March 31st, 2010

Solvency II - Approval of Internal Models: Part II, The Process of Approval

Posted at 10:00 AM ET
Eddy Vanbeneden, Managing Director

This series continues its review of the implementation measures described by CEIOPS regarding procedures to be followed for the approval of an internal model.

3. Approval process of internal models

The official form submitted by (re)insurers for approval of their internal model has many requirements:

  • A rationale for the use of the internal model
  • Results of a self-assessment of internal model readiness, mainly regarding Level 1 articles defining the use of internal models for Solvency II. This self assessment should cover a technical review of the internal model (scope, design, build, integrity and applications) and more particularly should define the following elements:

  1. The reconciliation process to assure accuracy of input data and accurate transfer to the internal model. The technical environment put in place will be reviewed regarding its reliability and the integration of systems
  2. The testing approach to review outputs based on the following criteria: reasonable, accurate, complete, appropriate and comprehensive
  3. The internal model limitations and shortcomings identified during the development and the steps taken to address the shortcomings
  4. The appropriateness of the internal model structure, parameters and methodologies
  5. A statement about deviance from the existing risk profile.
  • Demonstration that the internal model has been used as an authoritative instrument for a reasonable period. (CEIOPS has not defined “a reasonable period.)
  • Definition of the scope of the internal model and a summary of the (re)insurer’s business and strategy.
  • Demonstration of an understanding of the nature and origins of the risks identified, including a qualitative description of each risk and the measure of the exposure for the quantifiable risks.

In summary, here are the issues that the supervisory authorities are expected to assess

  • Scope and coverage of the internal model
  • Methodology and documentation
  • Data quality
  • Quantitative procedures
  • Qualitative procedures
  • Technological environment.

Change of Internal Model

Prior to engaging in the final approval process, a policy for changing the internal model should be established. This policy should cover future major and minor changes that the (re)insurer intends to implement in the internal model as well as the internal governance for future changes including internal communication, validation and documentation. Examples of model changes, as published by CEIOPS, are given in the Appendix to this series.

Approved minor changes can be implemented without entering a new approval period but they should be communicated regularly to the regulator, including the cumulative effects of changes to the qualitative and quantitative adequacy of the internal model. Major changes and any changes not previously approved will have to be approved by the regulator before the (re)insurer will be able to use the model for the calculation of the SCR.

Model changes include any relevant change to the risk profile as well. CEIOPS recognizes that an internal model will be subject to improvement and that model evolution is certainly good practice. CEIOPS doesn’t want to discourage innovation. However, the regulator should be kept closely informed of this development and a continuous discussion should ease the successive approval periods. A model extension is not considered a model change and as such is not covered by the change policy. But, any model extension has to be approved by the regulator.

(Re)insurers may assign model changes to the following categories:

  • Calculation kernel of the internal model
  • Risk management
  • Internal model governance
  • Existing and regulatory approved internal model change policy
  • Other aspects

Other aspects of the approval submission form

In the approval form, the (re)insurer should document the list of selected assumptions. CEIOPS recognizes that different but reasonable choices can be made that may cause significantly different estimates of the capital requirement. The documentation should explain the choices made, the scenario testing process implemented and a plan for any future changes.

(Re)insurers may use external data and external models, such as external cat model vendor tools, to assess their exposure. But such reliance must be noted and there is no exemption to the approval criteria for the use of such data or tools. When using external data and models, the company will demonstrate suitability for their use in the internal model. These external data and models have to be validated and reviewed by the regulator, as well.

When SCR results have been calculated by the internal model, CEIOPS asks (re)insurers to also send the Standard Formula calculations and results to the regulators for the initial two years after the internal model has been approved. At the conclusion of the two year period, regulators may request the calculations and results from the (re)insurers. The SCR calculation should ideally be done at the same granularity level as the Standard Formula but this is not required. Nevertheless, the (re)insurer will provide the allocation of the SCR to the most granular level used.

Finally, the documentation of the various components of the application package is important. More guidance on documentation will be provided when Level 3 is published.

Link to Part I: Introduction & Prerequisites for Approval >>

Contact Information
This series was prepared by Guy Carpenter’s Financial Intelligence Team (FIT). Questions regarding this briefing may be directed to any of the FIT members, listed below.

Susan Witcraft, Managing Director, Minneapolis              +1 952 832 2143
Frank Achtert, Managing Director, Munich                        +49 89 28 66 03 361
Eddy Vanbeneden, Managing Director, Brussels              +32 2 674 98 11
David Flandro, Senior Vice President, London                  +44 (0)20 7357 3267
Benoît Butel, Vice President, Paris                                    +33 1 56 76 48 26
Sebastien Portmann, Vice President, Zurich                     +41 44 285 9322

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