Many UK insurers believe they have work to do to get their Solvency II internal models up to par in order to validate and document risk measures, according to a report issued by Towers Watson.
Results of a survey conducted by the professional services firm of risk calibrations being used for specific market and non-market risks revealed that the largest challenges still include interest rates, credit spreads and mortality and lapse assumptions, with up to two-thirds of firms still looking to make considerable progress in these areas.
Towers Watson’s findings coincide with UK regulator, the Financial Services Authority (FSA), which announced a new data collection exercise for companies that have applied for the internal model approval process (IMAP), with an end of September deadline.
The survey responses from the vast majority of life companies that have applied for the IMAP revealed use of expert judgment but reluctance by some of the companies to rely too strongly on it as part of the calibration process. “Given the lack of data for many risks, we expected to see more explicit use of expert judgment to inform the calibration than the survey suggests,” said John Rowland, global head of life capital modelling at Towers Watson.
According to the firm, the range of stresses for the quantitative aspects of models that are used for a number of market and non-market risks appears wide. For example, notes the firm, credit risk, an extreme increase in the spread on A-rated, 10-year bond ranges from 1.1% to 3.6%. Longevity risk is also subject to significant variations in stresses with a range covering 14% to 37% of base mortality rates for males aged 65, compared to the standard formula stress of 20%.
“It’s not just the Solvency II statistical quality and calibration standards that are leading firms to revisit risk calibration,” added Rowland. “The virtuous cycle envisaged in the Solvency II use test is starting to drive firms to seek to optimise their risk profile in line with their risk appetite, which requires more detailed analysis. Solvency II is raising the bar for risk modelling.”
Firms are moving forward with their ahead effectively with their modelling methodology and data selection, according to the survey results, and individual risk distributions and documentation are well developed. However, the time spent on these aspects means that companies have typically focused less on risk correlations.
According to Rowland, dependency assumptions are often among the most significant drivers of capital requirements. “We would expect companies to address this to ensure that their Solvency II capital position is not overstated,” he said. “Ultimately, the challenge for every insurance firm is to ensure that their internal model calibration processes produce an internal model that is fit for purpose, tailored to their own specific risk profile.”
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