Introduction

Welcome to this chapter on Economic Balance Sheets and Internal Models. In the previous chapters of the "Risk responses and capital" section, we looked at how organisations measure and manage risk. Now, we are going to look at the practical tools used to represent those risks and calculate the capital needed to survive them.

Think of an economic balance sheet as a "real-world" snapshot of a company, while an internal model is the "engine" that helps us predict how that snapshot might change in the future. Don't worry if these terms sound a bit corporate—at their heart, they are just ways for actuaries to ensure a company stays solvent and healthy.

The Economic Balance Sheet (EBS)

Most companies produce financial statements based on standard accounting rules (like IFRS or local GAAP). However, for risk management and actuarial practice, we often prefer an Economic Balance Sheet (EBS).

On an EBS, both assets and liabilities are valued on a market-consistent basis. This means we value them based on current market prices or the present value of future cash flows, allowing for risk and the time value of money.

The Merits of an Economic Balance Sheet

Why do we go through the effort of creating an EBS instead of just using standard accounting figures? Here are the key merits:

  • Reflects Reality: Because it uses market-consistent valuations, it provides a more realistic view of the firm’s financial health at a specific point in time.
  • Better Risk Management: It shows how sensitive the firm's position is to changes in the economy. For example, if interest rates fall, an EBS will immediately show the impact on both the market value of bonds (assets) and the present value of future benefits (liabilities).
  • Consistency: It allows management to compare different types of business or different geographical regions on a "level playing field," as they are all measured using the same economic principles.
  • Transparency for Stakeholders: It gives regulators and investors a clearer picture of the true net economic value of the organisation, rather than values distorted by historical cost accounting.
  • Alignment with Market: It aligns the valuation of liabilities with the way the assets backing them are traded in the market.

Quick Analogy: Imagine you bought a house for \$200,000 ten years ago. An accounting balance sheet might still show it at \$200,000 (historical cost). An Economic Balance Sheet would show it at its current market value of \$350,000, which is much more useful if you are trying to decide how much you can afford to borrow against it!

Key Takeaway: The EBS is the foundation of modern risk-based capital frameworks. It ensures that the surplus/profit shown is a true reflection of the economic buffer available to the firm.

Internal Models

An internal model is a bespoke mathematical model developed by a firm to calculate its risk profile and capital requirements. While regulators often provide a "Standard Formula" that everyone can use, many large or complex firms prefer to build their own.

The Use of Internal Models

Internal models are used primarily for two types of capital assessment:

1. Assessing Economic Capital

Economic capital is the amount of capital a firm thinks it needs to remain solvent, based on its own unique risk appetite and internal view. An internal model allows the firm to:

  • Identify the specific risks it faces (which might not be captured by a one-size-fits-all formula).
  • Model the aggregation of risks, including how different risks might offset or reinforce each other (correlations).
  • Test low likelihood, high impact risks (tail risks) that are specific to its business model.
2. Assessing Regulatory Capital

In many jurisdictions, if a firm can prove its internal model is robust and accurate, regulators may allow them to use it to calculate their regulatory capital requirement instead of the standard regulatory formula.

  • Benefit: This often leads to a capital requirement that more closely follows the firm's actual risk profile, which might be lower (if the firm is well-diversified) or higher (if the firm takes on niche, high-risk business) than the standard formula suggests.
  • Regulatory Approval: Using an internal model for regulatory purposes usually requires strict "use tests," proving the model is actually used to run the business, not just to lower capital numbers.

Wider Uses in the Actuarial Control Cycle

Internal models aren't just for capital; they are integrated into the Actuarial Control Cycle for:

  • Pricing: Determining the "capital cost" of a new product.
  • Risk Mitigation: Testing how much capital would be saved by buying reinsurance or using derivatives.
  • Performance Measurement: Calculating "Return on Capital" for different business units.

Don't worry if this seems tricky... building an internal model is expensive and complex! It requires high-quality data, sophisticated stochastic modelling, and strong data governance. For many smaller firms, the cost of building an internal model might outweigh the benefits.

Summary of Key Concepts

The Economic Balance Sheet (EBS) Equation:
At its simplest level, the EBS focuses on the Economic Surplus:
\( Surplus = Market\ Value\ of\ Assets - Market\ Consistent\ Value\ of\ Liabilities \)

Internal Models vs. Standard Formulas:
While a standard formula is a "one-size-fits-all" regulatory tool, an internal model is a tailor-made suit—it fits the specific shape of the company's risks perfectly.

Key Review Box:

  • EBS Merit: Provides a realistic, market-consistent view of financial strength.
  • Internal Model Use: Tailors capital calculations (Economic and Regulatory) to the firm's specific risk profile.
  • Integration: Both tools are essential for Enterprise Risk Management (ERM) and for making informed commercial decisions.

Note: For more on the specific definitions of different capital types, see the chapter on "Economic capital, regulatory capital and risk-based capital". For details on how we treat specific risks within these models, see "Risk and capital management interrelationship".