David Rule of BoE on Use and Misuse of Internal Models by UK Insurers
While speaking at the 2019 Prudential Regulation Seminar of Association for British Insurer, David Rule of BoE discussed insurance models and the growing importance of model risk management. He described recent findings from the PRA work to guard against weakening of capital requirements calculated from internal models—also called the "model drift." He also highlighted the PRA expectations for how models are used by insurers’ senior management and boards. Insurers should be confident enough to use their models but not overconfident and misuse them, said Mr. Rule.
He mentioned that calculation errors or misuse of internal models used to calculate regulatory capital requirements could result in insufficient capital to protect policyholders. Solvency II allows insurers to apply to PRA for permission to use a model to calculate their capital requirements. PRA has approved 24 UK insurers to calculate capital requirements using a model, which is the highest number by EU country. That gives PRA the advantage of peer comparison. PRA tracks movements in internal model capital compared to the standard formula and the net best estimate of liabilities. The comparison revealed that, in 2016 and 2017, the aggregate capital requirements of UK general insurers with internal models increased more or less in line with the standard formula and best estimate of liabilities. No generalized model drift was apparent.
For life insurers, in aggregate, by contrast, both standard formula capital and best estimates of liabilities rose considerably more than internal model capital. "At face value, this looks like considerable model drift. For a couple of reasons, though, we are not yet ringing the alarm bells," said Mr. Rule. Since it is only two years of data, PRA will need a longer period to draw strong conclusions about trends. Second, some life insurers with internal models have been growing in areas where the standard formula over-states the risks—particularly, illiquid assets within Matching Adjustment portfolios. Additionally, life insurers have been expanding unit-linked business and transferring an increasing proportion of longevity risk on new annuities business through reinsurance, both of which would tend to lead to faster growth in the best estimate of liabilities than capital requirements. In short, the two benchmarks against which PRA compares internal model capital might not have been fully reliable measures of changing risks. The "bottom up" analysis of internal model outputs has also not suggested any generalized dilution of standards. Nonetheless, the significant reduction in internal model capital compared to the standard formula is not a trend that would be expected to continue over time. The Authority will be watching it carefully.
Finally, he explained that the FCA agreement with panel banks to provide LIBOR quotes will end in December 2021, which is now just over 30 months away. For insurers, the Solvency II discount curves for major currencies are currently LIBOR-based. PRA is aware that insurers need clarity about when and how these discount curves will transition to replacement risk-free rates. It understands the challenges this poses to insurers and is working constructively with EIOPA and others to address these issues. Insurers are encouraged to continue to focus on the actions within their control such as identifying where LIBOR exposure is on the balance sheets, engaging with counterparties, and preparing for operational changes. In conclusion, he reiterated that insurers need to be sufficiently confident to use their models but not so over-confident that they misuse them.
Related Link: Speech (PDF)
Keywords: Europe, UK, Insurance, Solvency II, Regulatory Capital, Internal Model, Standardized Approach, LIBOR, BoE
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