A Review of Solvency II Principles (Forward Looking Risk Assessment)

The Solvency II (Directive 2009/138/EC) regulatory compliance framework has put in place a robust ‘Three Pillar’ approach for the regulation of insurance and reinsurance undertakings (Undertakings) operating throughout the European Union (EU). Pillar 1 deals with quantitative requirements (e.g. assessment of own funds, Solvency Capital Requirement (SCR)), Pillar 3 deals with disclosure requirements (e.g. transparency, reporting to the public and to national supervisors), and Pillar 2 deals with qualitative requirements (e.g. Supervisory Review Process (SRP), Governance System). This four part blog series will deal with different Solvency II Principles, namely ‘Systems of Governance’ (PART 1), ‘Forward Looking Risk Assessment’ (PART 2), ‘Internal Models’ (PART 3), and ‘Supervisory Reporting’ (PART 4).

Solvency II Internal Models

Under Article 112 Solvency II Undertakings may calculate the SCR using either a Full Internal Model (FIM) or a Partial Internal Model (PIM). This is in addition to Undertakings being able to instead rely on the Standard Model. In essence the internal model is the collection of systems, processes, and calculations that an Undertaking puts in place internally in order to identify, measure, manage, and mitigate risks faced by the business. Market surveys to date have highlighted that in countries such as Greece, Germany, and the Netherlands, a large number of companies have decided not to implement an internal model. This is despite the fact that a number of research studies have highlighted that the majority of European insurers believe that the Standard Model does not accurately reflect the actual risk profile of many insurance and reinsurance firms.

Undertakings therefore face the difficult challenge of deciding on whether to adopt the Standard Model, with the potential for unduly burdensome capital requirements, or whether to develop a FIM or PIM in order to benefit from a more risk-sensitive and accurate model that will produce lower capital requirements. On the one hand, building a FIM or PIM will certainly allow Undertakings to have much improved insight into the Undertaking’s risk profile and capital requirements, which may allow it to strategically benefit through more efficient capital management practices. On the other hand, building a FIM or PIM is a highly complex, capital intensive, and time intensive process for Undertakings to adopt.

Not only will Undertakings face numerous operational challenges, they will also have to fulfil onerous expectations in order to obtain supervisory approval. Furthermore, once approval is obtained, Undertakings may not subsequently revert back to using the Standard Model except in duly justified circumstances and subject to the approval of the supervisory authorities. Developing a FIM or PIM in practice will be far from easy. Undertakings must adhere to strict statistical quality standards, calibration standards, validation standards, and documentation standards.

Undertakings must review at least annually, the causes and sources of profits and losses for each major business unit, and must demonstrate how the categorisation of risk chosen in the internal model explains the causes and sources of profits and losses. Bringing Catastrophe Risk models in-house and thereafter integrating them into a FIM or a PIM framework will be particularly challenging for firms, as this will require a subjective choice pertaining to the right method and right model that fits with the firm’s operational profile.

Fulfilling the Solvency II Article 120 ‘Use Test’ will also prove to be challenging for firms, as they will be required to demonstrate that the internal model is widely used in and plays an important role in their system of governance. In particular this must cover their risk-management system, their decision-making process, and their economic and solvency capital assessment and allocation processes. So, demonstrating internal model compliance will require Undertakings to prove that senior management widely and actively incorporate the internal model in day-to-day business decisions. Undertakings will also have to test the results and key assumptions of internal models at least on an annual basis. In reality, internal models may provide increased risk sensitivity and more efficient allocation of capital, but they will also significantly impact how key business functions operate going forwards.

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