Solvency II: PRA Issues Consultation Paper on Modelling of Volatility Adjustment

Although Solvency II is now well and truly in force, the Prudential Regulation Authority (PRA) continues to publish a number of consultations into Solvency II. The topics of the consultations have ranged from regulatory reporting to changes to the external audit requirement for parts of the Solvency and Financial Condition Report (SFCR).

On 11th April the PRA released a consultation paper (CP) that proposes revisions to the modelling of the volatility adjustment (VA). Here’s an overview of what it covers.

Who is the CP relevant to?

This paper is primarily intended for UK Solvency II firms as well as the Society of Lloyd’s and its managing agents.

It is also of interest to any firms that:

  • will look for volatility adjustment approval, either now or in the future; and
  • use a full or partial model when determining the Solvency Capital Requirement (SCR) of their firms.

What does it propose?

The consultation is broken into two proposals. The first is the introduction of a new supervisory statement (SS) entitled ‘Solvency II: Internal models – volatility adjustment in the modelling of market risk and credit risk stresses.’ The second proposal involves removing part of SS17/16, which is entitled ‘Solvency II: Internal models – assessment, model change and the role of non-executive directors.’

The SS draft aims to outline the PRA’s expectations of how firms apply the VA when calculating their SCR. In essence, the statement would permit firms to include a dynamic volatility adjustment (DVA) within an internal model when calculating SCR.

These proposed changes are in response to an opinion issued by the European Insurance and Occupational Pensions Authority (EIOPA). According to the PRA in the CP:

“The EIOPA Opinion implicitly accepts that firms that use an internal model to model credit risk may, as a general principle, apply a dynamic volatility adjustment (DVA) by allowing the VA to change when modelling credit spreads during the 1-year forecast of basic own funds.”

However, under the draft SS, where any model is amended to include a DVA, PRA approval would be required. Further, any firm using a DVA would still need to comply with Regulation 43 of the Solvency II Regulations.

These proposals, if introduced, should bring UK insurers in line with a number of other countries within the EU that already permit the use of a DVA.

Along with the proposal to introduce a new SS, the PRA proposes to remove Chapter 5 of SS17/16. This chapter essentially stated that the PRA did not expect firms to use a DVA when calculating their SCR, and so it would have to be deleted to accommodate the PRA’s proposed modelling changes.

When should I submit my comments?

The consultation will close on Wednesday, 11th July, 2018. This document [pdf] contains the full content of the consultation paper from the PRA.

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