Generating unfavourable VaR scenarios under Solvency II with patchwork copulas

Abstract The central idea of the paper is to present a general simple patchwork construction principle for multivariate copulas that create unfavourable VaR (i.e. Value at Risk) scenarios while maintaining given marginal distributions. This is of particular interest for the construction of Internal Models in the insurance industry under Solvency II in the European Union. Besides this, the Delegated Regulation by the European Commission requires all insurance companies under supervision to consider different risk scenarios in their risk management system for the company’s own risk assessment. Since it is unreasonable to assume that the potential worst case scenario will materialize in the company, we think that a modelling of various unfavourable scenarios as described in this paper is likewise appropriate. Our explicit copula approach can be considered as a special case of ordinal sums, which in two dimensions even leads to the technically worst VaR scenario.