On 25 November 2016, the PRA published supervisory statement SS17/16: Solvency II: internal models – assessment, model change and the role of non-executive directors. SS17/16 sets out the PRA’s expectations of firms regarding internal models. Key points include:
- Application for internal model approval. Once a formal internal model application has been submitted, there is limited opportunity for firms to make substantive changes. Firms should therefore make sure their applications are stable and approved prior to formal application. The PRA can only approve an internal model application if it is satisfied that the model has met all the Solvency II Directive tests and standards (T&S). The use of more generic management loadings cannot be used as a mitigant where the model does not meet the required T&S. Firms should have an alternative approach that they can use if they fail to gain model approval after submitting an application. They should have a clear understanding of the actions they would take in those circumstances.
- Credit risk. It is important that firms’ internal models do not adopt a purely ‘mechanistic approach’ to calculating fundamental spreads for the matching adjustment as a purely mechanistic approach is unlikely to satisfy the requirement that the SCR shall take into account all quantifiable risks to which a firm is exposed.
- Modelling of the premium provision for general insurance firms. General insurance firms should consider variability in premium provisions and not just claims on their Solvency II balance sheet. In the same way that events can cause claims provisions to vary, some of the same events may also cause the premium provision to vary. Firms that do not consider this risk may fall short of the internal model T&S.
- Volatility adjustment in the modelling of market risk and credit risk stresses. The PRA Rulebook requires that a firm’s SCR shall not cover the risk of loss of basic own funds resulting from changes to the volatility adjustment. As a result the PRA expects that firms would not assume any change to the level of volatility adjustment when calculating the SCR.
- Role of non-executive directors. One of the T&S firms need to meet is the use test. As part of the use test, firms must ensure that members of the board and others involved in running the firm have an understanding of the model. The PRA may speak to NEDs to gauge their understanding in order to assess whether firms are meeting the use test. While board members are not required to become technical experts in modelling techniques, the PRA does expect board members to understand and be able to explain areas such as the key strengths and limitations within the model, assumptions and judgements that have the most material impact on the model output and key sources of information the board has relied upon to satisfy itself that the model design and output is appropriate. The executive management should be able to explain the firm’s internal model in simple and transparent terms to NEDs.
- Validation of models. The PRA expects validation to be a combination of detailed ‘bottom-up’ testing and ‘top-down’ ownership by boards. Firms are expected to be able to evidence how boards are involved in overseeing and influencing the design of the validation process and in tracking validation issues through to resolution. Boards should demand support from executive management and should draw on a wide range of sources to ensure they are satisfied with the model.
- Internal model change policy. It is important for firms to consider whether the scope of the policy is sufficiently broad and appropriately flexible to be able to capture any changes which could have a material impact on the SCR or to enable the firm to meet the T&S. Firms should justify their choice of major change indicators including why any thresholds chosen are at an appropriate level. The PRA generally expects firms’ executive management to be responsible for the internal sign-off of major model changes and at least to be made aware of minor changes where appropriate. There should be a robust governance process to agree whether changes should be classified as minor or major, especially for borderline cases. In addition to submitting major changes for approval, firms are expected to provide a quarterly summary on minor model changes to the PRA in accordance with the EIOPA Guidelines.