 By Paul Maitland, Head of International ReMetrica at Aon Benfield
Revealed
Many insurers have chosen to reap the benefits of using an internal model for Pillar 1, even though there is considerable investment in time and resources. However, internal models can also play a positive role under Pillar II as part of the Own Risk and Solvency Assessment (ORSA) to demonstrate to regulators that risk is being effectively managed.
Introduction
Solvency II is putting the spotlight on capital modelling and creating both opportunities and challenges. There is significant growth in the adoption of partial or full internal models as insurers seek a more representative capital assessment than the Standard Formula. But there is also an increase in complexity as companies using internal models need to ensure their models can satisfy each pillar of Solvency II as well as existing and emerging accounting standards. In addition, they must ensure that these models are actually used in making key decisions about the business.
So far in the Solvency II project, both regulators and insurers have focused much of their attention on Pillar I to calculate solvency capital requirements. Efforts are now well advanced. Firms have stepped through several Quantitative Impact Studies and have chosen either the Standard Formula or an internal capital model using a Dynamic Financial Analysis tool such as Aon Benfield’s ReMetrica.
Onus on the ORSA
Attention is now shifting towards demonstrating wider risk management and governance capabilities to the regulator to satisfy Pillar II and, in particular, the completion of the Own Risk and Solvency Assessment, with Level 3 guidance from the European insurance regulator (EIOPA) due imminently. EIOPA has previously defined the ORSA only in broad, non-prescriptive terms, defining it as “the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the short and long term risks a (re)insurance undertaking faces or may face and to determine the own funds necessary to ensure that the undertaking’s overall solvency needs are met at all times.”
For firms that have chosen to build partial or full internal capital models, the ORSA necessitates a longer term view of risk. Whereas Pillar I requires risks to be considered on a one-year time horizon, insurers prefer to model the total risk emerging in run-off when making risk management decisions.
With this in mind, Aon Benfield updated ReMetrica to allow firms to generate both one year and longer-term views using a single model and thereby avoid duplication of effort.
In addition, Pillar II requires firms with internal models to prove to the regulator that adequate model governance processes exist around the model and its data. To help address this requirement, ReMetrica’s Enterprise Edition incorporates new components to help companies keep track of their models as they move one from iteration to the next. Enterprise Edition allows companies to control which users have access to the which parts of a model, record who has changed what and when, and compare one iteration of a model with another with reporting functions.
The ORSA has sometimes, mistakenly, been viewed as a simple box-ticking exercise, supplementing the Standard Formula with a handful of template documents and forms. Although understandable given the lack of prescriptive guidance from EIOPA, this approach misses a principal aim of Pillar II – to prove to the regulator that a risk management culture permeates the organisation, and influences both everyday decision-making and longer-term business strategy. A regulator could impose a capital loading if they do not see sufficient evidence of a strong risk mitigation strategy.
To this end, some firms using the Standard Formula for calculating capital are also turning to tools such as ReMetrica to model and analyse their key risks for Pillar II under a range of business scenarios and time frames. This particularly applies where risks, such as natural catastrophes, are not adequately captured by the standard formula; the risk profile is different from the Standard Formula assumptions or the risk interactions are complex.
Modelling key risks in such cases allows firms to demonstrate these are being analysed, measured and monitored. In turn, this provides a tangible, quantitative output to inform business decisions, thereby allowing a firm to realise real business value from the investment in meeting the requirements of Solvency II. It also provides a less burdensome entry point into capital modelling, with some firms likely to evolve these models into a partial or full internal model.
Solvency II is increasing both the take-up of models and the range of decisions influenced by models. Tools such as ReMetrica are well-suited to the disciplined, analytical approach to risk management required for Pillar II, with a clear direction towards wider usage and acceptance of modelling key risks.
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