Evolution or Revolution

Will Solvency II mark the next stage in the development of realistic reporting begun by the introduction of the ICA regime, or will it bring a more radical change to capital modelling? By Peter Vipond and Paul Barrett

An important question many insurers are asking themselves, when looking at Solvency II, is what will a Solvency II internal capital model look like? For UK life insurers the question is likely to be more specific: will Solvency II represent just the next stage in an evolution that has been ongoing since the introduction of realistic reporting, followed by the formal introduction of the Individual Capital Adequacy (ICA) regime in 2005, or does it represent a more revolutionary change?

Models, proportionality and the standard approach

Solvency II does, of course, have many objectives - but at its core it is based on the introduction of a market-consistent valuation of assets and liabilities, with a common, risk-based approach both to capital setting and supervision for all insurers across Europe. This one sentence has some quite dramatic consequences. It means applying market-based prices for assets and liabilities - or at the very least economically rational and justified assumptions to underpin internal valuations where appropriate market data does not exist. It means a discreet assessment of all the risks faced by an insurer to arrive at a robust assessment of the internal economic capital needed to support their business. For some insurers, especially those used to relying on traditional actuarial assumptions, including perhaps some small UK life companies and certainly many continental European insurers, this will come as something of a shock.

For this reason, a standard approach has been devised to calculate the Solvency Capital Requirement (SCR), and the proportionality principle enshrined in Solvency II will allow firms to use simplifications where this is justified by the nature and lack of complexity in their business. This should ensure most can get an 'entry pass' into the Solvency II regime, but those on the standard approach will necessarily be limited in the kind of business model they can operate, allowing the supervisor to gain comfort that the insurer is operating within the design parameters set out for the standard approach. Whilst many will be happy to operate in this Solvency II 'slow lane', there is a note of caution to be sounded. The final decision on the use of the 'standard approach' rests with the supervisor. Article 117 of the draft directive states that if the risk profile of an insurer deviates from the assumptions underlying the standard approach, the supervisor can require the firm to use an internal model to calculate the SCR.

Whilst it is implausible to think that regulators would, or could, require large numbers of firms to develop an internal model where they did not already have one (not least because national regulators, individually and collectively, are unlikely to have the resources to do this) it nevertheless sends a message that insurers will be expected to understand their risks and manage them appropriately.

This becomes even clearer when looking at the requirements in Article 44 for the Own Risk and Solvency Assessment (ORSA) and Article 50 concerning the Solvency and Financial Condition Report (SFCR). To highlight just a few of the requirements, Article 44 states that every insurer shall conduct its own risk and solvency assessment, taking into account specific risk profiles, approved risk tolerance limits and the wider business strategy. This would force the company to identify and measure risks it faces in the short and long term, including changes in economic conditions that could have an impact.

Article 50 requires a report to be published by the insurer that includes a description of the business and its performance, its system of governance and how appropriate it is for the risk the company faces. For each category of risk, a description of the risk exposure, concentration, mitigation and sensitivity is needed. The methods used in the valuation of liabilities and assets also has to be reported.

Indeed, the list goes on to cover the structure of own funds, the MCR and SCR and the key risks identified by an internal model where these differ from the standard approach. Already this represents a dramatic shift from the 'Old World' of boilerplate reports and standardised regulatory reporting. For many less sophisticated companies this may mean for the first time that they will have to fully embrace an enterprise risk management approach, with a far more detailed review of their own business to understand the risks they are running and then to share the results of that review not only with their supervisor, but also in large part with an external audience for scrutiny and comment.

ICA and the move to Solvency II models

Even in those markets where progress has been made in engaging the teleology of Solvency II, insurers would be ill advised to feel too sanguine - modelling will require a further development from the current ICA process. Currently, under the ICA process an insurer is obliged to submit to the regulator an assessment of their capital needs, reflecting the risks in their business sufficient to meet the familiar regulatory standard of 99.5% one-year Value at Risk (VaR). Insurers are free to use their internal economic capital models to produce this calculation, without any prior approval and without having to meet any specific methodological or statistical standards. Only some time later, when this assessment is reviewed by the regulator, will questions be asked about the methodology and assumptions used by the insurer to arrive at their capital assessment. Even then, the regulator is only seeking to be satisfied that the final ICA result produced by the firm is broadly consistent with the risks identified in the business. This is not a full model approval process, although the regulator reserves the right to apply a 'capital add-on' in the form of Individual Capital Guidance (ICG) where it is not satisfied with the assessment produced by the insurer. But still both the ICA calculation and any ICG 'add-on' remain private.

Whilst this liberal approach has certainly fostered the development of internal models and enabled them to be built around insurers' own business models, rather than pre-defined regulatory standards, it has taken some time and a fair degree of trust on both sides to reach the current position where there is some certainty and confidence in internal models and the results they produce. And of course throughout this period, the underpinning of the formal Solvency I requirements have remained in place to provide a basic safeguard. But this Solvency I 'safeguard' is somewhat arbitrary and indeed until the reforms of CP06/16, championed by the ABI, many life insurers found themselves caught by the 'statutory peak'. Even now the requirements of Solvency I remain inconsistent and divorced from the reality of risk-based capital assessment.

Modelling the business

Solvency II does away with this and offers the potential for the internal model to determine not only the target level of capital, the SCR, but also the Minimum Capital Requirement (MCR). This is an important step forward from where we are today and a point the ABI (and others) have been lobbying very hard on. We want to avoid the risk of entrenching for another generation of regulation a non risk-sensitive 'minimum capital requirement' that in practice constrains the way insurance businesses are run, placing them at a competitive disadvantage to the banks and other financial sectors.

In order to achieve this, the regulator must have a high level of confidence from day one that they can use the firm's own assessment to trigger regulatory actions, including the most serious interventions in the case of a failing business which could breach the MCR and put policyholders interests in jeopardy. Accordingly, the Solvency II directive sets out a series of stringent requirements for the approval of internal models. What are these requirements? The directive spells out some very clear expectations.

Article 118 sets out a use test, where the insurer must demonstrate that, "The internal model is widely used in and plays an important role in their system of governance," which is defined in some detail in Articles 41 to 49. Article 118 continues by further specifying that for regulatory approval, the internal model must, "Play an important role in (the firm's) risk-management system as laid down in Article 43 and (the firm's) decision-making processes." The internal model must also play an important role in the economic and solvency capital assessment and allocation processes, including the ORSA as required under Article 44 and described above. This use test will be the biggest single challenge for insurers in the implementation of Solvency II - demonstrating that the executive directors of the business are making decisions using the model, and it is not simply a post hoc calculation by technical staff.

Supporting this very broad requirement to embed the model across the business is a series of qualitative standards for the model. Article 119 sets out detailed statistical quality standards, including at paragraph 3, "Data used for the internal model shall be accurate, complete and appropriate," which according to interpretation could be a highly demanding standard.

Article 120 sets out a series of calibration standards and Articles 122 and 123 describe the validation and documentation standards that must be reached, which in essence would allow an informed observer to understand how the statistical processes had been developed and how the model could be operated. In short, a quite demanding series of tests.

Next steps: Level 2 implementing regulations

There is still, of course, a lot of implementation regulation to be developed, indeed until the Level 1 directive text is fixed we cannot be certain of the exact requirements for internal models to be used and approved under Solvency II. However, we already have a pretty good indication of the final outcome and work is now beginning on the more detailed Level 2 measures that will explain how these requirements are to be applied. The standard is being raised under Solvency II. Insurers will have more freedom to drive their businesses according to risk-based assessments, with a far more harmonised approach in place across Europe. Of course there is still tension to work out between the demand for harmonised models, and the demand from insurers to develop firm specific models; and the extent to which firms have freedom to model, comes with a responsibility to demonstrate that the output is robust and is being used to drive the business.

So, in some senses, as mentioned above, Solvency II may be seen as both an evolution of current approaches, but also a revolution in the way in which models are used and perceived, by insurers and in particular by regulators. What is clear is that the most advanced players will already be taking steps to prepare themselves for the challenge of model approval so that they may be in the first wave of insurers gaining Solvency II model approval and the competitive advantages that will bring.

Peter Vipond is director and Paul Barrett is assistant director of financial regulation and taxation at the Association of British Insurers.