Jennifer Khaleghy and Ashish Kwatra give four lessons to improve your IMPAP for internal model approval
Solvency II has meant a lot of extra work for those working within the insurance industry, not least those involved within the ca pital modelling arena. It has now been more than two years since the first wave of internal model approval process (IMAP). With many companies still considering model approval and ongoing restructuring in preparation for Brexit -resulting in further major model change - it would be useful to know exactly where we have ended up so far. So what have been the key practical issues to implement a successful IMAP? And what does 'good' look like?
This article sets out four key lessons learned from the experience of capital actuaries, discussing common market approach and best practice observed in the UK industry, with the objective of offering insight to the practical issues around the IMAP.
Plan the project carefully and early before resourcing up - avoid unnecessary delays and higher costs
The number of resources needed to implement a successful IMAP project is difficult to measure upfront and is dependent on a range of factors. However, it is very easy to assume that IMAP is a big project and so blindly recruit X number of people with solid capital and IMAP experience.
To us, that is not best practice and certainly not cost-effective. In our opinion, what you need, first and foremost, is a small number of people who fully understand the requirements of IMAP and have experience in implementing all aspects of the programme. Such people will tend to be actuaries (and experienced programme managers) who have been involved with implementing and managing a Solvency II programme. They should have the technical expertise (strong capital background) and understand the broader requirements of a successful IMAP programme.
It is important to understand, at the outset, exactly what documents and processes need to be developed, and exactly what these look like: What does a good technical methodology and calibration document look like? What is a future management actions plan? What policies do you need to include? What do you need to do around data, systems, IT and controls? How do you write a good common application package (CAP)? What is required to demonstrate a strong independent validation process? What should you include in the final cover letter?
These are just some of the questions that need thinking about at the planning stage, so that you do not under or overestimate the effort involved. Once you have identified all the activities, and have a good idea of the effort required, then it is more appropriate and cost-effective to think about resourcing.
As a final point, one of the most challenging aspects of planning is the management of (often tight) deadlines. In particular, the independent validation, board reporting and regulatory submission timescales tend to have a very short timeframe between them. Plan these carefully in advance to ensure you have enough time to meet each one. Poor planning at the start and a lack of understanding of what is required (and the quality of work required) tend to result in delays and subsequently higher costs in the long run.
Transitioning from ICA to a Solvency II internal model can be a long process
There are many subtle technical differences between individual capital assessment (ICA) and Solvency II internal model requirements. The flexibility of the existing ICA model to be reshaped into an internal model is a key factor in a smooth transition from an ICA model to an internal model. However, the main differences, in our opinion, are not limited to the model itself, but areas around it. More specifically:
- Governance: Under the ICA regime, firms typically had some sign-off process for the model and its outputs. However, Solvency II requirements bring the governance process to a different level, from the board's ownership of the internal model, to an expert judgment process, to various policies and committees.
- Independent validation: Under the ICA regime, firms typically had an informal validation process, carried out by the capital modelling team to ensure the integrity of the model outputs. This informal validation process is the so-called 'small v' referred to by the Prudential Regulation Authority (PRA), the UK regulator. Under the Solvency II regime, it is the 'big V' that the PRA is mostly interested in, where the internal model is formally validated by an independent party according to the firm's validation policy and standards.
- Documentation: Under the ICA regime, firms typically had some model documentation. However, Solvency II regulation requires more comprehensive documentation, which should be "sufficient to ensure that any independent knowledgeable third party would be able to understand" (Delegated Regulation Article 243, paragraph 1). Also, it covers not just the capital model itself but all other aspects around it, in order to meet the many requirements set out in the CAP.
Clearly, having an ICA model is a good starting point, but, unfortunately, there is still a long journey towards meeting all the IMAP requirements. There is no hard rule regarding how long it will take for the transition from ICA to IMAP. Very broadly speaking, based on our experience in the UK industry, companies tend to spend two to three years in preparation for an IMAP submission.
Have a very clear documentation structure - the CAP can be very useful!
It is very helpful to have a clear documentation structure, which can be used not only to develop your programme but also as a way of articulating the full suite of documents to the regulator. A good documentation structure will include a full list of documents (a so-called 'inventory of evidence'), the purpose of each document and the documentation trees to show how all these documents link together.
The first obvious question is how do you come up with the full list of documents required? This is where the CAP can be very useful. The CAP is a large spreadsheet designed by the European Insurance and Occupational Pensions Authority (EIOPA), which states the internal model requirements. As part of the final application (and pre-application), you are required to complete this spreadsheet explaining how you satisfy these requirements with reference to relevant documentation.
Although completion of the CAP itself may be a daunting exercise, it is a great starting point for developing a documentation structure. As an example, you can split the CAP requirements into separate categories (calibration, data, systems) and develop a list of documents required to satisfy the requirements for each category.
Independent validation is one of the main areas that the PRA focuses on and is pivotal to a successful IMAP submission.
Independent validation is a key area of focus for the PRA and is pivotal to a successful IMAP submission.
The process covers setting up an appropriate validation policy, drawing up a validation test plan, careful selection of independent and skilful validators, adequate resource allocation, execution of the test plan, and a final validation report. In order to demonstrate a credible validation process, all these steps should be carried out correctly from the initial cycle of validation. Otherwise you could waste a lot of time (ie, months), which would jeopardise the IMAP timeline.
A common mistake that we have seen across the market is the use of test plans that make validation a box-ticking audit process, with hundreds of validation tests merely confirming the existence of the required evidence, instead of appraising the quality of the evidence.
This adds little value to the IMAP process or to the business. The best practice is to have meaningful validation tests carried out
by skilful validators to assess the quality of the evidence. It is also important to validate not just the capital model itself but a much wider range of areas, including governance, model use, model development, IT and systems, and data.
For pre-application, the PRA requires, at a minimum, one full cycle of independent validation (this includes demonstrating ongoing remediation activity for the issues identified). Between the pre-application and the final application, a new full cycle of independent validation is expected to take place.
Ashish Kwatra and Jennifer (Kang) Khaleghy are both experienced capital actuaries, specialising in Solvency II and implementation of the IMAP programmes