Our latest episode of “The Standard Formula” Back to Basics series explores the internal model method for calculating the Solvency Capital Requirement. Host Rob Chaplin is joined by George Belcher to dissect the advantages and disadvantages of this model, as well as the necessary approval to use an internal method and the accompanying preparation phase, among related topics.
Episode Summary
“Insurers are expected to hold eligible owned funds in excess of the Solvency Capital Requirement. There are two main methods of calculating the SCR under Solvency II, the standard formula and internal model methods.”
In this episode of “The Standard Formula” podcast, Rob Chaplin, host and head of Skadden’s Europe Financial Institutions Group is joined by colleague George Belcher to discuss Solvency II’s internal models (IM). Despite a higher cost of development, IMs offer numerous benefits, such as more accurate risk sensitivity, more flexibility and more available data. Rob and George also explore partial IMs, changes to existing models, the PRA approval process and implications of the U.K.'s move away from EU Solvency II standards.
Key Points
- Preparing Ahead: A firm may only use an IM with supervisory approval, which must be decided within six months from receipt of the application. The process can take up to a year, so prepping for the time factor is important.
- Regulatory Expectations and PRA Approval: The use of IMs often comes with benchmarking requirements from the Prudential Regulation Authority (PRA) to ensure its specifications are in line with market practice.
- Impact of the U.K.'s Solvency II Shift: The U.K. is moving away from the EU Solvency II regime and is adapting its own version to meet the needs of the U.K. insurance market. This episode looks at potential changes, particularly around IM requirements, that could impact insurers.
Voiceover (00:01):
From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome back to The Standard Formula Podcast. I'm Rob Chaplin. Today I'm joined by my colleague, George Belcher. Together, in this episode of our Solvency II Back to Basics series, we'll be exploring the topic of internal models. George, let's start with what internal models are.
George Belcher (00:39):
Thank you, Rob. Insurers are expected to hold eligible-owned funds in excess of the solvency capital requirement or SCR. There are two main methods of calculating the SCR under Solvency II under the standard formula and under an internal model.
(00:57):
As we heard on the last podcast, the calculation of the SCR under the standard formula method is very complex, involving many assumptions around seven categories of risk, and within that, 22 subcategories of risk. Under the internal model or IM method, an insurer must analyze data relating to its own risks and develop its own assumptions, calibrations, and correlations. Stochastic models and other sophisticated statistical techniques typically be used.
(01:25):
Although the IM is bespoke to the firm in question, the Prudential Regulation Authority in the UK, or PRA, will require a certain amount of benchmarking to ensure there is a degree of consistency between IM firms. In practice, this may to a degree limit the individuality of firms' IMs. Other requirements for the IM include an annual review of causes and sources of profits and losses and attribution of risk categories to the same and a regular cycle of IM validation and documentation. Rob, what are the advantages and disadvantages of using an IM?
Rob Chaplin (01:58):
Thanks, George. Advantages to an IM typically include risk sensitivity. An IM tracks risks more accurately, and therefore overall capital will be more accurately determined when compared to the standard formula. Less capital leads to lower costs of capital, leading to cost advantages and the potential to utilize capital more efficiently within the business.
(02:27):
Risk awareness. Developing an IM requires a firm to invest time and resources in understanding the risks of the business at a fundamental level.
(02:38):
Flexibility. More flexibility in how the firm takes credit for certain risk mitigation techniques it has implemented, IMs develop over time, and can respond more quickly than the standard formula to changes in an insurer's risk landscape.
(02:56):
Sophistication. An IM generally allows a firm to better reflect the complexities of a multinational or specialist insurance business when compared to the standard formula.
(03:09):
Data. An IM provides the firm with more data, which can be used to make positive business decisions. For example, the model can provide information on different return periods, which can be extremely useful.
(03:24):
Duration. An IM permits an insurer to calibrate its IM using a longer time scale than the standard formula. This may allow insurers to accommodate longer-term considerations into their IMs, such as sustainability risks. Originally, it was assumed that smaller companies would use the standard formula at first and graduate to IMs at a later stage. In practice, however, the full benefits of an IM have not been borne out. The cost of developing an IM typically runs to tens of millions even for mid-sized companies and hundreds of millions for larger companies. Further, the capital benefit of using an IM has sometimes proved illusory as supervisors tend to use the approval process to enforce the inclusion of conservatism into assumptions that concern them.
(04:18):
Moreover, practice has evolved and moved away from the original concept of the SCR. The original concept of Solvency II was that all insurers would have to hold capital of at least 100% of SCR. Many regulators now expect companies to document their risk appetite in a policy with firms now generally expected to set their risk appetites at perhaps 130% of SCR for a company with a strong parent and parental guarantees to 150%, and perhaps even more for a self-standing company. Publicly quoted companies typically run at levels in excess of 180% of SCR. Frequently, you can see coverage levels even higher.
(05:02):
Effectively, SCR has become a kind of minimum capital requirement, or MCR, and risk appetite has become the new SCR. Relatedly, supervisors have typically required the larger companies in their market and those with particularly complex businesses to adopt an IM, which can be viewed as a means of supporting this conservatism. We'll touch at the end on efforts to improve this position. George, tell us about partial IMs.
George Belcher (05:33):
Sure. A firm may also choose a partial IM where a particular aspect of its business does not fit well within the standard formula. In that case, it must explain and justify the reason for the limited scope of the model in its approval application. The partial IM must result in an SCR, which reflects the risk profile of the firm more appropriately and must integrate into the SCR standard formula, which Rob leads us onto approval.
Rob Chaplin (05:59):
Yes. Thanks, George. A firm may only use an IM with and to the extent of supervisory approval. Once approval has been granted, the firm is required to use the model to calculate its SCR. An application for approval of an IM must be decided by the supervisory authority within six months from receipt of the complete application. In practice, the overall process is likely to take up to a year with submissions typically running to thousands of pages. So you also need to add in a lengthy preparation phase. George.
George Belcher (06:35):
Thanks, Rob. Let's take a close look at the use test. At the core of the use test is the requirement that firms demonstrate that the IM is "widely used in and plays an important role in their system of governance." So insurers are expected to develop systems and controls to identify, measure, and manage each risk. The use test specifies that they should use the same models for this purpose, as I use to calculate the best estimates of liabilities or BEL and SCR. The idea is that the proper risk management should not be a compliance issue, but lie at the heart of the running of the business.
(07:12):
The PRA also stresses the responsibilities of the board, although not necessary for board members to be technical experts. The PRA does, however, expect board members to be able to understand and explain areas such as the key strengths, limitations, and judgments within the model. Assumptions and judgments that have the most material impact on the model output and key sources of information and advice which the board has relied on.
(07:36):
The PRA also expects that the executive should be able to explain the firm's IM in simple and transparent terms to the NEDs, or non-executive directors, and for the NEDs to challenge how the viability and sustainability of the business model, risk appetite, and management framework are reflected in the IM. Can you talk us through model changes, Rob?
Rob Chaplin (07:59):
Of course. Once an IM has been approved, the ability of a firm to make changes to the model is restricted. A firm can't make any changes to its model which are not in accordance with the IM change policy, which will have been approved as part of the IM approval. Minor changes to the model which are in accordance with the policy can be made without PRA approval.
(08:22):
Major changes to the model as well as changes to the IM change policy must be approved in advance by the PRA. PRA expects firms to engage as early as possible with their supervision team about plan changes to their IMs.
(08:36):
The PRA expects firms to submit no more than one model change application per year. Although the application could include several individual major changes. In unusual circumstances, there might be more than one application in a year.
(08:52):
Transactions such as an acquisition or investment in a new asset class could lead to a change in the firm's risk profile requiring a model change application. It may not always be possible to obtain approval prior to the transaction, in which case the firm should discuss with the PRA a way forward.
(09:12):
Firms should provide a summary of their changes, the reasons for changes, the potential impact, and the intended time scales. They should also articulate how they prioritize their changes as opposed to other model improvements.
(09:29):
It's important to include qualitative and quantitative indicators in the model change policy. The PRA encourages firms to consider the appropriateness of having different indicators or threshold levels for different risks or components of the model. It can be helpful if firms provide examples of model changes that meet their major change indicators in order to demonstrate the appropriateness of thresholds chosen.
(09:56):
Once a formal IM application has been submitted to the PRA, there is limited opportunity for firms to make any substantive changes. Where changes in material, a new application is likely to be required. Alternatively, firms themselves have an option to stop the clock on the current application. So, George, what about the move to Solvency UK? Has that made a difference?
George Belcher (10:21):
Following the UK's departure from the European Union in December, 2020, the UK is moving away from the EU Solvency II regime adopting Solvency II to the needs of the UK insurance market, otherwise known as Solvency UK. As part of this process, in June, 2023, the PRA released a consultation paper, number 12/23, which set out its proposals across a wide range of areas, including internal models.
(10:49):
For internal models, the PRA will move away from a number of prescriptive requirements towards a smaller number of more principles-based requirements. For example, around modeling standards.
(10:59):
In summary, the PRA reforms will streamline the tests and standards required for new IMs and changes to IMs, introduce more flexibility when the PRA grants new permissions and variations, implement a range of safeguards that could be used to bring an IM that is not wholly compliant into compliance, and mitigate the risks arising from such non-compliance in all other circumstances. Introduce an ongoing IM review framework, building on the PRA's existing supervised review processes, and finally, introduce an alternative to outright rejection of an IM application, namely imposition of one or two new safeguards being a residual capital add-on tool and model use requirements.
(11:43):
The PRA has also reconfirmed its intent in policy statement 224 to determine the outcome of a complete application within 6 months from receipt, and to provide the firm with a written notice of that determination and to make reasonable efforts to do so.
(11:59):
These changes to systems and controls will need to be implemented by insurers by the end of December in 2024.
Rob Chaplin (12:06):
Thanks, George. That brings us to the end of today's episode. Thank you to our listeners for joining us. We hope you will continue to tune in for future episodes. In case you missed it, our last episode covered SCR. If you have any questions or comments on any of the topics we spoke about today or Solvency II in general, do please feel free to contact us. Thank you, and we hope you'll join us next time.
Voiceover (12:34):
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