Prudential Standard FSI 5 (Calculation of the SCR Using a Full or Partial Internal Model)

Question 1

5 Key requirements to obtain and maintain approval for the use of an Internal Model

Answer 1

• Insurers must have an effective system of governance for the Internal Model.
• Insurers must demonstrate via the Use Test that the model is widely-used and plays an important role in their system of governance.
• Insurers must meet requirements relating to statistical quality, data quality, model calibration and validation.
• Insurers must adequately document the design and operational details of their Internal Model.
• Partial models may be approved provided they are sufficiently justified and integrated.

Question 2

Insurers applying to use a partial internal model must satisfy the Prudential Authority that:

Answer 2

• The limited scope of application of the model is properly justified.
• The resulting SCR appropriately reflects the risk profile of the insurer.
• The model’s design allows it to be fully integrated into the structure of the SCR Standardised Formula.
• There is no ambiguity as to which risks, assets and/or liabilities are included in the scope of the Internal Model.

Question 3

Model Change Policy

Answer 3

Insurers must develop and maintain a Model Change Policy that sets out the processes and controls that they will adhere to when implementing changes to the Internal Model.

Insurers should submit their Model Change Policy to the Prudential Authority as part of their application for Internal Model Use.

Question 4

The system of governance for the Internal Model must: (5)

Answer 4

• Establish, implement and maintain effective cooperation, internal reporting and communication, internal reporting and communication of information relating to the Internal Model at all relevant levels within the insurer.
• Be robust with well-defined, clear, consistent and documented lines of responsibility across the organisation.
• Ensure that Senior Management and personnel responsible for developing, monitoring and maintaining the Internal Model possesses sufficient qualifications, knowledge and experience.
• Include comprehensive documentation of the Internal Model.
• Include adequate processes and controls for the development, review and use of the Internal Model.

Question 5

Roles and responsibilities for the day-to-day operation of the Internal Model should include responsibilities for (6)

Answer 5

• Designing and implementing
• Testing and validating
• Documenting
• Analysing (and reporting on) the performance
• Suggesting areas for improvement of
  the Internal Model
• Developing an ongoing two-way communication loop with the Actuarial Function to ensure adequate actuarial input into the design and operation of the model.

Question 6

The Use Test

Answer 6

Insurers using an Internal Model should be able to demonstrate that the model is widely used and plays an important role in their system of governance.

This should include the use of the model in:

• decision-making processes
• business planning
• risk management
• capital assessment
• capital allocation
• the Own Risk and Solvency Assessment (ORSA)

Question 7

The board of directors as a collective whole should have a general understanding of the Internal model and have knowledge of: (9)

Answer 7

• structure
• scope and purpose
• risks covered
• general methodology applied
• limitations
• diversification effects taken into account
• The model components that have a high dependency on expert judgement, and the significance of expert judgement on the model outcome.
• The way the model aligns to the business and is integrate in the insurer’s risk management system;
• The model development plan

Question 8

The Internal Model should be aligned with the business in the following manner: (5)

Answer 8

• Modelling approaches reflect the nature, scale and complexity of the risks inherent in the business of the insurer which are within the scope of the Internal Model.

The OUTPUTS of the Internal Model:

• are consistent with the content of the internal and external reporting of the insurer.
• differentiate between material lines of business, between risk categories and between major business units.
• are sufficiently granular to play an important role in relevant risk management and business decisions.
• The Model Change Policy provides that the Internal Model is adjusted for changes in the scope or nature of the business of the insurer.

Question 9

Insurers should be able to demonstrate that the Internal Model is widely integrated in their risk management system in the following manner: (5)

Answer 9

• Material quantifiable risks identified by the risk management system which are within the scope of the Internal Model are covered by the Internal Model.
• The outputs of the Internal Model, including the measurement of diversification effects, are taken into account in formulating risk strategies, including the development of risk tolerance limits and risk mitigation strategies.
• The relevant outputs of the Internal Model are covered by the internal reporting procedures of the risk management system.
• The quantifications of risk and the risk ranking produced by the Internal Model trigger risk management actions, where relevant.
• The Model Change Policy provides that the Internal Model may change to reflect changes in the risk management system.

Question 10

Methods used in the calculation of the Probability Distribution Forecast should be: (4)

Answer 10

• Based on adequate, applicable and relevant actuarial and statistical techniques.
• Consistent with the methods used to calculate technical provisions.
• Based upon current and credible information.
• Based on realistic assumptions.

Question 11

Risk ranking (4)

Answer 11

Insurers should be able to rank all material risks covered by the Internal Model, and satisfy the following key principles in relation to risk ranking:

• Coverage
• Resolution
• Congruence
• Consistency

Question 12

Principles in relation to risk ranking:

Coverage

Answer 12

Risk ranking should be applied to all material risks covered by the internal model.

Question 13

Principles in relation to risk ranking:

Resolution

Answer 13

There should be sufficiently precise differentiation of various risk categories and components to allow Senior Management to take appropriate decisions.

Question 14

Principles in relation to risk ranking:

Congruence

Answer 14

Risk ranking should be consistent with the classification of risks used in the risk management system.

Question 15

Principles in relation to risk ranking:

Consistency

Answer 15

Risks of a similar nature should be ranked consistently throughout the insurer and over time.

Question 16

Recognition of diversification effects

Answer 16

Insurers may take into account dependencies and diversification effects within and across risk categories in their Internal Model, provided that the system used for measuring those diversification effects is adequate.

Question 17

Recognition of diversification effects:

At minimum, the system used for measuring the diversification effects must: (7)

Answer 17

• Identify the key variables driving dependencies;
• Provide support for the existence of diversification effects;
• Justify the assumptions underlying the modelling of dependencies;
• Take into particular consideration extreme scenarios and tail dependence;
• Take into account the characteristics of the risk measure used in the Internal Model;
• Test the robustness of this system on a regular basis;
• Take diversification effects actively into account in business decisions.

Question 18

Calibration of the Internal Model

Answer 18

The SCR derived from the Internal Model must meet the 
- 99.5% confidence level, 
- one-year 
- value-at-risk 
calibration requirement.

Question 19

Data used for the Internal Model must be (4)

Answer 19

ACCURATE
To avoid material distortions to the model output.

COMPLETE
The data provide comprehensive information.

APPROPRIATE
The data do not contain biases which make it unfit for purpose.

CURRENT
The data are up-to-date.

Question 20

As part of the regular data quality reviews, insurers should be able to demonstrate that: (10)

Answer 20

• The data are free from material mistakes, errors and omissions.
• The data are consistent over time, such that the model output refers to a well-defined point in time.
• Comprehensive data for all relevant business lines and all relevant model variables, are available for use in the model.
• The data include sufficient historical information to assess the characteristics of the underlying risk and to identify trends in the risk.
• No relevant data available are excluded from consideration without justification.
• The granularity of data is sufficient to allow for adequate actuarial and statistical techniques to be used.
• The data used are relevant to their business and the portfolio of risks being analysed.
• Data used for prediction exercises provide a reasonable guide to the future.
• Data are collected, processes and applied in a transparent and structured manner.
• Data are up-to-date.

Question 21

Validation of the Internal Model

Answer 21

Insurers must have a regular cycle of model validation which includes monitoring the performance of the Internal Model, reviewing the ongoing appropriateness of its specification and testing its results against experience.

Question 22

4 Model validation tools

Answer 22

• Back-testing (i.e. testing model results and assumptions against experience)
• Sensitivity analysis and other tests on the stability of the model
• Stress testing and scenario analysis
• Profit and loss attribution

Question 23

Documentation of the Internal Model

Answer 23

Insurers must document the design and operational details of their Internal Model.

The documentation must provide a detailed outline of the theory, assumptions, and mathematical and empirical bases underlying the Internal Model.

The documentation must be timely and kept up-to-date.

Question 24

Insurers may use a partial Internal Model to model: (6)

Answer 24

• 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 the whole of their business
• one or more risk components, in the same or different risk category, for one of more major business units.
• the adjustment for the loss-absorbing capacity of technical provisions and deferred taxes
• the capital requirement for operational risk