Estimating insurer ́s capital requirements through Markov switching models in the Solvency II framework

Solvency II will transform the system for determining capital requirements for insurers. The new regulatory framework proposes a standard model, but at the same time, it encourages the use of internal models of self-evaluation and risk management. This paper attempts to assess the adequacy of Markov switching models for the design of internal models of insurers' equity risk exposure. We have used monthly data from four of the main European indices for the period between January1990 and January 2010. The comparison of models across different statistical criteria and backtesting shows the superiority of Markov switching models over simpler models, to capture insurers' equity risk. Subsequently, we compared capital requirements resulting from applying these models against the Solvency II proposal. The results showed that the funds needed to take the equity risk are dependent on the specification used. Also, the capital raised by Markov switching specifications exceeds those of the standard model. This means that companies using the standard model or another based on similar assumptions are underestimating the risk actually assumed.