Insurance Group Risk Management Model for the Next-Generation Solvency Framework

Abstract

This paper presents a general framework for the capital allocation model that minimizes insurance group risk. The Global Financial Crisis greatly affected insurer management. The enormous losses sustained by American International Group’s derivative subsidiary are still fresh in our minds, and group risk management has recently become a material issue. On facing serious financial distress, an insurance group adopts a methodology wherein it focuses its capital on its material subsidiaries using capital and risk transfer instruments (CRTIs) such as reinsurance, loans, and guarantees. To this end, we model the dependency structure between the parent company and its subsidiaries in terms of the associated assets and liabilities, using some copula functions and calculate the optimal risk transferring ratios. At the same time, we consider the parent company’s limited liability toward its subsidiary and evaluate a put-option value to run off an immaterial subsidiary facing financial distress for the diversification of risk on the whole group. Major findings are that different dependency structures result in different risk transferring ratios and the diversification effect for group risk is different depending on the kind of CRTI.