The Institute of Risk Management’s Internal Model Industry Forum has published a guidance document based on its research into the effective validation of risk models created by the insurance industry to comply with the requirements of Solvency II.
Entitled ‘The Validation Cycle: Developing Sustainable Confidence and Value’, this is the first guidance document designed to support the potential for risk models to add value for businesses beyond purely meeting regulatory requirements. The publication was produced by a work stream of industry practitioners led by Rob Merry (HSBC’s global head of Independent Model Review, Insurance and Pensions) with support from Barney Wanstall, insurance consulting director at PwC.
The insurance industry has spent millions complying with the Solvency II regime, with large companies each paying around £200 million for the required system and business changes. Lloyd’s of London alone estimated its expenditure on compliance to be £300 million.
Included in this expenditure has been the creation of sophisticated risk models which assess the inherent ‘riskiness’ of each business and the resulting capital levels required to support solvency. However, the Institute of Risk Management (IRM) is adamant there’s still some way to go before real business value is created from these internal models.
To address the issue, the IRM set up the cross-industry Internal Model Industry Forum (IMIF) in 2014 with the aim of producing a collaborative industry view of Best Practice around the use and validation of internal models. The IMIF now has over 300 members, plus support from key consultancies, representatives from the industry regulator, the Prudential Regulatory Authority, the Institute and Faculty of Actuaries and ORIC International.
Challenging and Changing Financial Environment
IRM chairman and IMIF founder José Morago told Risk UK: “Insurers increasingly rely on sophisticated models to navigate a challenging and changing financial environment. Making sure models create value in decision-making, that they’re well understood and gain the confidence of Boards and regulators has never been more demanding or challenging.”
Morago added: “The IMIF’s first guidance document is the result of input and experience from over 300 industry experts. It will help firms make the important decisions needed to keep their models fit-for-purpose. Further guidance will follow on other aspects of the use of such models.”
The guidance document proposes that insurers implement a ‘validation cycle’ for the financial models established for Solvency II. This validation cycle is a control mechanism designed to ensure models remain effective as the risk environment evolves. The validation cycle is a resilient and sustainable process configured to maintain the confidence of the Board and regulators.
Validation acts as an added layer of security in addition to what the model owners and developers already do to satisfy themselves that their model is fit-for-purpose.
The guidance document proposes a validation cycle that includes the following stages:
*Identifying and evaluating potential ‘trigger events’ that could require model re-validation
*Planning and executing the validation
*Assessing the outcomes of the validation exercise
*Identifying lessons learned from the process
*Communicating and acting upon the validation findings
Copies of the guidance document are available from the IRM’s website.
*’The Validation Cycle: Developing Sustainable Confidence and Value’ is sponsored by PwC, KPMG, Deloitte and Milliman