Internal Models are as necessary as they are problematic. They enable insurers to capture and manage complex risks, yet remain vulnerable to misinterpretation and misuse. The more complex the model the more vulnerable it can become.
In November 2014 research conducted by Solvency II Wire revealed that approximately 175 insurance and reinsurance entities across Europe were in pre-application for a Solvency II internal model or a partial internal model.
Survey participants, mostly National Competent Authorities (NCAs), were also asked what they considered to be the biggest challenges for insurers preparing for an internal model. They identified four broad themes: handling the volume of work and amount of documentation; ensuring data quality; applying the use test; and adapting the model to local specificities.
Counting IMAPs
The Solvency II Wire research counted the number of firms in an Internal Model Application Process (IMAP) in each country. EIOPA, however, uses a slightly different methodology and counts the pre-applications by insurance groups, not individual entities: EIOPA considers that there are just over 100 pre-application processes under way.
Volume and documentation
Not surprisingly the sheer volume of technical work and related documentation required for producing an internal model is proving demanding for firms. The challenges identified by NCAs include managing the tight timescale and a lack of human resources and expertise. The latter is partially exacerbated by the increasing burden on specific functions and fulfilment of the four-eyes principle (stipulating that at least two people need to be involved in any key decision taken by the undertaking). The associated challenges around documentation include meeting the extensive documentation requirements and filling the EIOPA application template. For cross-border groups the challenge is more onerous as they have to manage the expectations and specific requirements in the different Member States where they operate. “The different standards across the various European supervisors are leading to a multitude of documentation [requirements] for the same aspects of the internal model,” Robert Lempertseder, Head of Risk Analytics and Reporting, Munich Re, said. This was particularly so for the more qualitative aspects of the documentation such as the use test and expert judgment where a range of standards seem to exist, he added. “Currently a group needs to address the different requests of all solo supervisors of the internal model. This issue can be addressed by better coordination within the college of supervisors or by more precise guidance from EIOPA on documentation standards.” EIOPA recognised the amount of work and technical challenges involved in preparing the models and has set up a number of initiatives, such as the Centre of Expertise in Internal Models, to help manage the process for both regulators and industry. Mr Candland points out that despite the onerous requirements there are a number of benefits associated with the work and data collection. “It is worth remembering that even though Solvency II has been a catalyst for a lot of this investment, the investment was probably always needed or would have been needed. Insurers are in the business of taking on risks and charging for them. From a pricing point it is in the interest of insurers to collect the data in order to ensure that their pricing is in line with the risks they accept and that they will continue to be profitable. This will help insurers to avoid insolvencies and, thus, improve protection of consumers.”The importance of data quality
A number of NCAs expressed concerns that insurers would struggle with the stringent data quality requirements in Solvency II. And there is an expectation for very high standard of justification and understanding of where the assumptions for the model are coming from.
Use test, the board and culture
Beyond the technical challenges, regulators singled out a number of challenges associated with application and integration of the model and its outputs into the business, decision making, risk management and governance processes: the so called ‘use test’. Vesa Ronkainen, Head of EIOPA’s Centre of Expertise in Internal Models, told Solvency II Wire that it was not surprising the use test requirements were a challenge. “These are complicated models and it is a new type of work for many board members,” he said. “The general idea is that requirements have to be proportionate.”
Embedding a risk-based view
Introducing an internal model and applying the use test go hand in hand with the need to disseminate and embed a risk-based view and culture throughout the organisation. An area that survey participants identified as challenging.
Challenging and challenges for the Board
Solvency II will bring the role of senior management under scrutiny, for all insurance undertakings. But for those using an internal model the challenge for board members and non-executive directors (NEDs) is particularly acute. The increased responsibility and need to be at least familiar with the some aspects of the internal model have led to concerns that inevitably, as the responsibility placed on NEDs increases, less technically minded Board members might be less willing to take on the work. “Managing an insurance company is an increasingly complex business,” Mr Wainwright, said. “That does not seem to be deterring existing NEDs or new candidates yet. In time, the new senior management regime that the PRA is introducing for insurers may cause people to have second thoughts about the industry, especially if the regulators are more successful in their efforts to target enforcement action at managers, as opposed to imposing penalties on firms. For the time being, the sense seems to be that the banking industry will bear the brunt of this development, if and when it comes.”Local specificities
The challenges discussed above apply to all internal model firms, but large cross-border groups and their local subsidiaries face an additional set of challenges in adjusting the model to fit local markets of varying size and industry sophistication.
Quest for the holy BAU grail
At present most firms are engaged in preparing to submit their internal model application, having completed the pre-application stage. Substantial resources have been spent designing and implementing the models, and, as with most things Solvency II, the aim is to move into business-as-usual (BAU) operations as soon as possible to start reaping the benefits of implementation. EIOPA recognises that the process will take time and may vary by country and company size. “It will not be unusual for companies to need a couple of goes through the cycle before the process can be considered BAU,” Mr Candland, said. “I imagine the next couple of years will continue to be challenging and then we will gradually go down the slope of effort needed.” Or as Mr Ronkainen puts it, “Of course we could assume that the first application for internal model is the most difficult one. The next time you can use the experience. So in future that would hopefully decrease the amount of work that is needed.” BAU may be the holy grail but it is most certainly not the end of the quest. Mr Candland emphasises that model work is always work in progress. “It will be important that the on-going model validation work continues, so firms spot when they need to improve their model to reflect changes in the external environment as well as internal changes to the firm and the mix of risks on its balance sheet.” — To subscribe to the Solvency II Wire mailing list for free click here.