How to Gain Confidence in the Results of Internal Risk Models? Approaches and Techniques for Validation

The development of risk models for managing portfolios of financial institutions and insurance companies requires, both from the regulatory and management points of view, a strong validation of the quality of the results provided by internal risk models. In Solvency II, for instance, regulators ask for independent validation reports from companies who apply for the approval of their internal models. We analyze here various ways to enable management and regulators to gain confidence in the quality of models. It all starts by ensuring a good calibration of the risk models and the dependencies between the various risk drivers. Then, by applying stress tests to the model and various empirical analyses, in particular the probability integral transform, we can build a full and credible framework to validate risk models.