03 February 2010

Published in: Capital - models, Regulation - supervision

Pre-application for internal models will be challenging

The process laid out in the 81 pages of CEIOPS guidance requires reams of information from insurers and lengthy dialogue with the supervisors, as Towers Watson explains.

Consultation paper 80, issued by the Committee of European Insurance and Operational Pensions Supervisors (CEIOPS) on 28 January, sets out in detail CEIOPS' draft level 3 guidance on the main stages involved in the pre-application process for an internal model.

The main aim is to ensure supervisory convergence in the pre-application process although the guidance is not binding on supervisory authorities.

The process will also give insurers insights into how ready they are for internal model approval and how the supervisory authority is going to approach the assessment of the internal model.

Key points:

• it is not mandatory for companies to take part in the process in order to be able to apply for internal model approval.
• participation in the pre-application process does not guarantee approval when the formal application is submitted and therefore companies should ensure they are able to calculate the standard formula solvency capital requirement (SCR) in case approval is not granted.
• it is going to be challenging to achieve convergence in supervisory approach to the approval of internal models, particularly for groups.

Main stages of pre-application process

The paper splits the stages of the pre-application process into:

1. Criteria for resource allocation
2. Supervisory authority planning
3. Review of information
4. Process for coming to a view
5. Rolling information over from review to assessment

Criteria for resource allocation

Allocation of the resources of the supervisory authorities should be based on the following set of criteria:

1. The point in time the undertaking first informed the supervisor of the interest in taking part in the pre-application process
2. The nature, scale and complexity of the risks of the undertaking
3. The undertaking's prospects for developing an approvable internal model in a reasonable period of time. This requires judgement on the current state of the models and supervisors should consider:
   1. the undertaking's own assessment of their risks
   2. the undertaking's self-assessment of the ability to meet the Solvency II internal model requirements
   3. the undertaking's detailed plans for general Solvency II implementation and internal model development
   4. whether the existing documentation is good enough to enable the supervisor to understand the current state of the model and the intended scope
   5. the degree of involvement of the administrative or management body in the internal model
   6. demonstrated use of the internal model in decision-making
   7. completed QIS4 and intention to complete/have completed QIS5

Early preparations and committed resources by insurers will therefore be a key determinant in the interaction with the supervisory authority. In addition, the demand for companies to take part in the pre-application process in some countries will significantly stretch the supervisory authorities and companies will be required to submit a large amount of information to the supervisor.

The level and detail of this information appears to require companies to have made material progress on their implementation of Solvency II and their internal model in particular. Any areas which have not been completed are expected to be planned and scoped in detail. It seems unlikely that many companies will be in a position to submit all the information currently required.

Supervisory authority planning

The supervisory plan is intended to cover the pre-application process as a whole and the individual processes for each undertaking taking part in the pre-application process. After initial discussions between the supervisor and the undertaking, the supervisor will list the information to be gathered. For example, information on the scope of the internal model, plans for demonstrating compliance with the internal model requirements, internal model documentation and so on.

The supervisory plan will include items such as the objectives of the pre-application process, the scope of the pre-application process, delivery dates, milestones, an activity plan and a resource plan.

A series of issues for supervisory planning specifically related to groups are also set out in the paper. For example, for international groups there should be one pre-application process which is led by the lead/group supervisor in cooperation with the other supervisors. The group supervisor should identify the key facts and issues about the group internal model and discuss these with the college of supervisors as soon as possible. The college will then decide how to take the process forward and develop a framework for the process. Some examples of possible frameworks are shown in annex A of the paper.

Review of information

Supervisory authorities must review the information collected to assess the preparedness of companies to submit an application for internal model approval. The review is likely to be in depth (and a similar level of detail to the review of the final application) and some examples are given to illustrate this. The proportionality principle will be applied to the depth of review and, for groups, a consistent approach should be applied by all supervisors within the college.

The information to be reviewed to be able to give a view on the preparedness of an insurer for an application for internal model approval includes:

1. the results of the latest ORSA and details of the undertaking's business and risk strategies
2. the scope of application for full and partial internal models and model coverage
3. risk management process and risk profile
4. the self-assessment by the undertaking of compliance with internal model requirements
5. information on the calculation kernel of the internal model
6. information on the use of external models and data
7. model governance systems and controls
8. up-to-date independent review/validation report on the internal model
9. policy for changing the full and partial internal model
10. plans for future model improvements
11. capital requirements split by risk category
12. a copy of the application letter

The process followed for reviewing the internal model will be flexible as every internal model is different. The information will be reviewed following an iterative process in which the information is considered, issues are identified, these are communicated to the company concerned and the company will respond.

This process is repeated until all concerns have been addressed. If an undertaking makes changes to parts of the model that have already been reviewed, they must submit new information to the supervisor for review. Information will be reviewed through a mixture of on-site visits, desk- based reviews and ad hoc conversations. Supervisors can request further information to gain a better understanding of the internal model and form their views on the level of preparedness.

The pre-application process is also a good opportunity for an undertaking to test the scope of its model change policy as its model will be developing during the course of the pre-application process.

Process for coming to a view

There should be several opportunities for supervisory authorities to share their views on how prepared an undertaking is to submit an application for internal model approval (because of the iterative nature of the process) and the supervisory authority should communicate its views as soon as possible. The feedback given to undertakings is likely to emphasize the deficiencies with the internal model.

This should enable undertakings to make changes/revisions or develop alternative approaches before submitting a formal application for internal model approval. Materials should be reviewed by the supervisory authorities as and when they become available and conclusions on previously reviewed information may change as a result of the new information received.

In addition, the supervisory view of what is right/what is good practice may change as they are exposed to more and more modelling approaches from different companies. There is a risk that the standards will be continually raised as supervisors review more internal models and that it will become much harder for companies to get approval of their internal models.

Rolling information over from review to assessment

Supervisory authorities will be able to use any information or insights that they have gathered on the quality of the model during the pre-application process (including the depth of the review likely to be required for different parts of the model) in the assessment of the application for internal model approval. Undertakings will have to keep a complete record of all enhancements and changes of the internal model since it was reviewed during the pre-application process. This will enable the supervisory authorities to easily update their knowledge of the internal model and reduce the risk of them treating companies unfairly because their views were based on the model as it was in the pre-application phase.

Next steps

The consultation period for this advice ends at 16:00 CET on 8 March 2010.

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