PRA Feedback on Internal Models

In addition to the PRA Solvency II Directors update later published on 12 February which we discussed in our blog, which detailed the PRA SII Directors update this letter also included a separate appendix providing some feedback from the PRA on internal models.

Given that spring is just around the corner and with it the IMAP submission dates this letter provided some timely feedback for those working towards an IMAP date this year or indeed those considering a future application. In this blog we discuss the main themes raised in the feedback.

In their feedback the PRA touched on three key areas for firms currently developing an internal model.

Contingency Planning

For those busy preparing their IMAP application I suspect that contingency planning for their model not being approved is far from their mind. However as part of its feedback the PRA took the opportunity to remind firms of the need to develop a contingency plan should their internal model application not be approved. In addition the PRA provided a number of areas which it would expect firms to consider when developing their contingency plans. These included considering the dependencies between all your Solvency II regime approval applications, any management actions required should the internal model not be approved and the timescales required to implement these as well as the development of key risk indicators so that firms can identify when the contingency plan may need to implemented. This feedback should provide some guidance to firms when developing or refining their contingency plan.

Expert judgement

Anyone current working on Solvency II implementation projects will be aware of the importance of documenting expert judgements. As part of their feedback the PRA noted that the documentation provided by firms to the PRA was not always of the standard required to give the PRA the confidence it needs to accept the expert judgements made. In order to help the PRA understand the rationale for the expert judgements the PRA highlighted four key areas when documentation is required to demonstrate the expert judgements being made. These were:

1. Having in place a mechanism to ensure that key judgements are identified
2. Ensuring that decisions and approvals relating to expert judgement is taken by those at an appropriate level
3. Reminding firms that the documentation and validation of the judgement should be proportional to the importance of the decision, and;
4. Ensuring that the definition of expert judgement is sufficiently broad to ensure that the correct aspects of the internal model are identified.

Firms should look to ensure that they have addressed these as part of their internal model application.

Validation

Validation of internal models and the responsibility for undertaking this has been an issue considered widely across the industry. In their feedback the PRA reminded firms that external validation is not a requirement of either the Solvency II Directive or the PRA. The PRA noted that in-house validation may be more effective but also reminded firms performing in-house validation of the need to demonstrate that there is robust challenge by individuals who are independent as well as suitability qualified and sufficiently senior. The PRA also highlighted three areas where validation is not meeting the standard they expected. Interesting this list included validation reports that show that every test has been passed as well the more predictable areas of failing to identify model limitations or areas for further development and failing to demonstrate that the probability distribution forecast is a good fit for the firm’s risk profile.

Our commentary

The PRA feedback provides a timely feedback for those firms busy preparing for a late spring/early summer 2015 IMAP application as well as those considering a future internal model application.

The PRA feedback raises a number of interesting areas for discussion including who is best placed to perform your validation. We have seen forms adopting a variety of approaches from using a full external team to supplementing their internal teams with additional resource at peak periods or in particular specialist areas of the internal model e.g. longevity.

We would be delighted to discuss any of the issues raised in our blog with you as well as to discuss ways in which we could support you whether this be by supporting your contingency planning, reviewing your expert judgement framework or supporting your validation team.