General Insurance Article - Solvency II: the platform for a dynamic modelling approach?

 Solvency II: the final straw or the platform for a dynamic modelling approach?

 David Gregson, Consultant Actuary at OAC, says it’s time to get back to basics. Solvency II should be used to assess what is essential for effective risk management to create a modelling solution fit for the future.

 Enterprise-wide risk modelsoften contain a significant degree of complication, stretching all the way from the manipulation of input data from multiple sources,through to the complexity of the projection calculations and the variety of ways for analysing and reporting results. But that’s just the tip of the complexity iceberg.

 
 Consolidation in the insurance sector has left many companies managing legacy systems which struggle to accommodate the reporting requirements of Pillars 1 and 2. The benefits of economies of scale from merger often remain unrealised due to the requirement for separate development and maintenance teams to retain system functionality and capability in response to internal and external drivers.

 
 Add Solvency II into the equation, and it is not surprising that extra tasks are becoming increasingly difficult to embed within current models. An opportunity exists to take a completely fresh, top-down approach and design a solution which can be used across the business in response to the Use Test.

 
 Is Solvency II really that complicated?
 Instinctively, the advanced modelling requirements of Solvency II suggest that models will have to become more complex but, scratch beneath the surface,and the components needed to comply with theimpending legislation aresimilar to current systems.

 
 In terms of projecting cash flows, there is arguably nothing new. The key differencesarising from Solvency II include:

 
 • the application of a market consistent basis;
 • the introduction of Solvency Capital Requirement calculations; and
 • theneed to accommodate a risk margin.

 
 These distinctions simply change the way values are derived from a cashflow projection and how these estimates are combined. Consequently, any model capable of calculating a range of predictions from stochastic scenarios and a series of ‘shocks’ applied to a particular world state, should be able to adapt to Solvency II.

 
 Even apparently diverse products, such asterm assurance and endowment policies,are built upon a series of probability-weighted cash flows and follow the same basic logic, suggesting that there is likely to be a significant overlap in premium, expense and decrement functionality.So, why not havea single premium or expense model which can be used across all your products?

 
 With simplicity comes dynamic development
 Such thinking paves the way for a new design philosophy and opens the door to a cost-effective approach to modelling based on the notion of inheritance.

 
 Starting with a 'parent' module,more complicated requirements can be added by replicating the ‘parent’ and either attaching to, or adjusting, only the specific functions that need changing.

 
 Taking this idea a step further, the same module can be re-used within a single policy, incorporating a choice of funds or optional benefits. In a unit-linked policy, for example, a standard module can be re-used multiple timesto include the growth rates, management charges and other variables specific to each fundin which a policy is invested.

 
 But this is not just a theoretical concept. Actuarial systems have already been developed to use inheritance to support a full range of flexible unit-linked and unitised with-profits business, alongside more conventional non-linked business.

 
 One company, faced with the challenge of accurately modelling its insurance products using its existing system, transferred to this modular approach to achieve an outcome that allowed consistency across its wide range of business as well as being significantly easier to develop and understand.

 
 Other benefits gained by those companies which have already switched to this innovative solution include:

 
 • increased speed to market due to coding re-use;
 • ease of Solvency II integration because of a consistency inthe model’s parameters;
 • improved run times;
 • fasterand easier access to results; and
 • a wider potential product offering because of the model’s flexibility.

 
 It is too easy for today’s technology to become tomorrow’s legacy. A common blueprint ensuresthat the scale and design potential of a risk model becomes limitless. But, more importantly, the model remains agile and responsiveto whatever changes occur, either within an organisation or across the industry. Will your model adjust effortlessly to the risks and the type of business managed by your firm in years to come?

  

 Author: David Gregson, OAC Actuaries and Consultants
 With an initial background in regulatory reporting gained within one of the UK’s largest mutual insurers, David now specialises in risk management and developing modelling methodologies for clients to achieve a better understanding of their business and in order to meet ongoing regulatory requirements.

  

 His actuarial experience also includes solvency measurement and estimation, regulatory valuations, and developing and pricing new product lines for life offices.

  

 David is involved with developing OAC’s Solvency II services, including the design of models within Mo.net.

 He actively participates in thought leadership and has written a number of articles on the subject of Solvency II.