Solvency Assessment and Management: Pillar 2 - Sub Committee ORSA and Use Test Task Group Discussion Document 35 (v 3) Use Test

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1 Solvency Assessment and Management: Pillar 2 - Sub Committee ORSA and Use Test Task Group Discussion Document 35 (v 3) Use Test EXECUTIVE SUMMARY 1. INTRODUCTION AND PURPOSE The purpose of this document is to provide a proposal for the basis for subordinated legislation in South Africa on the use test requirements relating to the Internal Model. It should be noted that this specific proposal only applies where an insurer or insurance group opts to use an Internal Model for the purposes of the MCR and SCR calculation. For clarification purposes, where an insurer uses a partial internal model, this guidance is applicable to those elements of the model that are not following the standard formula, but are internally developed. Some jurisdictions also interpret the Use Test as the demonstration that the principles of the ORSA and system of risk management are embedded in the business and decision making processes of an insurer or insurance group. In South Africa, this interpretation is referred to as the Embedment Test and further guidance on this is included in the ORSA discussion document. 2. INTERNATIONAL STANDARDS: IAIS ICPs ICP17 1 paragraphs 17.13, EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) The relevant Level I article is 120. The recommendation from this Work Group was that this article is adopted without any changes. 4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE Article 120, paragraph 1 reads as follows: Insurance and reinsurance companies shall demonstrate that the internal model is widely used in and plays an important role in their system of governance,., in particular: a) Their risk-management system as laid down in Article 44 and their decision-making processes; b) Their economic and solvency capital assessment and allocation processes, including the assessment referred to in Article 45. ICP is less descriptive but in essence requires exactly the same. It reads as follows: Where a solvency regime allows the use of internal models to determine regulatory capital requirements, the solvency regime requires: 1 IAIS ICP 17 Capital Adequacy standards and guidance material 1

2 The insurer to fully embed the internal model, its methodologies and results, into the insurer s risk strategy and operational processes (the use test ). Article 120, paragraph 2 states that: In addition, insurance and reinsurance companies shall demonstrate that the frequency of calculation of the Solvency Capital Requirements using the internal model is consistent with the frequency with which they use their internal model for the other purposes covered by the first paragraph. No reference to the frequency of calculation is made in ICP 17. Article 120, paragraph 3 states: The administrative, management or supervisory body shall be responsible for ensuring the ongoing appropriateness of the design and operations of the internal model, and that the internal model continues to appropriately reflect the risk profile of the insurer and reinsurance companies concerned. The second paragraph of ICP 17.16: the solvency regime requires the insurer s board and senior management to have control of and responsibility for the construction and use of the internal model for risk management purposes, and ensure sufficient understanding of the model s construction at appropriate levels within the insurer s organizational structure. In particular, the solvency regime requires the insurer s board and senior management to understand the consequences of the internal model s output and limitations for risk and capital decisions. While Article 120 refers to the responsibility for the appropriateness and the design of the model, ICP17 concentrates also on the management s responsibility to have a deep understanding of the construction, output and limitations of the model. Level I Text EU Directive IAIS ICP 17 Article 120, par 1. Insurance and reinsurance undertakings shall demonstrate that the internal model is widely used in and plays an important role in their system of governance,, in particular: ICP 17.16: the insurer to fully embed the internal model, its methodologies and results, into the insurer s risk strategy and operational processes. a) Their risk-management system as laid down in Article 44 and their decision-making process; b) Their economic and solvency capital assessment and allocation process, including the assessment referred to in Article 45. Article 120, par 2. In addition, insurance and reinsurance undertakings shall demonstrate that the frequency of calculation of the Solvency Capital Requirement using the 2

3 internal model is consistent with the frequency with which they use their internal model for the other purposes covered by the first paragraph. Article 120, par 3. The administrative, management or supervisory body shall be responsible for ensuring the on-going appropriateness of the design and operations of the internal model, and that the internal model continues to appropriately reflect the risk profile of the insurance and reinsurance undertakings concerned. ICP 17.16: the insurer s board and senior management to have control of and responsibility for the construction and use of the internal model for risk management purposes, and ensure sufficient understanding of the model s construction at appropriate levels within the insurer s organizational structure. In particular, the solvency regime requires the insurer s board and senior management to understand the consequences of the internal model s output and limitations for risk and capital decisions. ICP17.16: the insurer to have adequate governance and internal controls in place with respect to the internal model 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) This section explores the options available, in terms of different approaches to achieving the same principles/outcomes outlined above. 5.1 IAIS standards and guidance papers The following papers were considered: Guidance paper , paragraph 3.4. The wording of this paragraph is set out below: 47. In considering the use of an internal model for regulatory capital purposes by an insurer, the supervisors should not merely focus on its use for that narrow purpose, but should consider the wider use of the internal model by the insurer for its own risk and capital management. 48. The 'use test' is the process by which the internal model is assessed in terms of its application within the insurer's risk management and governance processes. In order for the insurer s internal model to be most effective it should be genuinely relevant for use within its business for risk and capital management purposes. 49. Where an insurer decides to adopt a higher confidence level than the level required for regulatory capital purposes for its own purposes, for example, in order to maintain a certain investment grade rating, then 'calibration' testing should also be conducted by the insurer to allow the insurer to determine the level of capital needed 2 IAIS Guidance Paper no on the use of internal models for regulatory capital purposes (2008) 3

4 at this higher level. The insurer should then assess whether holding this amount of capital is consistent with the insurer's overall business strategy. 50. The insurer should have the flexibility to develop its internal model as an important tool in strategic decision making. An insurer should therefore have the flexibility to use the most appropriate risk measure and modelling techniques in its internal models. It may be beneficial if the insurer is able to demonstrate why it has chosen a particular risk measure, and it should include in its internal model an appropriate recalibration or reconciliation, if necessary, between the modelling criteria used in the model for its own risk and capital management purposes and those set by the supervisor for regulatory capital purposes. Differences between the economic capital and the regulatory capital requirements should be explicit and capable of being explained by the insurer to its board and the supervisor. 51. The 'use test' is a key method by which the insurer can demonstrate that its internal model is integrated within its risk and capital management, and system of governance processes and procedures. As part of the 'use test', an insurer should examine how the internal model is used for operational management purposes, how the results are used to influence the risk management strategy and business plan of the insurer, and how senior management are involved in applying the internal model in running the business. An insurer should demonstrate to the supervisor that an internal model used for regulatory capital purposes remains useful and is applied consistently over time, and that it has the full support of and ownership by the board and senior management. 52. The insurer's senior management should take responsibility for the design and implementation of the internal model, in order to ensure full embedding of the model within the insurers' risk and capital management processes and operational procedures. The methodology used in building the model should be compatible with the overall enterprise risk management framework agreed to by the board and senior management. Although the board and senior management may not be able to deconstruct the internal model in detail, it is important that the board has overall oversight of the model's operation on an ongoing basis, and the level of understanding necessary to achieve this. The board and senior management should also ensure that processes are in place to update the internal model to take into account changes in the insurer's risk strategy or other business changes. 53. Various business units within the insurer may be involved in the construction and operation of the internal model, such as risk management, capital management, finance and actuarial departments, depending on the size of the insurer. The technical ability of staff involved in the construction and operation of the internal model should be an important consideration for the insurer. For a model to pass the 'use test' it would be expected that an insurer would have a framework for the model's application across business units. This framework should define lines of responsibility for the production and use of information derived from the model. It should also define the purpose and type of the management information available from the model, the decisions to be taken using that information, and responsibilities for taking those decisions. The use test should also ensure the adequacy of systems and controls in place for the maintenance, data feeds, and results of the model. The IAIS notes that internal models may require significant IT resources and costs, which should be a consideration for the insurer in developing its models. 54. The IAIS considers that governance processes and communication in respect of an internal model are as important as its construction. An internal model should be subject to appropriate review and challenge so that it is relevant and reliable when used by the insurer. The key elements and results from the internal model should be understood by the key personnel within the insurer, including the board, and not only by those who have constructed it. This understanding should ensure that the internal 4

5 model remains a useful decision-making tool. If the internal model is not widely understood, it will not be achieving its purpose and adding value to the business. The 'use test' is key in ensuring the relevance of the internal model to the insurer s business. Standard , paragraphs 10, 11 and 12. These are both a duplication of ICP17. The wording of these paragraphs is set out below: 10. The insurer should ensure that the internal model, its methodologies and results, are fully embedded into the risk strategy and operational processes of the insurer (the 'use test'). 11. The insurer's board and senior management should have overall control of and responsibility for the construction and use of the internal model for risk management purposes, and ensure that there is sufficient understanding of the model's construction at appropriate levels within the insurer's organisational structure. In particular, the board and senior management should understand the consequences of the internal model's outputs and limitations for risk and capital management decisions. 12. The insurer should have adequate governance and internal controls in place in respect to the internal model. ICP 17, specifically 17.13, Key highlights from ICP 17 which may be comparable to level 2 text are as follows: IIn considering the use of an internal model for regulatory capital purposes by an insurer, supervisors should not merely focus on its use for that narrow purpose, but should consider the wider use of the internal model by the insurer for its own risk and capital management.in order for the insurer s internal model to be most effective it should be genuinely relevant for use within its business for risk and capital management purposes. As part of the use test an insurer should examine o how the internal model is used for operational management purposes, o how the results are used to influence the risk management strategy and business plan of the insurer, o and how senior management are involved in applying the internal model to run the business. An insurer should demonstrate that an internal model remains useful and is applied consistently over time, and that it has the full support of and ownership by the Board and senior management. 5.2 CEIOPS CPs (consultation papers) The following paper was considered: Former CP56 Tests and Standards for Internal Model Approval, Section 3. A summary of section 3 of former CP56 is as follows (paragraph numbering as per former CP56): 3 IAIS Standard No on the use of internal models for regulatory capital purposes (2008) 5

6 3.7 A fundamental requirement for an undertaking to qualify for an internal model approach to determine regulatory capital requirements is that it demonstrates to its supervisory authority that there is sufficient discipline in its internal model development and application such that it is widely used and plays an important role in the course of conducting its regular business, particularly in risk management. From a regulatory perspective, the Use test philosophy boils down to the following: if an undertaking does not trust its model sufficiently to use it, why should the supervisory authority? 3.9 The main aim of Solvency II is policy holder protection, and an undertaking that uses an internal model to quantify risks, rank risks, set the risk strategy, produce riskmanagement information and inform decision-making will have insight into extreme events. Using this risk management in decision-making would assist in protecting policy holders A major implication of this fundamental requirement is that insurers and reinsurers must have one and only one modelling framework.... An undertaking will not be able to meet the Use test if it has one modelling framework for internal decision making and a different modelling framework for regulatory capital assessment CEIOPS is recommending that a series of principles is adopted to assess compliance with the Use test. These principles stem from a foundation principle. If an undertaking or the supervisory authority is unclear about how to interpret one of the principles or should a new situation that has not been envisaged arise, then reference to the foundation principle should be made. Foundation Principle: the undertaking s use of the internal model shall be sufficiently material to result in pressure to improve the quality of the internal model The foundation principle is not a requirement to extend the scope of a partial internal model, but to improve the internal model within the scope approved The undertaking should ensure that there is a robust internal challenge of the assumptions underlying the internal model. This is described in more detail in the Section on Validation standards. GENERAL PRINCIPLES The section below provides the 9 general principles provided in section 3 of CP56 that supplement the foundation principle, as well as an overview of each principle: Principle 1: The Board and senior management shall be able to demonstrate understanding of the internal model. The level 1 text requires that the model is widely used in and plays and important role in the insurer. It is unlikely that an internal model will be used in a company if it is not understood by the senior management. The Board shall give evidence of understanding of the internal model. Each member of the Board shall have an overall understanding of the internal model, which may be gained from training by the company. Each member of senior management shall have an overall understanding as well as a detailed understanding in the areas 6

7 where they use the model. The Board will have to demonstrate where the outputs of the internal model are used in decision-making. Each member of the Board shall give evidence of an overall understanding of the internal model, including: o The structure of the internal model and how it fits with their business model and risk-management framework; o The limitations of the internal model and that they take account of these limitations in their decision-making; o The scope and purpose of the internal model and the risks covered by the model, as well as those not covered. Each member of senior management shall have an overall understanding of the internal model as well as a detailed understanding in the areas where they use the internal model, including: o The methodology behind the internal model; o The drivers behind market movements, together with its own portfolio position, understand the limitations of the model, in particular in times when historical relationships in markets break down; o Understanding the dynamics of the model, or how the different elements fit together; o Understanding the limitations of the model, for each aspect of it. This should include the limitations of statistical assumptions and limitations in business planning assumptions; o In which area and on which entity/hierarchy level with the company/group diversification effects arise as well as dependencies throughout the risk profiles; o The scope and purpose of the internal model and the risks covered by the model, as well as those not covered. The Board and the senior management shall not manipulate the internal model in order to obtain outputs that do not appropriately reflect its risk profile. Whilst the focus of the Use test is the company s economic capital, it is also important that the Board, as well as senior management, has a view on the consumption of regulatory capital, in particular on how and why the eligible own funds compared to the SCR changes over time. Principle 2: The internal model shall fit the business model. The design of the internal model shall be in alignment with the company s business model in at least the following aspects: o The methods used to calculate the probability distribution forecast underlying the internal model shall be consistent with the methods used to calculate technical provisions; o The outputs of the internal model shall reconcile with internal and external (financial) reporting; o Modelling approaches shall reflect the nature, scale and complexity of the risks modelled; o The internal model shall be changes to reflect changes in the business model, which should be allowed for in the model change policy; o The capital-allocation approach and the granularity of allocation shall reflect the company s risk-management system, its business model and the decision-making processes in the company; o Companies shall be aware how the profit and loss attribution may differ from the profits and losses reported in the accounting system and what the causes of these differences are; 7

8 o The internal model shall be able to produce results between entities and material lines of business and have overall capital results split by material risks to assist in risk-management activities. Principle 3: The internal model shall be used to support and verify decision-making in the company. Internal models shall be able to give companies information that will allow them to assess the expected profit from potential decisions and assess the potential variability in the expected profit from potential decisions. The analysis that supports decision-making shall be proportionate to the expected outcome of the decision and shall be documented. The internal model and its results shall be regularly discussed in relevant (risk) bodies, and also at board level. Decisions should not follow the output of the internal model without question. Decisions makers shall be aware of the shortcomings of the model and tailor their decisions accordingly. Principle 4: The internal model shall cover sufficient risks to make it use-ful for riskmanagement and decision-making. The company shall demonstrate that the scope of the internal model covers sufficient uses and risks to be widely used in and play an important role in the system of governance, risk-management system and decision-making processes, as well as capital assessment and allocation. Principle 5: Companies shall design the internal model in such a way that it facilitates analysis of business decisions. The internal model shall be designed to inform internal debate in the company, The results of the internal model shall be communicated to the Board members so that they are able to take responsibility for the results. Principle 6: The internal model shall be widely integrated with the risk-management system. Uses of the internal model that will demonstrate that the internal model is used in the risk-management system may include: o That the quantification of risks and risk ranking, including the quantification of diversification effects produced by the internal model, trigger action in the company; o That the quantification of risks and risk ranking, including the quantification of diversification effects produced by the internal model and assessment of accumulations of risks and tail dependencies, are used to formulate risks strategies, including the development of the company s risk appetite and any risk mitigation, and improve the risk-management system overall; o That outputs are used to formulate risk limits and appear on reports to internal forums in the company. At each point in the internal model where diversification effects occur, there shall be clear responsibility in the company for quantifying and allocating any diversification benefits. If the risk-management system changes or if there are proposed changes, the internal model shall be changed to reflect this. 8

9 Principle 7: The internal model shall be used to improve the company s riskmanagement system. Article 112(5) requires a company applying to use an internal model to have an adequate risk-management system. The internal model, which is used to quantify risks, shall be designed to allow companies to gain more insight into their risks, and hence improve risk management by using a feedback look between the riskmanagement system and the internal model. Principle 8: The integration into the risk-management system shall be on a consistent basis for all uses. The internal model shall produce output that is based on the relevant internal or external accounting basis for each use. The Board shall demonstrate that they understand the basis of the output. The Use test shall apply at least at the level at which strategy and risk management are defined. If these are defined at a group level, the Use test shall also apply at this level. The uses included in the scope of the internal model shall then be assessed by the supervisory authorities at a group level. In addition, the Use test shall be assessed at the level of related companies. Principle 9: The Solvency Capital Requirement shall be calculated at least annually from a full run of the internal model, and also when there is a significant change to the undertaking s risk profile, assumptions underlying the model and/or the methodology arising from decisions or business model changes, and whenever a recalculation is necessary to provide up to date information for decision making or any other use of the model, or to fulfil supervisory requirements. Companies shall calculate the Solvency Capital Requirement using the internal model at least annually, and may calculate the Solvency Capital Requirement more frequently, The supervisor may require companies to calculate the Solvency Capital Requirement using a full run of the model more frequently than annually if necessary. As companies will update the methodology, parameters and data input to the internal model on a regular basis, companies may calculate the change in the Solvency Capital Requirement for only the risk modules affected by such change. The MCR shall be calculated quarterly and the proposed methodology requires a link to the SCR. Under the principle of proportionality, companies using an internal model shall apply a quarterly calculation that is sufficiently sophisticated to produce the quarterly SCR. However, this does not necessarily assume a full model run and approximations may be allowed. 5.3 Other relevant jurisdictions (e.g. OSFI, APRA) The Australian Prudential regulatory Authority (APRA) refers to the approval of an Internal Model in Prudential Standard GPS 113, paragraph 15: APRA will not provide approval for use of the Internal Model Based (IMB) Method unless it is satisfied that the Economic Capital Model (ECM) plays an integral role in the insurer s management and decision making processes, and that this use is embedded in the insurer s operations. APRA s consideration of model use will include, but will not be limited to, some of the indicators set out in the Attachment to this standard. 9

10 No material reference to the Use Test could be found in any The Canadian Office of the Superintendent of Financial Institutions (OSFI) documentation. A paper called OSFI Guidance for the development of a Models Based Solvency Framework for Canadian Life Insurance Companies (January 2010) states that The company s models must satisfy a use test, the nature of which is to be defined in the future. 5.4 Mapping of differences between above approaches (Level 2 and 3) There are no differences between the different approaches. The principles set out in the Solvency II framework (former CP56) encompasses the elements included by the IAIS, OSFI and APRA. The Solvency II framework contains the most comprehensive list of principles and includes those recommended by other frameworks. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT 6.1 Discussion of inherent advantages and disadvantages of each approach There are no differences between the different approaches. The advantages of adopting the principles as incorporated in Solvency II are that they will ensure that companies have a better understanding of the risks to which they are exposed to. This will then lead to an improved risk-management framework and ultimate to better policyholder protection, which is the ultimate aim of Solvency II. 6.2 Impact of the approaches on EU 3 rd country equivalence The recommendation from the Task Group is that the Use Test Principles according to former CP 56 are adopted unchanged. There will therefore be no impact on 3 rd country equivalence. 6.3 Comparison of the approaches with the prevailing legislative framework There is nothing in the prevailing legislation on Internal Models or the Use Test and therefore no comparison is required. 6.4 Conclusions on preferred approach See Section 7 below. 7. RECOMMENDATION The recommendation of the Task Group is that the Use Test Principles according to former CP56 (as set out in section 5.2) are adopted as secondary legislation in South Africa. The Use Test only applies to insurers that use an approved internal model to calculate their Solvency Capital Requirement. Where an insurer has an approved internal model, one modelling framework should be used to calculate both economic and regulatory capital, and to inform internal decision making. The only changes recommended are that all reference to the management or supervisory body should be changed to the Board, and that Principle 1 be expanded to confirm what is required by an overall understanding of the internal model. These principles are: 10

11 1. Foundation Principle: the undertaking s use of the internal model shall be sufficiently material to result in pressure to improve the quality of the internal model. 2. Principle 1: Senior management and the Board shall be able to demonstrate understanding of the internal model. The majority of each member of the Board and the Chairman of the Board and the majority of senior management** are required to have an overall understanding of the internal model, and senior management are required to have a detailed understanding in the areas where they use the internal model. An overall understanding means knowledge of: the structure of the internal model and the way the model fits to the business and is integrated in the risk-management system of the insurance or reinsurance undertaking; the scope and purpose of the internal model and the risks covered by the internal model, as well as those not covered; the general methodology applied in the internal model calculations; the limitations of the internal model; the diversification effects taken into account in the internal model. ** It was the consensus view of the Task Group was that the sentence should read: Each member of the Board and senior management. The recommendation of the Task Group was based on the philosophy that the use of an internal model requires the bar to be raised around governance and understanding of the internal model. The majority of the Pillar II Subcommittee members preferred the wording as stated above in Principle 1. This view was based on the philosophies of transformation and overall lack of skilled board and senior management members in South Africa. 3. Principle 2: The internal model shall fit the business model. 4. Principle 3: The internal model shall be used to support and verify decision-making in the undertaking. 5. Principle 4: The internal model shall cover all reasonably foreseeable and relevant material risks to make it useful for risk management and decision-making. 6. Principle 5: Undertakings shall design the internal model in such a way that it facilitates analysis of business decisions. 7. Principle 6: The internal model shall be widely integrated with the risk-management system. 8. Principle 7: The internal model shall be used to improve the undertaking s riskmanagement system. 9. Principle 8: The integration into the risk-management system shall be on a consistent basis for all uses. 10. Principle 9: The Solvency Capital Requirement shall be calculated at least annually from a full run of the internal model, and also when there is a significant change to the undertaking s risk profile, assumptions underlying the model and/or the methodology arising from decisions or business model changes, and whenever a recalculation is necessary to provide up to date information for decision making or any other use of the model, or to fulfil supervisory requirements. 11