Countdown to Solvency II - Your competitors meet the use test already – do you?

So, your internal model has been specified, designed, built, tested and validated (hopefully in approximately that order). Your Board has been through a series of training sessions designed to help them to distinguish between a non-Gaussian copula and a negative binomial. But now you have to demonstrate how your model is actually used to inform real business decisions. Yes, you have to pass the “use test”.

 By Tim Edwards, Director, PwC

 That seems a bit, well, challenging. Especially when you consider that you have to make sure that the test is passed, separately, for every single legal entity that is going to be using the internal model to calculate its SCR (as well, of course, as the Group itself).

 From experience working with many insurers though, the use test is really not quite as scary as it first appears. 

 The Solvency II Level 1 Directive itself states (Art. 120) that the model must be used as part of your system of governance, your risk management function, and in your decision-making processes.

 So what do you actually have to do? The Directive and Delegated Acts (Level 2) are pretty clear, so I make no apology for referencing the rules.

 First, there is an overarching expectation, that “the internal model and its results are regularly discussed and reviewed [by the Board]” (Art. 214, Level 2). What does that mean in practice, though?

 To provide a bit of guidance, there are several compulsory uses, which include:

 • Calculation of SCR (you are applying for permission to do that, so it is a use!) (Art. 101, L1)
 • Capital allocation (Art. 120.b, L1)
 • Risk ranking (strangely buried in Art. 121.4, L1)
 • The setting of business strategy (Art. 214.a, L2)
 • The impact that potential decisions have on your risk profile – including the impact on profit or loss and the associated potential variability (Art. 214.d, L2)
 • Model outputs -including the measurement of diversification effects. These must be taken into account in formulating risk strategies, including the development of risk tolerance limits and risk mitigation strategies. (Art. 214.e, L2). For example, reinsurance and investment guidelines
 • The relevant outputs of the internal model must be covered by the internal reporting procedures of the risk management system (Art. 214.f, L2)
 • The quantifications of risks and the risk ranking produced by the internal model trigger risk management actions where relevant (Art. 214.g, L2);

 There is even a helpful Article (Art. 216, L2) that permits a simplified approach for use test purposes. As originally drafted, this permits, for example, the use of a smaller number of iterations to help to narrow down decisions more efficiently. It also permits – maybe even encourages - the frequent use of components of the model (e.g. the economic scenario generators (“ESG”) to support investment decisions, the cat component or sub- / external model to support portfolio management, and the underwriting risk / reinsurance component to inform reinsurance purchase). The Level 2 makes it clear that this applies to the model itself, and not to the use of a different model altogether (e.g. any form of approximated model, like a spreadsheet tool).

 It all seems a bit theoretical at this point. So, how do you pull all this together?

 To deliver [most of] the use test, you need a good ORSA – and the key that unlocks the mystery of the ORSA, is the internal model.

 The Directive itself provides the clue: you have to use the internal model in your “economic and solvency capital assessment and allocation processes, including the assessment referred to in Article 45”. Yes, the ORSA.

 In the ORSA, you take a forward-looking (say, three years) view of your business, its risks and the economic (actual) capital needed by way of support.

 • You should make sure the internal model has supported (or challenged!) your view of risk (e.g. which business activities and risks are the most significant).
 • You will recognise the impact of risk aggregation, and also any benefits arising from diversification.
 • The model should therefore also inform your capital allocation processes and outcomes.
 • Capital allocation is, in turn, informed by, and informs (in an iterative way) your strategy setting.
 • Strategy setting includes, at least for the year ahead, your business planning.
 • Business planning includes – of course – your reinsurance programme and your investment policy and guidelines.

 If your internal model is being used for all these purposes, then of course it will have to be discussed by, understood by, and appreciated by your Board.

 There are already many insurers for whom all of this represents operational reality. They meet the use test. Do you?

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