. It has been validated by external experts and accepted by FINMA for regulatory usage purposes, and is currently undergoing the revised FINMA approval process. Furthermore, the model is approved by the Luxembourg regulator for the Solvency II reporting of Swiss Re’s legal entities in Continental Europe.