Solvency II – Internal Models

1. Solvency II – Internal Models Ian Marshall Cape Town, 5 March 2010

2. Procedure for the approval of an internal model CEIOPS 6 months Pre -application Application Assessment Decision

3. Pre-application Level 3 Guidance on pre-application published for consultation until 8 March 2010 Designed to be flexible, to meet requirements of each specific model Undertakings engage with supervisors while developing and implementing their internal models, and early view on their preparedness to apply Undertakings will understand at an early stage how supervisor propose to approach assessment Participation does not guarantee approval undertakings should consider contingency planning in case the model is not approved CEIOPS Supervisors give their view on how prepared the undertaking is to submit the application

4. Key points – Aplication/Assessment Application to include documentation to show that the model meets tests and standards required from the model Completeness of application: 6 month period starts when the complete application is received Completeness of application should be defined in an objective way Once application received, supervisors shall assess completeness If not completed, supervisor shall notify 6 months has not begun Assessment by supervisor: On-going communication, may include request for further information from undertakings Possibility of suspension of 6 months in case adjustments needed Right to withdraw application by undertakings

5. Key points – Application: Policy for model changes CEIOPS Minor Model Changes No prior supervisory approval needed Major Model Changes Prior supervisory approval needed Responsibility of the undertaking to set up policy Wider than just changes to the calculation kernel Application for approval process: proportionality applies Art. 112 (Art. 115.3) “Approval process” Regular reports to supervisor Classification of Model changes: - Major - Minor

6. Key points – Decision CEIOPS Decision Approval Rejection • Communication of the reasons • SCR calculation using the standard formula • No disclosure of the rejection • SCR calculation using the IM • Shall be disclosed, unless inappropriate or unnecessary • May include terms and conditions

7. Tests and standards for internal models CEIOPS • Use Test • Governance • Statistical quality standards • Calibration standards • Profit and Loss Attribution • Validation standards • Documentation standards • External models and data

8. Foundation Principle: Inherent desire to improve quality Use test: principle based approach Principle 1 Principle 9 recalculation understanding of the internal model Principle 8 integration into the risk-management system on a consistent basis for all uses Principle 2 fit the business model Principle 7 Principle 3 improve the undertaking’s risk-management system support and verify decision-making Principle 5 Principle 4 Principle 6 design to facilitate analysis of business decisions cover sufficient risks: useful for risk management and decision-making widely integrated with the risk-management system

9. Feedback loop Governance • High level internal model Governance (most senior management level): bears overall responsibility; consequently also for the internal model; delegates responsibility for “implementation” of the internal model to the risk management function • Detailed internal model Governance (risk management function): Setting up and implementing the internal model; reviewing and validating the internal model; informs the most senior level of management about the internal model, and draws up proposals for improving it; analyses the functional capabilities of the internal model, and drafts meaningful summaries of these

10. Statistical Quality Standards Building Blocks of an internal Model Assumption & Methodology Management Actions Risks Data Output: Probability Distribution Forecast Options & Guaranties Expected Payments Diversification & Risk Mitigation Techniques

11. Statistical Quality Standards • Principle: Freedom of methods for internal modelling, but • Methods used to calculate the probability distribution forecast: onus on the undertaking to justify methods and assumptions. • Data: policy established by undertaking; use of expert judgment allowed, if there is a robust process for setting the expert judgment. • Diversification effects: identification of key variables driving dependencies, justification of assumptions; take into account tail dependence and extreme scenarios, and characteristics of the risk measure used in internal model. • Coverage all material risks: undertakings shall demonstrate that all material quantifiable risks are covered.

12. Calibration Standards • Only 1 internal model - for regulatory and internal use • 2 parallel objectives 1. Must be used internally → Choice of own time horizon • → Choice of own risk measure 2. Equivalent protection of policyholders • SCR equivalent to Value-at-Risk 0,995 (BOF S2 over 1 year) • By using: Outputs of the internal model with possible approximations • Approximations (if needed) • Satisfying statiscal quality, validation & documentation standars

13. Scope Limitations Tools used Validation Policy Documentation Frequency Independence Governance Profit and Loss attribution, Validation P&L Attribution: • Profits and losses allocated to various risk categories modelled • Profits and losses must be consistent with probability distribution forecast Validation: • Undertaken by the firm. A validation policy for each firm is required to tailor validation processes to firm • Set of tools to gain confidence in the model: testing against experience; sensitivity testing; reverse stress testing

14. Documentation, External models and data Documentation: • It must be thorough, detailedand complete enough to allow third parties to replicate the internal model Outputs of the internal model reproducible • Importance of proportionality principle • It shall indicate any circumstances under which the internal model does not work effectively (weaknesses) • The documentation shall include evidence that all levels of management of the undertaking understand the relevant aspects of the internal model External models and data: • Use of external vendor models does not exempt insurers from any of the standards • Firms shall document and explain the role of vendor products and the extent to which they are used within undertaking’s internal processes + demonstrate a thorough understanding of such products • Clearly articulated strategies for regularly reviewing the performance of vendor model results and the integrity of external data used

15. Partial Internal Models • Contents: • Scope of partial internal models (PIMs) • Transitional plan to extend the scope of a partial internal model • Techniques to integrate partial internal models • Adaptations to the standards

16. Partial Internal Models: Technique to integrate the PIM and the standard formula

17. Links • CEIOPS’ Advice on the procedure to be followed for the approval of an internal modelhttp://www.ceiops.eu/media/files/consultations/consultationpapers/CP37/CEIOPS-L2-Final-Advice-Procedure-approval-internal-model.pdf • CEIOPS’ Advice on Tests and Standardshttp://www.ceiops.eu/media/files/consultations/consultationpapers/CP56/CEIOPS-L2-Advice-on-Tests-and-Standards-internal-model-approval.pdf • CEIOPS’ Advice on Partial Internal models:http://www.ceiops.eu/media/files/consultations/consultationpapers/CP65/CEIOPS-L2-Advice-Partial-Internal-Models.pdf • CEIOP’S Consultation Paper 80: L3 Guidance on pre-application: http://www.ceiops.eu/index.php?option=content&task=view&id=702 • CEIOPS’ Stock-take Report on the use of internal models in insurance: http://www.ceiops.eu/media/files/publications/reports/Stock-taking-report-on-the-use-of-Internal-Models-in-Insurance.pdf • CEIOPS’ Paper on Lessons learnt from the crisis: http://www.ceiops.eu/media/files/publications/reports/CEIOPS-SEC-107-08-Lessons-learned-from-the-crisis-SII-and-beyond.pdf

18. Questions?