Solvency Capital Requirement - Internal Models

1.1

Unless otherwise stated, this Part applies to:

1. (1) a UK Solvency II firm; and
2. (2) in accordance with Insurance General Application 3, the Society.

1.2

In this Part, the following definitions shall apply:

internal model approval application

means an application by a firm for internal model approval.

internal model change policy

means a firm’s policy for making minor and major changes to its internal model.

internal model requirements

means the requirements set out in Solvency Capital Requirement – Internal Models 10 to 15.

2.1

A firm may calculate its SCR using an internal model that is either a full internal model or a partial internal model only:

1. (1) if it has been granted internal model approval in respect of its internal model; and
2. (2) to the extent of its internal model approval.

2.2

A firm that has been granted internal model approval must calculate its SCR using the internal model for which internal model approval has been granted.

[Note: Art. 112(1) and Art. 112(2) of the Solvency II Directive]

3.1

A firm making an internal model approval application must submit, as a minimum, documentary evidence that demonstrates to the PRA’s satisfaction that the internal model and, if the context requires, the firm satisfies the internal model requirements.

[Note: Art. 112(3) of the Solvency II Directive]

3.2

A firm making an internal model approval application must demonstrate to the PRA’s satisfaction that its systems for identifying, measuring, monitoring, managing and reporting risk are adequate.

[Note: Art. 112(5) of the Solvency II Directive]

3.3

When making an internal model approval application, a firm must submit its internal model change policy to the PRA for approval.

[Note: Art. 115 of the Solvency II Directive]

3.4

Upon request by the PRA, a firm with an internal model approval must provide the PRA with an estimate of the SCR determined in accordance with the standard formula.

[Note: Art. 112(7) of the Solvency II Directive]

4.1

Where an internal model approval application relates to the use of a partial internal model, the internal model requirements apply with any changes that are necessary to take account of the limited scope of the application of the internal model.

[Note: Art. 112(3) of the Solvency II Directive]

4.2

A firm making an internal model approval application to use a partial internal model must:

1. (1) explain, and properly justify, the reason for the limited scope of application of the internal model;
2. (2) explain how the resulting SCR reflects more appropriately the risk profile of the firm and complies with Solvency Capital Requirement - General Provisions 2 to 4; and
3. (3) demonstrate that the design of its partial internal model is consistent with the principles in Solvency Capital Requirement - General Provisions 2 to 4 so as to allow the partial internal model to be fully integrated into the standard formula.

[Note: Art. 113(1) of the Solvency II Directive]

5.1

Upon request by the PRA, a firm which has made an internal model approval application in respect of a partial internal model that only covers certain sub-modules of a specific risk module, or some of the business units of the firm with respect to a specific risk module, or parts of both, must submit a realistic transitional plan to extend the scope of the proposed partial internal model.

[Note: Art. 113(2) of the Solvency II Directive]

5.2

The realistic transitional plan referred to in 5.1 must set out the manner in which the firm plans to extend the scope of the proposed partial internal model to other sub-modules or business units of the firm, in order to ensure that the internal model covers a predominant part of the firm’s insurance business with respect to that specific risk module.

[Note: Art. 113(2) of the Solvency II Directive]

6.1

A firm with internal model approval must not change its internal model otherwise than in accordance with the firm’s internal model change policy as approved by the PRA.

[Note: Art. 115 of the Solvency II Directive]

6.2

A firm’s internal model change policy must include a specification of minor and major changes to the internal model.

[Note: Art. 115 of the Solvency II Directive]

6.3

A firm with internal model approval must not:

1. (1) make any major change to its internal model; or
2. (2) make any change to its internal model change policy;

without obtaining the prior approval of the PRA in accordance with the procedures set out in 3 to 5 for obtaining internal model approval.

[Note: Art. 115 of the Solvency II Directive]

7.1

A firm’s:

1. (1) internal model approval application; and
2. (2) application to the PRA for approval to make a major change to its internal model which is the subject of an internal model approval;

must be approved by the firm’s governing body.

[Note: Art. 116 of the Solvency II Directive]

7.2

A firm must have in place systems which ensure that its internal model operates properly on a continuous basis.

[Note: Art. 116 of the Solvency II Directive]

8.1

A firm with an internal model approval must not, in respect of the internal model for which that internal model approval has been granted, revert to calculating the whole or any part of the SCR in accordance with the standard formula.

[Note: Art. 117 of the Solvency II Directive]

9.1

If a firm with internal model approval ceases to comply with the internal model requirements, the firm must, without delay, either present to the PRA a plan to restore compliance within a reasonable period of time, or demonstrate to the PRA that the effect of non-compliance is immaterial.

[Note: Art. 118(1) of the Solvency II Directive]

10.1

A firm must demonstrate to the PRA that its internal model is widely used, and plays an important role in its system of governance (referred to in Conditions Governing Business 2 – 7, Insurance - Fitness and Propriety 2.1 to 2.3, 4.1, 4.3 and 4.4 and Insurance – Allocation of Responsibilities 4) and particularly in its:

1. (1) risk-management system, as set out in Conditions Governing Business 3.1 to 3.7, and decision-making processes; and
2. (2) economic and solvency capital assessment and allocation processes, including its ORSA, as set out in Conditions Governing Business 3.8 to 3.11.

[Note: Art. 120 of the Solvency II Directive]

10.2

A firm must also demonstrate to the PRA that the frequency of calculation of its SCR using the internal model is consistent with the frequency with which it uses its internal model for the purposes set out in 10.1.

[Note: Art. 120 of the Solvency II Directive]

10.3

A firm must ensure the ongoing appropriateness of the design and operations of its internal model, and that the internal model continues to appropriately reflect the risk profile of the firm.

[Note: Art. 120 of the Solvency II Directive]

11.1

A firm must ensure that its internal model and, in particular, the calculation of the probability distribution forecast underlying it, complies with 11.2 to 11.8.

[Note: Art. 121(1) of the Solvency II Directive]

11.2

The methods used to calculate the probability distribution forecast must be:

1. (1) based on adequate, applicable and relevant actuarial and statistical techniques;
2. (2) based upon current and credible information and realistic assumptions; and
3. (3) consistent with the methods used to calculate technical provisions.

[Note: Art. 121(2) of the Solvency II Directive]

11.3

A firm must be able to justify the assumptions underlying its internal model to the PRA.

[Note: Art. 121(2) of the Solvency II Directive]

11.4

1. (1) Data used for the internal model must be accurate, complete and appropriate.
2. (2) A firm must update the data sets used in the calculation of the probability distribution forecast at least annually.

[Note: Art. 121(3) of the Solvency II Directive]

11.5

Without limiting the operation of 11.2, irrespective of the method chosen to calculate the probability distribution forecast, the ability of the internal model to rank risk must be sufficient to ensure that it is widely used and plays an important role in the system of governance of the firm, in particular in its risk-management system and decision-making processes, and capital allocation in accordance with 10.1.

[Note: Art. 121(4) of the Solvency II Directive]

11.6

The internal model must cover all of the material risks to which the firm is exposed, including at least the risks set out in Solvency Capital Requirement – General Provisions 3.3(1).

[Note: Art. 121(4) of the Solvency II Directive]

11.7

In its internal model, a firm must:

1. (1) accurately assess:
1. (a) the particular risks associated with financial guarantees and any contractual options, where material; and
2. (b) the risks associated with both policyholder options and the firm’s contractual options,
2. taking into account the impact that future changes in financial and non-financial conditions may have on the exercise of those options; and
3. (2) take account of all payments to policyholders which it expects to make, whether or not those payments are contractually guaranteed.

[Note: Art. 121(7) and (9) of the Solvency II Directive]

11.8

A firm’s internal model must only take into account:

1. (1) as regards diversification effects, dependencies within and across risk categories, if the PRA is satisfied, as part of the internal model approval, that the firm’s system for measuring those diversification effects is adequate;
2. (2) the effect of risk-mitigation techniques, if and to the extent that credit risk and other risks arising from the use of risk-mitigation techniques are properly reflected in the internal model; and
3. (3) future management actions, if and to the extent that:
1. (a) they are future management actions that the firm would reasonably expect to carry out in specific circumstances; and
2. (b) the firm makes allowance in its internal model for the time necessary to implement those actions.

[Note: Art. 121(5), (6) and (8) of the Solvency II Directive]

12.1

A firm may use, for internal modelling purposes, a different time period or risk measure than that set out in Solvency Capital Requirement – General Provisions 3.4 only where the outputs of the internal model can be used by the firm to calculate the SCR in a manner that provides policyholders with a level of protection equivalent to that set out in Solvency Capital Requirement – General Provisions 3.2 to 3.5.

[Note: Art. 122(1) of the Solvency II Directive]

12.2

A firm must derive the SCR directly from the probability distribution forecast generated by its internal model, using the Value-at-Risk risk measure set out in Solvency Capital Requirement – General Provisions 3.4.

[Note: Art. 122(2) of the Solvency II Directive]

12.3

When required to do so by the PRA, a firm must run its internal model on relevant benchmark portfolios, using assumptions based on external rather than internal data in order to verify the calibration of the internal model and to check that its specification is in line with generally accepted market practice.

[Note: Art. 122(4) of the Solvency II Directive]

13.1

A firm with internal model approval must review, at least annually, the causes and sources of profits and losses for each major business unit.

[Note: Art. 123 of the Solvency II Directive]

13.2

A firm must demonstrate how the categorisation of risk chosen in its internal model explains the causes and sources of profits and losses.

[Note: Art. 123 of the Solvency II Directive]

13.3

A firm must ensure that its categorisation of risk and attribution of profits and losses reflects its risk profile.

[Note: Art. 123 of the Solvency II Directive]

14.1

1. (1) A firm must have in place a regular cycle of internal model validation which includes:
1. (a) monitoring the performance of the internal model, reviewing the ongoing appropriateness of its specification and testing its results against experience;
2. (b) an effective statistical process for validating the internal model which enables the firm to demonstrate to the PRA that the resulting capital requirements are appropriate;
3. (c) an analysis of the stability of the internal model and, in particular, the testing of the sensitivity of the results of the internal model to changes in key underlying assumptions; and
4. (d) an assessment of the accuracy, completeness and appropriateness of the data used by the internal model.
2. (2) The statistical methods applied for the purposes of (1)(b) must test the appropriateness of the probability distribution forecast compared to loss experience, all material new data and information relating thereto.

[Note: Art. 124 of the Solvency II Directive]

15.1

A firm must document the design and operational details of its internal model.

[Note: Art. 125 of the Solvency II Directive]

15.2

The documentation referred to in 15.1 must:

1. (1) demonstrate compliance with 10 to 14:
2. (2) provide a detailed outline of the theory, assumptions, and mathematical and empirical bases underlying the internal model;
3. (3) indicate any circumstances under which the internal model does not work effectively; and
4. (4) include all major changes to the internal model, as referred to in 6.

[Note: Art. 125 of the Solvency II Directive]

16.1

The internal model requirements apply regardless whether a firm uses, in its internal model, a model or data obtained from a third party.

[Note: Art. 126 of the Solvency II Directive]

17.1

This Chapter applies to the Society in relation to the use of an internal model for the purpose of Solvency Capital Requirement – General Provisions 3.1.

17.2

The internal model must:

1. (1) separately identify and aggregate any diminution in basic own funds arising as a result of the application of risk scenarios taken into account in the internal model to:
1. (a) the insurance business of members; and
2. (b) the central assets and central liabilities; and
2. (2) where the risk scenarios taken into account in the internal model result in the own funds attributable to a particular member being exhausted, identify the consequent impact upon own funds attributable to the Society.