Model Behaviour

CEIOPS has kicked off its consultation on Level 3 implementation measures for Solvency II with a paper on the pre-application process for internal models (CP80).  Recent analysis of the impact of the revised calibration of the Solvency Capital Requirement (SCR) Standard Formula may push more companies towards the internal model option, speculates Andrew McGuinness.

As insurance companies across Europe prepare for the next Quantitative Impact Study (QIS5) this autumn, many organisations have been struggling to get to grips with the impact of the CEIOPS consultation papers published since QIS4.

CEIOPS’ summary feedback statement on the consultation for those papers, published at the end of January, reveals the depth of concerns in some areas. The proposed calibration for the SCR Standard Formula has been one of the major areas of debate; and in some cases, for example market risks, the calibration has been revised downwards following consultation. 

Interestingly, an extension until the end of March for the final advice on non-life (CP71) and health underwriting (CP72) risk and the Minimum Capital Requirement (MCR) calibrations (CP73) has been requested, in order to collect more data from a wider array of Member States.

Even given the changes already made in the other areas, the significance of this delay for non-life companies deciding how to proceed is hinted at by the findings of recent EMB analysis on the financial impact of changes to the Standard Formula calculation of the SCR since QIS4.

The research, conducted with a group of around 50 entities with QIS4 SCRs ranging from €2 million to €1 billion, and a combined capitalisation of over €8 billion, found an average SCR increase of 62% compared to QIS4 levels. This will be an alarming figure to many companies, particularly when you consider the range of increases which varied from 10% up to a daunting 120%.

But in the context of recent CEIOPS announcements, it is how the increases are constituted that will leave the non-life market, and particularly those leaning towards the Standard Formula SCR, looking for clarity. By far the largest part, 43%, of the overall capital uplift uncovered by EMB resulted from the calibration of non-life premium and reserve risk specified in CP71 (see figure 1 below).
 

Trade-off
The market has appreciated for some time that the relative simplicity of the Standard Formula comes at a cost: the capital calculated will not necessarily reflect the risk profile of an individual entity, since ‘one size fits all’ actually fits nobody. But, increases on the scale found by EMB are likely to cause some companies to contemplate that cost more closely.

We will have to wait to see how CEIOPS decides to address some of these issues in its final advice. QIS5 will provide companies with the opportunity to test out the revised calibrations, but it will leave precious little time for manoeuvre if they don’t like the outcome at that point.

The alternative route to the Standard Formula is to use a supervisor-approved internal model, whether full or partial.  This brings us to the latest CEIOPS consultation paper, focusing on the pre-application process for the approval of internal models. CP80 is built on the Final Level 2 Advice on the internal model approval process (CEIOPS DOC-28/09, former CP37) submitted to the European Commission, and of course is written with one eye on putting into practice the stipulations of the tests and standards for internal model approval (CEIOPS DOC-48/09, former CP56).

Some country supervisors, notably the Financial Services Authority in the UK, have already issued some guidance for firms wishing to go down the internal model route. Here, 99 companies have applied to take part in the model ‘dry run’ starting this year, which includes a pilot pre-application process involving four insurers. By not applying, the internal model option has not necessarily been closed down for the others come 2012, but they may have to stand at the back of a very long queue.

Outside the UK, the situation is less clear cut. While some country supervisors have been engaging in informal dialogue with insurers under their jurisdiction, the aim of the CEIOPS paper is to bring some consistency to the model pre-application process across the 30 countries. As the first consulted snippet of Level 3 advice, it is as much directed at supervisors as it is companies, in recognition of the potentially huge volume of approval work they face.

Fail to plan, plan to fail
It stresses that company participation in the pre-application process is voluntary and is no guarantee of final approval for an internal model. The paper also states that companies should be able to submit an application to use an internal model without having gone through the pre-application process. The aim of the pre-application process is also for Supervisory Authorities to give a view on how prepared the undertaking is to submit an application.

For companies wishing to take part in a pre-application process, CEIOPS recommends the following are in place for initial discussions

• A company view on whether it intends to seek approval for an internal model and when it plans to do so;
• The proposed scope of the model;
• An assessment of how the model meets the agreed Level 1 text of the Directive and, as much as possible, the Level 2 text, while recognising that parts of this remain to be finalised;
• A detailed project plan for completion of the model;
• Substantial evidence of efforts to document the model and any information the undertaking deems necessary and relevant to understand the model at the stage of provisional application.

It also urges companies to have a backup plan for the use of the Standard Formula for calculating their SCR in the event a model is not approved in time for Solvency II implementation.

The paper outlines the expectation that there will not be a ‘one size fits all’ pre-application process and that insurers should be attempting to discuss their models with country supervisors. It also covers some principles and guidelines that should be used by Colleges of Supervisors in designing the processes for approval of group internal models.

Companies across Europe that have been sitting on the fence about the Standard Formula or an internal model will very soon have to come off it. As the latest CEIOPS paper confirms, models require detailed planning, but the alternative, an uncertain and potentially damaging uplift to regulatory capital, may just give some a ‘push’ in that direction.

Andrew McGuinness is a Director at EMB, the international actuarial and business consultancy.