How does the Prudential Regulation Authority check that insurance firms are ensuring their models continue to produce appropriate capital requirements?

Under Solvency II, which sets out regulatory requirements for insurance firms, insurers can apply to regulators for permission to use an internal model — instead of a standard formula — to calculate their SCRs. 

The PRA defines model drift as the risk that, over time, the SCRs calculated using an internal model no longer reflects the risks that a firm faces. We monitor model drift using a range of supervisory tools.

For life insurers, and to a lesser extent general insurers, the observed increases in capital requirements calculated using internal models are significantly lower than the increases in other related measures, such as standard formula capital and best estimate liabilities (Chart A).

Chart A Firms’ internal model capital requirements increase by less than other related measures

Percentage changes in internal model capital requirements between 1 January 2016 and 31 December 2018, compared to other related measures

Sources: Firm submissions and Bank calculations. 

An initial analysis would lead us to question whether firms’ models continue to provide an accurate assessment of their risks, and as mentioned below we have identified some areas to investigate further. However, most of the difference in observed increases can be attributed to structural changes to firms’ balance sheets and changes in firms’ risk profiles.¹

Firms’ internal model calculations are based on assumptions about a range of risks. It is reasonable for these assumptions to be reviewed and adjusted over time, in light of emerging experience, but this should not lead to a loss in model accuracy.

For life firms, we have observed a significant reduction in the median calibration for credit spread risk (Chart B). We are investigating further as the reasons for this reduction are unclear, and we would challenge firms if this trend continues.

Chart B Firms’ internal model calculations are based on assumptions about many types of risk

Change in industry median risk calibrations for life firms between 1 January 2016 and 31 December 2018

Sources: Firm submissions and Bank calculations.

Firms’ calibrations for interest rate risk have also changed a lot. We attribute this to yield curve movements in the low interest rate environment, rather than potential model drift.

Using internal model output, we attempt to account for movements in the SCRs for general insurance firms (Chart C) between legitimate changes (eg exposure and business mix) and changes that signal potential model drift (eg weakening of parameters). We have observed possible model drift for general insurers, from weakened insurance risk parameters, and we have followed this up with individual firms.

Chart C Reasons why a firm’s capital requirements could change

Analysis of internal model output (IMO) of a general insurer showing movement in capital requirements (example)

Source: Bank calculations based on firms' IMO submissions.

The PRA is monitoring trends in firms’ modelled SCRs. We are especially vigilant about SCR changes that cannot be adequately justified.

Some firms analyse their own data for possible model drift. We encourage other firms to look at this too.

 

This post has been prepared with the help of Guy Brett-Robertson, Paul Collins, Amanda Istari, Ryan Li, Dimitris Papachristou, Chintan Patel and Jiaqi Tan.

This analysis was presented to the Prudential Regulation Committee in December 2019.

This analysis was carried out prior to Covid-19. The full impact of Covid-19 on the insurance sector is yet to emerge. The effect of market turbulence observed over the first half of 2020 as well as insurance claims, on the firms’ internal models, is likely to come through over the coming months.

Share your thoughts with us at BankOverground@bankofengland.co.uk

1. The structural changes to firms’ balance sheets and changes in firms’ risk profiles could be due to: 
(a) restructures and transfers of insurance business, some of which were driven by Brexit;
(b) insurers implementing risk mitigation actions, such as buying reinsurance; 
(c) life insurers increasing their holdings of restructured illiquid assets which attract a much higher capital charge under the standard formula;
(d) life insurers expanding in the unit-linked market, which has relatively low capital requirements; or 
(e) general insurers reducing or completely cutting unprofitable sections of their books.