rates ; estimating the impact of the combination of risks to which the insurer is exposed on its balance sheet across many different scenarios ; taking these outputs and converting them into a simpler set of equations – or proxy model – that relates the insurer ’ s net assets to a series of risk factor inputs. the purpose of estimating a proxy model is to make it tractable to run many more scenarios. the complexity of the underlying valuation models would make this impractical computationally. running hundreds of thousands of scenarios through the proxy model in order to generate a distribution of probable balance sheet outcomes over one year ; and this definition is based on the one in supervisory guidance on model risk management, sr letter 11 - 7, federal reserve board and office of comptroller of the currency, april 4 2011 all speeches are available online at www. bankofengland. co. uk / publications / pages / speeches / default. aspx focusing on the tail of losses and estimating the 99. 5th percentile of the distribution to identify the minimum amount of capital necessary to protect the insurer against a ‘ 1 in 200 ’ scenario. ( see chart 1 ) the use of models in solvency ii is more ambitious than in banking regulation. comparing use of models in banking and insurance regulation : the insurance capital model framework encompasses the whole balance sheet whereas banking models focus on particular risks ( market, credit, counterparty ). in the case of credit risk, models are built for particular portfolios ; insurance models estimate overall capital requirements taking account of assumed diversification benefits across different risks whereas bank capital requirements are determined risk by risk and added together, with no diversification benefits across risks, although diversification is taken into account within risks ; regulation determines or constrains more elements of bank than insurance models ; in banking regulation, the standardised approach is calibrated to give higher capital requirements than internal models for a typical bank whereas in insurance the two approaches are calibrated to the same confidence level ; and it is more straightforward for banking supervisors to top up capital requirements using so - called pillar 2 of the bank capital framework. once an internal model has been approved under solvency ii, supervisors have more limited scope to apply capital add - ons, which can only be temporary. i make no apology therefore for the exacting nature of our internal model approval and change processes for uk insurers. models must meet the tests and standards set out in solvency ii. these are both quantitative –

better policy can take some credit for this improvement, as the anchoring of inflation expectations led to a huge reduction in inflation volatility. it was tempting to think that we had moved onto the “ taylor frontier ” – which maps feasible combinations of the smallest variances of the output gap and inflation. the great stability appeared to be a permanent break from earlier periods – periods when monetary policy exhibited more unpredictable behaviour and left the economy to the north - east of the taylor frontier ( chart 2 ). and in one important sense it was – the dark days of double - digit inflation were consigned to the past. the inflation measure used is the quarterly rate of increase of the gdp deflator, defined as the ratio of nominal gdp to real gdp. the output gap is estimated as the difference between the log of real gdp and the trend path of log gdp, derived using the hp - filter. source : ons and bank of england calculations. bis central bankers ’ speeches but the great stability was not representative of a new normal. the variance of the output gap – though not inflation – has been much higher over the past five years as the financial crisis generated a deep recession ( chart 3 ). so what have we learned? the banking and broader economic crisis has demonstrated that macroeconomic policy can face an additional trade - off between ensuring the soundness of the financial system in the medium term, and keeping output in line with potential output and inflation on target in the near term. such a trade - off arises because financial vulnerabilities can build even while output is growing steadily and inflation is low and stable. let me give three examples of the sort of underlying mechanisms at play. first, persistent misperceptions of future spending power may generate a mix of demand that proves to be unsustainable. i believe this was an important factor underlying the crisis. although output in deficit countries – like the uk – appeared to be growing at a sustainable rate, that gave a misleading impression of the sustainability of the great stability. in fact the level of domestic demand was too high and the level of net exports correspondingly too weak. second, as hyman minsky described, periods of stability encourage exuberance in credit markets, leading eventually to instability. and third, low short - term policy rates may encourage investors to take on more risk than they would otherwise accept as they “ search for yield ”. it is arguable that monetary policy paid insufficient heed to the potential impact of such