Category: Capital management · Reviewed by Chrissie Anderson, Client Executive · Last reviewed
Internal model (Solvency II)
An internal model under Solvency II is a firm-specific stochastic capital model approved by the supervisor for calculating all or part of the SCR. Full internal models replace the standard formula entirely; partial internal models substitute for specific risk modules.
Approval requirements
Articles 112–127 of the Directive and the Delegated Regulation set six tests:
Use test — the model must be actively used in decision-making, not just for regulatory capital.
Statistical quality standards — data, methods, distributions and assumptions are reasonable and supported.
Calibration standards — the model must produce capital at the 99.5% one-year VaR or be re-scaled to that level.
Profit and loss attribution — actual financial outcomes must be explainable by the model’s risk drivers.
Validation standards — the model must be independently and regularly validated.
Documentation standards — design, theory, calibration, validation and limitations must be fully documented.
Approval process
PRA approval typically takes 12–24 months and includes the SCR Model Change framework for ongoing changes. Lloyd’s operates an analogous Lloyd’s Internal Model (LIM) approval and oversight regime for managing agents.
Why firms use internal models
Better-aligned to actual risk profile, particularly specialty lines.
Recognition of bespoke reinsurance structures.
Capital efficiency — often 10–30% capital savings vs standard formula.
Sophisticated diversification credit.
Strategic discipline — embeds capital thinking into business decisions.
References
Solvency II Directive 2009/138/EC, Articles 112–127.
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