A Towers Watson survey of the risk calibrations applied to Solvency II internal models in development by UK life insurers has shown that many companies regard themselves as still having considerable work to do to validate and document risk measures.
Specific market and non-market risks that are seen as presenting the biggest validation challenges include interest rates, credit spreads and mortality and lapse assumptions, with up to two thirds of firms still looking to make considerable progress in these areas.
The findings coincide with the Financial Services Authority (FSA) announcing a new data collection exercise for companies that have applied for the internal model approval process (IMAP), with an end of September deadline. This is expected to inform the FSA’s assessment of firms’ internal model calibrations.
The Towers Watson survey, which received responses from the vast majority of life companies that have applied for the IMAP, also reveals use of expert judgement but reluctance from some firms to rely too heavily on it as part of the calibration process. “Given the lack of data for many risks we expected to see more explicit use of expert judgement to inform the calibration than the survey suggests,” said John Rowland, Global head of Life Capital Modelling at Towers Watson.
On the quantitative aspects of models, the range of stresses used for a number of market and non-market risks appears wide. This is particularly evident for credit risk, where an extreme increase in the spread on an A-rated 10 year bond ranges from 1.1% to 3.6%. Longevity risk is also subject to quite wide variations in stresses with a range covering 14%-37% of base mortality rates for males aged 65, compared to the Standard Formula stress of 20%.
Rowland said “It’s not just the Solvency II statistical quality and calibration standards that are leading firms to revisit risk calibration. The virtuous circle envisaged in the Solvency II Use Test is starting to drive firms to seek to optimise their risk profile in line with their risk appetite, which requires more detailed analysis. Solvency II is raising the bar for risk modelling.”
On a positive note, the survey shows that firms believe they are generally moving ahead effectively with their modelling methodology and data selection, and individual risk distributions and documentation are well developed. However, the time spent on these aspects means that companies have typically focused less on risk correlations.
Rowland added “Dependency assumptions are often among the most significant drivers of capital requirements. We would expect companies to address this to ensure that their Solvency II capital position is not overstated.
Ultimately, the challenge for every insurance firm is to ensure that their internal model calibration processes produce an internal model that is fit for purpose tailored to their own specific risk profile.”
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