By Julien Masselot, Principal and Head of Capital and Risk and Todd Harrison, Associate and Senior Consulting Actuary at barnett Waddingham
The changes so far have been wide reaching. Burrowing through the releases at times has created a sense of familiarity. While in parts a replication exercise under a different banner, complacency plants the seeds of regret.
Solvency UK: Internal Models are on the agenda
So, what is changing?
The biggest change for Internal Model applications is that the Prudential Regulation Authority (PRA) will grant ‘permission’ to use an Internal Model to set regulatory capital, rather than ‘approval’. The overall process is expected to remain similar, offering greater flexibility due to fewer prescriptive measures. This should mean a more accessible ‘permissions’ process, with safeguards to avoid creating a systemic risk to the sector.
New safeguards are designed to complement the new definition. For instance, there will be safeguards in the form of capital add-ons, enabling permission to be granted. Previously, simplifications or limitations would have led to permission being denied. The PRA may also specify business safeguards, such as allowing new business to be written despite limited data (but likely only up to a certain level). For the curious observers, regular reports on aggregate safeguards and capital add-ons will be issued.
Countless insurers maintain strong capital models which are used for internal purposes. These changes will increase insurer appetite to formally apply for Internal Model permission. However, a principles-based approach requires that the reduction in regulatory scrutiny is offset somehow.
Second-line risk management teams should be prepared to expect greater inquiry from the regulator around their validation conclusions and monitoring of the Internal Model changes, whether this is provided internally or through external support.
What if our Internal Model is already approved?
Approved Internal Models should remain largely unaffected, subject to tweaks to Model change and validation policies and processes supporting their interaction with the regulator. Some may welcome this as an opportunity to reduce existing red tape, whereas others may continue as before.
While the profit-and-loss attribution exercise is no longer mandatory, market intention seems limited to remove this test from their repertoire. The decisions around relinquishing legacy requirements will depend on individual preference. Even so, these choices should bear in mind the potential to lose valuable insights which have, to date, been readily accessible.
Supervisory oversight is also changing in the form of Internal Model Ongoing Review (IMOR). This change in philosophy should improve visibility at the point of submitting Internal Model SCR and streamline the process.
Previously, annual capital results, usually submitted in April or May, faced delayed engagement from the PRA until after the subsequent Board meeting. By then, the analysis supporting the changes to capital (crucial for explaining the submitted SCR) could be up to six months old, complicating responses to queries. Integrating the analysis of change as part of the IMOR approach should minimise these typical stop-start disruptions.
However, IMOR also introduces an annual attestation requirement from a Senior Management Function (SMF) role, not dissimilar to Lloyd’s of London. Chief Risk Officers are likely to be in the frame, with this role having already had overlap with the Internal Model, through the second line Internal Model validation process.
Whether the Chief Risk Officer feels appropriately knowledgeable to provide such an attestation may have an impact on their willingness to assume such a position. This may lead to the Chief Financial Officer taking the reign, or perhaps even the Chief Operating Officer depending on their experience. This underscores the importance of providing appropriate Internal Model training to those SMF stakeholders within a firm, as one may suddenly be required to put their name on the line.
Internal Model analysis of change: “No problem, we do that already?”
Analysis of Change (AoC) has been brought more into focus, in the face of reduced administrative burden elsewhere. Conversations in the company market often gloss over the Internal Model AoC requirement, assumed to be straightforward. However, those familiar with Lloyd’s expectation for syndicates reporting may be more cautious, given evolving expectations and the potential for subjective review. Even firms in a presumed ‘steady state’ could face increased scrutiny. Robust quantitative analysis and clear, defensible storytelling to meet regulatory demands are paramount.
Our experience of reviewing AoCs suggests that whilst most people do it, quality exists on a spectrum. This variation often arises from how effectively the story is communicated in clear, structured steps. A firm’s approach to Model batching plays a key role in this process.
Model change batching: more than one way to tell the story
Batching Internal Model changes involves grouping related changes to streamline reporting. This should be done carefully to maintain transparency and consider its impact on Major Model Change (MMC) triggers. Although triggering an MMC may not be a major concern, minimising additional capital submissions throughout the year is understandably beneficial for business.
Model batching design is crucial. It not only supports clear communication but also provides a framework for advanced planning. When integrated effectively, batching can have a real influence on your work plan, preventing unnecessary MMCs. Change batches could be each individual change. This will likely increase your admin burden and trigger additional MMCs. Alternatively, related areas or common drivers can be grouped. These batches could combine multiple changes linked to new business plans, or gradual updates to climate change methodology affecting distinct business risks.
Major Model Change (MMC)
The batching and ordering of model changes can be the deciding factor in whether an MMC is triggered. By batching counteracting movements for the same driver, their offsetting effect can reduce the overall impact. Further, sequencing changes differently can limit the aggregation of movements in the same direction. This reduces the burden on the business.
Despite that, and when approached strategically, an MMC can serve as a valuable risk management tool. They can allow teams to become more agile in adapting to model changes.
Balancing the workload versus the risk management benefit is key. Advanced planning helps ensure that the balance is fair and the right resources are available, making the process more efficient. This approach also fosters better relationships both internally (between capital modelling, risk management, and other departments) and externally (with regulators), reducing the risk of unexpected scrutiny.
Gradual adjustments or a gateway to significant change?
Solvency UK may not yet have achieved the ambition of a promised land for general insurers. In fact, it’s felt more like tinkering around the edges without getting to some of the more substantive issues. But that in and of itself presents opportunities.
The Treasury and the PRA have shown willingness to make Solvency UK fit for purpose. If they continue to make Solvency UK more accessible, then we might find a massive shift in appetite towards Internal Models in the UK.
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