Clifford Chance
Countdown to Solvency UK - Internal Models Under Solvency UK: Challenges and Opportunities
On 28 and 29 February 2024, the Prudential Regulation Authority (PRA) released two important policy statements— PS2/24 and PS3/24 — marking a significant step in adapting the Solvency II framework for the UK insurance market.
The PRA's new reforms include streamlining and clarifying the approval process for Internal Models (IMs), which insurers can use to calculate their Solvency Capital Requirement (SCR) on a bespoke basis rather than using the standard formula approach. The reforms will come into effect on 31 December 2024. This article explores the key changes, challenges and opportunities arising from this transition.
Background
IMs are sophisticated tools that allow insurers to calculate their SCR by assessing their unique risk profiles in a more tailored fashion than under the standard formula approach.
Under Solvency II, firms have the option to calculate the own funds required to be held using either the standard formula or an IM approved by the regulator. While the standard formula is applicable across the board, it is often criticised for its rigidity and lack of responsiveness to the risk profiles of individual firms.
In contrast, IMs allow insurers to incorporate their own specific assumptions, calibrations, and advanced statistical techniques, providing a more nuanced understanding of risks they face such as those in underwriting, credit, market, operational and liquidity. For example, a firm with significant exposure to cyber risks can tailor its IM to reflect the distinct nature of that risk, rather than relying on generic factors.
However, the adoption of an IM is not without its challenges. Relatively few UK Solvency II insurers have adopted IMs to date. Development costs can be significant, particularly for mid-sized and larger insurers, due to the need for robust data infrastructure, sophisticated analytics, and ongoing compliance with regulatory standards. The PRA hopes that their reforms will alleviate some of these burdens by shifting towards a regulatory approach that emphasises adaptability whilst maintaining high modelling standards.
Amendments to the PRA Rulebook
The PRA has implemented important amendments to its Rulebook, particularly in the Glossary and the Solvency Capital Requirement – Internal Models part.
The PRA will no longer approve a firm's IM – it will now grant firms a permission that modifies the SCR – Internal Models part of the PRA Rulebook as it applies to that firm. Similarly, for a major model change the PRA will not approve the amended IM but will exercise its power to vary a firm's existing permission to calculate its SCR using an internal model.
This change in the legal mechanism by which a firm is allowed to use an IM in calculating its SCR is not expected to bring about a substantive change in how the PRA engages with firms in respect of the IMs.
The PRA has also integrated the Commission Delegated Regulation (EU) 2015/35 (CDR) into its regulatory framework, reorganising this material into Parts 16B to 16G of the PRA Rulebook. This restructuring aligns this retained EU law with the PRA's established Rulebook style. There is also an attempt to standardise terminology and definitions across the PRA’s requirements which should help firms navigate their compliance requirements.
New and Updated Statement of Policy and Supervisory Statement
The introduction of the new Statement of Policy (SoP), titled "Solvency II internal models: Permissions and ongoing monitoring", represents a significant evolution in the PRA's approach to IM approvals and ongoing compliance. This SoP replaces the earlier SS12/16.
In tandem with the new SoP, the PRA has also introduced a new Supervisory Statement SS1/24 Expectations for meeting the PRA’s internal model requirements for insurers under Solvency II that outlines the expectations for insurers in meeting IM requirements. This guidance is an important resource for firms looking to ensure compliance with the PRA’s regulatory framework.
The new IM regime applies to both full and partial models and to solo and group IMs, unless otherwise stated.
Key Changes
Streamlining approval process
Important changes have been made to address some of the issues outlined above.
The PRA has decided that many of the tests and standards (T&S) previously required to be satisfied are overly prescriptive and has sought to streamline these in a range of areas:
- Documentation – The CDR prescribed the information that documentation of the IM must include. These provisions are not being transferred wholesale to the PRA Rulebook but are being included in SS1/24 as expectations of how a firm might demonstrate compliance with the high-level requirements set out in the PRA Rulebook.
- Data appropriateness – the PRA intends to rely on firms to responsibly comply with the CDR requirement that data must reflect the risks to which a firm is exposed, rather than specifying in detail – in the Rulebook or SS1/24 – how this requirement should be satisfied.
- Management actions – the requirement to comply with Articles 23 and 236 CDR, will be consolidated into a cross-reference in the rulebook requiring firms to comply with Article 23.
- Approximation. The PRA proposes not to transfer Article 238 CDR to the Rulebook. Instead, where a firm cannot meet the requirement to derive its SCR directly from the forecast generated by its IM, the PRA will deal with this case by case.
To facilitate this streamlined approach, the PRA has also refined its processes around pre-application checks and completeness reviews. While maintaining these steps ensures a firm’s readiness for the IM approval process, the PRA has acknowledged that pre-application engagement may not be required in all instances, so alleviating unnecessary administrative burdens. Responding to feedback, the PRA will provide an updated Self-Assessment Template (SAT), which aligns with the simplified IM requirements and will help firms assess their compliance against new standards. Importantly, the PRA has assessed that cost implications tied to these adjustments are expected to be minimal and largely one-off, helping to keep compliance costs manageable.
The PRA has indicated that it will endeavour to approve applications within six months, which if achieved will be a significant improvement over current timeline.
The PRA has also introduced amendments to streamline governance for minor or administrative changes to internal model change policies. Under the revised SoP and new rule Solvency Capital Requirement – Internal Models 6.4, firms can make such changes without needing to apply to the PRA for a variation of permission. This adjustment removes the unnecessary regulatory burden for non-substantive updates, such as changes to company names or logos, updates to staff titles or responsibilities, corrections to drafting errors, and renumbering of references.
Model Limitation Adjustment
Under the current regime a firm can spend considerable time and effort in submitting an application for approval of an IM, but if the PRA identifies any respects in which the proposed model does not fully meet all T&S, it has no choice but to either reject the application in its entirety or defer approval until the issue has been addressed completely by the firm, which may take considerable time.
The new framework will move away from this binary approach. If a residual market limitation (RML) is identified, then there is a new option – the PRA can still approve the IM as long as safeguards are used to mitigate or correct these limitations. An RML refers to a part of an internal model that stops a firm from proving that it meets in full the PRA SCR rules and internal model standards in all situations where the model is used or intended to be used.
The PRA can set:
- an RML capital add-on intended to mitigate the effect of non-compliance with the IM requirements and/or ensure compliance with the calibration standards. This would only be available where the RML is not considered significant.
- a requirement safeguard – a qualitative requirement which would apply to a firm's business practice or its IM use.
The PRA has made MLAs an integral part of its regulatory reforms. By implementing a structured MLA framework, the PRA intends to ensure that these adjustments are applied consistently and transparently across all firms, thereby enhancing the overall integrity of the regulatory system. The expectation is that firms will generally apply positive MLAs to boost their model performance and accuracy. However, the PRA acknowledges that negative MLAs may be warranted in rare cases, which will require close supervisory oversight and discussion.
Moreover, the PRA emphasises the importance of firms developing comprehensive plans to address the underlying issues that necessitate the use of MLAs. This approach is meant to encourage firms to take ownership of their IM's performance and work towards continual improvement. The PRA expects firms not only to identify deficiencies but also to implement strategic changes to rectify them over time. This focus on remediation reflects the PRA's commitment to ensuring that the firm's IM remains robust and properly aligned with its risk profile and regulatory expectations.
The PRA has also introduced a two-year extension for firms to address MLA-related issues in certain circumstances. This extension allows firms additional time to engage with the PRA, conduct thorough assessments of their models, and implement necessary changes without the immediate threat of regulatory penalties. By facilitating this process, the PRA aims to foster an environment where firms can enhance their internal risk management practices while ensuring compliance with the regulatory standards that safeguard the financial system.
The PRA's reforms also address the assessment of an IM in the context of merger and acquisition activity. When a firm with an IM considers acquiring another firm, the PRA will expect a thorough evaluation of how the existing IM integrates with or accommodates the risks associated with the entity to be acquired. This is important for maintaining the integrity and reliability of capital calculations post-acquisition. The PRA emphasises that a firm must ensure its IMs remain compliant with regulatory standards and adequately reflects the combined risk profile of the merged organisation.
The PRA has signalled that is prepared to engage closely with firms during the acquisition process to ensure that any potential changes to an IM are managed effectively. This includes evaluating whether the IM of both the acquiring and acquired firms can be harmonised or if adjustments are necessary to account for the new risk landscape. The PRA may grant firms a temporary flexibility period to make necessary adjustments to their IM following an acquisition, acknowledging the complexity of integrating two distinct operational frameworks and providing firms with the time needed to conduct comprehensive analyses and implement changes. This proactive engagement underscores the PRA's commitment to a regulatory environment that balances the need for stringent risk management with the realities of operational integration following significant corporate transactions.
Despite the efforts to reduce the regulatory burden, the PRA's streamlined framework also incorporates new elements intended to support ongoing model compliance. These include an Analysis of Change (AoC) framework, an Internal Model Ongoing Review (IMOR) process, and an annual attestation requirement; these are explored in more detail below.
While these additions have raised some concerns about increased complexity of compliance, the PRA has clarified that these processes build upon existing practices within firms and are not meant to complicate the framework. In response to queries from respondents about the structure and interpretation of the new requirements, the PRA provided additional guidance to distinguish between "expectations" (outlined in supervisory statements) and enforceable "requirements" (within the PRA Rulebook), aiming to eliminate any ambiguity.
Internal Model Ongoing Review Framework (IMOR)
Under the existing framework, the PRA carries out a programme of assessments of the ongoing appropriateness of an approved IM.
The new IMOR framework represents an evolution in the PRA's oversight of IMs and aims to ensure that these models remain compliant and appropriate throughout their lifecycle. Building on existing supervisory processes, the IMOR framework introduces a structured approach to ongoing model assessment. The IMOR framework will consist of four "strands". The framework incorporates various elements, such as thematic reviews that focus on specific areas of concern within the industry, model drift analysis that examines how models may diverge from their intended performance over time, and firm-specific deep dives that provide an in-depth examination of individual firms' internal modelling practices.
By proactively monitoring model performance and compliance, the IMOR framework aims to mitigate risks associated with an outdated or misaligned IM, ultimately contributing to a more resilient financial system.
Strand 1 – Thematic Reviews
One of the key features of the IMOR framework is its emphasis on thematic work, which will allow the PRA to identify and address emerging trends or common issues across the industry. The PRA hopes that these reviews will allow it to assess the effectiveness of IMs in capturing specific risks, such as those related to market volatility or changes in regulatory expectations.
Furthermore, the PRA believes that the firm-specific deep dives within the IMOR framework facilitate a tailored assessment of each firm's internal modelling practices and should, in turn, allow the PRA to gain deeper insights into that firm's risk environments and modelling methodologies.
Strand 2 – Analysis of change exercise (AoC)
IM firms will be required to complete an annual AoC exercise covering movements in the SCR and submit this to the PRA. See below for more detail.
Strand 3 – Assessment of ongoing internal model compliance.
This will be required to provide an annual attestation that the firm satisfied the calibration standards and IM requirements. If any areas of non-compliance are identified the firm will be required to attest that it has a credible plan to address them. See below for more detail.
Strand 4 - Monitoring of safeguards
Where safeguards have been imposed as part of the granting of more IM permissions, the PRA will review the appropriateness and effectiveness of these safeguards.
Reporting and Attestation Requirements
As noted above, the PRA proposes to require IM firms to complete an annual AoC exercise and submit the results to the PRA. This AoC requirement replaces the previous Profit & Loss (P&L) attribution exercise, which the PRA has identified as less effective for monitoring shifts in risk exposure. The AoC aims to provide firms and the PRA with a clearer understanding of the drivers behind changes in IMs and their impact on capital requirements. By focusing on variations in risk exposure, the AoC aligns with the PRA’s objectives of ensuring that each firm's IM remains robust, appropriately calibrated, and reflective of its risk profiles. This focus on risk factors offers a more nuanced view than the P&L attribution, which often failed to capture the full scope of risk exposure changes, particularly in complex insurance portfolios.
An additional requirement introduced by the PRA is the annual attestation of compliance with IM standards. This attestation is a formal declaration from firms, affirming that their IM continues to meet PRA calibration standards and IM requirements. The attestation, generally signed off by the Chief Risk Officer (CRO) or an equivalent senior officer, underscores accountability at the highest level of management. This step is intended to strengthen governance and ensure that senior management remains actively engaged in monitoring and maintaining compliance with regulatory standards. Furthermore, the attestation is meant to provide the PRA with a reliable mechanism to gauge ongoing compliance without requiring extensive direct intervention, thereby improving regulatory efficiency and firm accountability.
Challenges and Strategic Opportunities
The PRA’s shift to a principles-based approach for IMs is a positive step, particularly the move away from the rigid binary “yes or no” approval process. Streamlining the approval process and reducing prescriptive rules should also help more firms tailor their models to their risk profiles, which eventually should assist in potentially lowering approval barriers. The introduction of safeguards should help in managing model limitations, although their effectiveness will need ongoing assessment by the PRA.
Despite these advantages, challenges remain. The shift away from prescriptive rules places greater responsibility on firms to interpret a significant amount of new guidance, including the updated Statement of Policy and SS1/24. While important, this guidance is not straightforward to work through, increasing the risk of inconsistent application. The integration of MLAs also requires extensive documentation from firms, and the new IMOR framework involves additional oversight by the PRA. These reforms, while beneficial in some ways, may therefore increase compliance burdens. For the reforms to succeed, firms must navigate these challenges, and the PRA should offer clear, consistent support to firms to ensure the framework provides its intended benefits.
