FSI 5-Calculation of SCR using a Full or Partial Internal Model

Question 1

Outline the requirements to obtain and maintain an internal model to calculate SCR? (5)

Answer 1

• Insurers must have an effective system of governance for the internal model

• Insurers must demonstrate that the model is widely used and plays an important role in the system of governance

• Insurer must meet the requirements regarding to statistical quality, data quality, model calibration and validation

• Insurer must adequately document the design and operation details of their model

• Partial models may be approved provided they are sufficiently justified and integrated

Question 2

Outline the responsibilities regarding internal models? (3)

Answer 2

• Where an insurer chooses to adopt an internal model approach the board of directors are responsible that appropriate approval is obtained from the PA

• The board must also approve key methodologies used in the internal model and is responsible of the results of the SCR calculation

• The HAF is responsible to provide an opinion to the board of directors regarding the accuracy of the calculations as well as the appropriateness of the assumptions underlying the internal model

Question 3

How frequent should a calculation be done using an internal model? (1)

Answer 3

• A complete SCR calculation should be done quarterly using the approved internal model

Question 4

Describe the aproval process for an internal model? (5)

Answer 4

• First the insurer should notify the prudential authority of their intension and complete the pre-application process

• Subject to the PA being satisfied with the pre-application process an insurer can submit an application to use the internal model

• In addition for a partial internal model the insurer must satisfy the PA
o The limited scope of the application is properly justified
o The results SCR appropriately reflect the risk profile of the insurer
o The model design allows integration with the standardised formula approach
o There is no ambiguity which assets, liabilities and risk are applicable to the internal model

• Insurers must develop and maintain a model change policy that sets out the process and controls that they will adhere regarding changes (this will be required in the application to the prudential authority)

• Any material changes to policy that is integral to the use of the model needs approval from the prudential authority

Question 5

Outline the requirements for an effective governance framework relating to the internal model? (5)

Answer 5

o Establish, implement and maintain effective cooperation, internal reporting and communication of information relating to the internal model

o Be robust with well-defined, clear, consistent and documented line of responsibility across organisation

o Ensure that senior management and personnel responsible have appropriate expertise and experience

o Comprehensive documentation of the internal model

o Include adequate process and controls for development, review and use of internal model

Question 6

Outline the various responsibilities of the board of directors regarding the internal model? (9)

Answer 6

o Approving the application for approval to use internal model

o Deciding on the roles and responsibilities in relation to model governance

o Deciding on the strategic direction of the model

o Agreeing on major changes in advance

o Aligning the model design and operation with the risk profile and operations

o Sufficient resources available to develop monitor and main the model

o Monitoring on-going compliance with requirements for the internal model approval

o Ensuring there are adequate internal review procedures around design, operation and validation

o Ensuring outputs are aligned with the use

Question 7

What are the roles and responsibilities regarding the operations of the internal model? (7)

(Governanace)

Answer 7

o Design and implementation of the internal model
o Testing and validation of the internal model
o Documenting the internal model and changes
o Analysing the performance of the internal model
o Suggesting areas for improvements
o Liaising closely with the users of the outputs
o Developing an on-going two-way communication with the actuarial function

Question 8

List the various areas of use of the internal model as part of the use test? (4)

Answer 8

o Decision making process

o Business planning

o Risk management

o Capital assessment and allocation

o ORSA

Question 9

The board of directors should have an understanding of the following aspects of the model? (8)

Answer 9

o Structure of the model including alignment with business and integration with risk management

o The scope and purpose of the internal model as well as the risks covered by the internal model

o General methodology of the internal model regarding calculations

o Limitations of the internal model

o Where model components rely on expert judgement the significance of the judgement on outcomes

o Diversification affects taken into account in the model

o Influence on decision making

o Model development plan

Question 10

Describe the probability density forecast in the internal model? (6)

Answer 10

• The use of an internal model will typically involve the generation of a probability distribution forecast which assign probability to changes in own funds from a wide range of future events

• Any methodology that evaluates the financial impacts of events must meet the statistical quality in these standards

• The probability distribution forecast should ensure:
o The exhaustive set of mutually exclusive events should reflect the risk profile of the insurer
o Forecasts should be based on relevant information

• The methods used in the calculation of the probability distribution forecast should be:
o Based on adequate, applicable and relevant statistical and actuarial techniques
o Consistent with the calculation of technical provisions according to FSI 2.2
o Based on current and credible information
o Based on realistic assumptions

• Where the is insufficient data for extreme events then internal model will be based on key points from probability forecast

• A internal model that only generates key points of probability distribution forecast will be subject to stricter validation and governance

Question 11

outline the requirements regrding risk coverage and ranking from an internal model? (5)

Answer 11

• Insurer should be able to rank all material risk and satisfy the following principles:
o Coverage-include all risk in the internal model
o Resolution-allow appropriate differentiation in classification such that appropriate decisions can be made
o Congruence-Ranking should be based on a risk management system
o Consistency- Ranking of risks over time should be consistent with their nature

• The internal model should include all material risks that the insurer is exposed to and for a minimum include all risk covered in the standardised formula

Question 12

outline the recognition of diversification effects in the internal model? (1, 6)

Answer 12

• The insurer can allow for diversification and dependencies in their model provided they can be measured adequately

• At a minimum the internal model when measuring diversification must:
o Identify key variables driving dependencies
o Provide support regarding existence diversification effects
o Justify assumptions underlying the model
o Consider extreme scenarios and tail dependencies
o Take into account robustness of the system on a regular basis
o Take diversification effects into account in decisions

Question 13

State the recognition of risk mitigation in the internal model? (1)

Answer 13

• The recognition of risk mitigation is that they are the same as in the standardised formula approach

Question 14

Ouline the allowance for options and guarantees regarding the internal model? (2)

Answer 14

• The insurer must accurately assess the risks associated with guarantees and contractual options

• The key features of guarantees and options should be considered as well as the impact of financial and non-financial conditions on the exercise of the option

Question 15

Describe the allowance for future managemnt actions in the internal model? (4)

Answer 15

• The implications of future management actions should be considered taking in to account the implementation of the options as well as the significance of the action

• This should be consistent with the requirements provided in FSI 2.2

• Assumptions regarding future management actions must be and approved by the board including
o Identification of actions incorporated in the model
o Circumstances where insurer would reasonable carry out actions and when not
o The order and governance associated with future management actions
o Description of on-going work to ensure that insurer is required to carry out these actions
o Description of how future management actions have been reflected in probability distribution forecast
o Description of internal reporting procedure to implement future management plan

• Deviations from planned management actions could have a significant impact on SCR and must be reported to PA including the reasons for the deviations

Question 16

state allowance for expected profit on new business? (1)

Answer 16

• Expected future profits from new business should not be included in the internal model as there is significant uncertainty regarding new business volumes and assumptions

Question 17

describe the callibration requirement of the internal model? (3)

Answer 17

• The SCR calculations must meet the 99.5% confidence level over a one year time horizon

• Where an insurer use different confidence level for internal reporting the probability distribution forecast should be used to derive SCR (otherwise adjustments and approximations are required)

• The PA may require that the model be run using a benchmark portfolio to determine if the model is appropriately calibrated

Question 18

Describe the data policy requirements for an internal model? (3,4,4)

Answer 18

• The insurer must establish a policy on quality and update in respect of data used

• This policy must be submitted as part of the approval process to the PA and will form part of the supervisory analysis

• The data policy at a minimum must include the following:
o Details of data quality requirements and how they are implemented by the insurer
o Process taken to check and validate data quality including actions if data is not accurate, complete, appropriate, relevant
o Methodology used to evaluate expert judgement in relation to the data
o Process to update data included in the calculation of the probability density forecast
 Frequency
 Trigger for unscheduled updates
 Circumstance that require a re-run
 Required timeframes for actions

Question 19

outline the allowance for the use of external models? (6)

Answer 19

• Where an insurer uses an external model they must:
o Document and explain the role of the external model and data
o Explain reasons for preferring the external model
o List alternatives and explain reasoning for choice
o Demonstrate an understanding of external model
o Be aware of limitations
o Clearly articulate strategies for model validation and review

• The insurer should also document risk from the use of external model and if material and quantifiable include then in calculation of the SCR

Question 20

Describe the validation process of an inetrnal model? (6)

Answer 20

• The insurer must have a regular cycle of model validation where the performance of the model is evaluated, review appropriateness of specifications and comparisons against the actual experience

• The scope of validation should encompass all quantitative and qualitative process including:
o Data
o Methods
o Assumptions
o Expert judgment
o Documentations
o Systems and IT
o Model governance
o Use test

• The model validation must include appropriate statistical process based on
o Taking into account current information, relevant and appropriate techniques and generally acceptable market practice
o Detailed understanding if economic and actuarial theory and assumptions underlying the methods to generate probability distribution forecast

• The model validation results should be reported to appropriate level of management and be used for future changes

• The validation responsibilities should be independent of operational responsibilities

• The board of director’s have ultimate responsibility for validation and should not delegate

Question 21

List validation tools that can be used? (4)

Answer 21

o Back-testing

o Sensitivity analysis

o Stress testing and scenario analysis

o Profit and loss attribution

Question 22

List item that should be included in the validation policy? (6)

Answer 22

• Validation policy should address the following:
o Purpose and scope
o Validation tools and methods
o Frequency
o Governance of validation results including assigned responsibility
o Limitations and future developments
o Independent review requirements

• Validation policy should be reviewed annually and material changes reported to PA

Question 23

outline the principle regarding documentation? (6)

Answer 23

• Insurers must document the design and operational details of the internal model
o Theory and assumptions
o Mathematical and empirical basis
o Timely and kept up-to-date

• The documentation should contain sufficient detail such that a third part can
o Form a sound judgement as to the reliability of the internal model
o Assess compliance with standards
o Understand the reasoning behind the design

Question 24

List the various sections that should be included in documentation? (9)

Answer 24

o An overview of the structure of the document

o All relevant testing and validation

o Evidence that management understand the internal model

o Limitations and drawbacks of the model

o Overview of historical development

o Changes to model and compliance with model change policy

o Operational details including IT systems as well as data management as per data policy

o Details regarding theory, assumption and mathematic and economic bases and use of expert judgement on data, assumptions and parameters

o Details on compliance with prudential requirements

Question 25

Outline the various uses of a partial internal model? (6)

Answer 25

• One or more risk categories for the whole of their business

• One or more risk categories for one or more major business units

• One or more risk components for their whole business

• One or more risk components, in same or different risk category, for one or more major business units

• The adjustment for loss-absorbing capacity of technical provisions and deferred tax liability

• Capital requirements for operational risk

Question 26

Describe the integation requirements of partial internal models with standardized formula? (5)

Answer 26

• Insurers that are using a partial internal model must integrate result with standardised formula ensuring:
o All material and quantifiable risks are taken into account in the calculation of SCR
o Any diversification incorporated as part of the integration are justifiable
o Overall SCR is calibrated a confidence level of 99.5% over a one year time horizon

• The correlation matrix is the default method to integrate the partial internal model with standardised formula unless there is strong evidence that this will lead to inappropriate outcomes

• Alternative techniques will then need to be discussed with the prudential authority