Internal models versus standard formula: South Africa's experience

Thanks to onerous costs and Solvency II’s tight deadline, many insurers are pulling out of the internal model approval process and opting instead for the standard formula. Clive Davidson draws a parallel with similar events in South Africa and asks whether there could be negative implications for smaller firms

A central tenet of Europe’s Solvency II and similar regimes, such as South Africa’s Solvency Assessment and Management (Sam), is that insurers can opt to use an approved internal model to calculate regulatory capital rather than the regulator’s standard formula. It is something many companies argued for in the reforms and, following a great deal of time and energy expended on establishing the rules under which such models would be acceptable, it was assumed that the majority of more sophisticated firms would take up the option. However, after an initial rush of enthusiasm, and as the deadline for implementation of the new regime nears, a growing number of companies are withdrawing from the approval process.

More than a third of UK insurers that originally planned to seek internal model approval for Solvency II are reported to have withdrawn from the process since 2011 (see box, below). In South Africa, all the major life insurers are now adopting the standard formula. This raises a number of questions, such as whether the bar has been set too high for internal model approval, or whether internal models are in fact appropriate regulatory tools, and whether powerful industry groups are able to influence the terms of the standard formula in their favour and to the detriment of others, particularly smaller companies who have fewer resources to develop models?

Old Mutual, founded in Cape Town but now headquartered in London, had an economic capital framework in place across the group for a number of years. It began enhancing its economic capital model as part of the internal model application process (Imap) under Solvency II for its UK insurance operations and signed up for the equivalent process under Sam for its emerging markets business. However, in early 2013, several circumstances for Old Mutual converged resulting in it deciding to withdraw from both Imap and Sam.

For a start, the group embarked upon structural changes, whereby its life unit-linked business in the UK and Europe would be reduced substantially and its Old Mutual Bermuda private wealth business would be de-risked significantly by the time Solvency II goes live. In addition, at the time in 2013, there was significant uncertainty around Solvency II, with delays moving the starting point to 2016, which aligned with Sam deadlines. Furthermore, the other major life insurance companies in South Africa indicated they would go with the Sam standard formula. Given that the majority of Old Mutual’s insurance business is in South Africa, this local trend encouraged the company to follow suit and withdraw from the Sam model approval process – a decision that was reinforced when the South African Financial Services Board (FSB) announced that all companies in South Africa would have to submit results on a standard formula basis for an initial period anyway.

“All these factors resulted in us recognising that by the time Solvency II comes into force in 2016, the most material risks to capital for the group from insurance will be from the South Africa businesses. By that time they will be subject to their own Sam regime standard formula requirement, so the potential for benefit from seeking approval of the internal model from a UK regulator could be limited,” says Jean-Marc Robert, head of economic capital for Old Mutual.

Other major South African life insurers that are opting for the standard formula include Cape Town-based Sanlam and Johannesburg-based Discovery. “We think the standard formula provides a good enough fit to our risk profile. In our view, an internal model would not have produced a materially different outcome,” says André Zeeman, Sanlam group’s chief actuary.

Surina Meintjies, chief compliance officer at Discovery, adds: “From the results of the past three quantitative impact studies, we are comfortable we can meet the solvency requirements on the standard formula, and the time and effort required to develop an internal model, put it through a period of use and gain approval would not yield a material benefit to our business at this time.”

Most of the major life firms participated in Sam task groups and were able to bring their influence to bear on the development of the standard formula. The FSB adjusted the standard formula’s prescribed calibrations for the stresses to be applied to the market-value balance sheet when calculating capital for risk types such as equities, interest rates, property, lapse, mortality and  operational risks, with the stresses to be informed by South African data, rather than the Solvency II European stresses.
But despite the local tailoring, the revised standard formula does not meet all South African insurers’ needs. At the moment, non-life and niche insurers are more likely to opt for internal models.

“Currently, more non-life insurers are applying for internal model approval than life insurers, which suggests that the standard formula is less suitable for non-life insurers than life insurers,” says Francois Kruger, insurance partner with PwC, based in Johannesburg.

By its nature, a standard formula is never going to fit all insurers perfectly. Niche players, for example, know that they live outside the mainstream and may have to trade off extra compliance effort against the profits they can earn from their specialisation. More worrying is the potential for a powerful mainstream lobby group within the industry to influence the parameters of the standard formula in its direction, to the detriment of others.

“The use of an internal model versus the standard formula must be considered relative to the nature, size and complexity of an insurer. While participation from the bigger industry players might have resulted in a standard formula more appropriate for the nature of their business, the standard formula might perhaps be less appropriate for smaller or niche insurers, who can least afford the cost associated with the regulatory approved model,” says a leading South African insurer who did not wish to be identified.

If it turns out that the revised Sam standard formula imposes heavy capital obligations on smaller and niche insurers – who are less likely to have developed internal models – they could find themselves between a rock and a hard place. “There is tremendous additional work and cost associated with getting approval for an internal model for regulatory capital requirements,” says Kruger of PwC. Nevertheless, it can be worth biting the bullet and applying for approval. “Although going through the process of obtaining approval for an internal or partial model is burdensome in the short term, there may potentially be long-term benefits for some insurers. These may include embedding risk and capital management in the organisation and better reflecting the specific risk profile and the nature of the business, which may ultimately result in lower regulatory capital requirements,” he says.

The major South African life firms are certainly not rejecting modelling altogether. Most already use internal models for their own economic capital calculations, as well as in meeting the own risk and solvency assessment regulatory requirements. But for the moment at least, the additional effort of complying with the validation, documentation and other aspects of the official approval process does not appear to be worth it. However, this could change once Sam goes live and there is real experience of the results of the standard formula versus models – and how the regulator responds to the outcome.

“Our current view is that the standard formula will be adequate in most cases for typical long-term insurers. However, time will tell,” says Zeeman of Sanlam. The insurer adds: “A decision to submit an application for internal model approval will depend on the continuous review of the appropriateness of the standard formula relative to the nature of our business. Over time the expectations from the regulator regarding the top four or five industry players and their use of regulatory approved internal models might also influence such a decision.”

In the end, Sam, like Solvency II, is about protecting policyholders and maintaining a viable industry. It may take some trial and error on the part of the regulators and the industry to get the balance right for all stakeholders in terms of the cost and benefits of internal models versus the standard formula.

Box: UK insurers pulling out of internal model approval process
More than a third of UK insurers that originally planned to seek internal model approval for Solvency II are reported to have withdrawn from the process since 2011. Only a few firms have gone public on their decision, with a couple saying it is down to the particular nature of their business relative to the new rules. Among the rest, some are struggling with the approval process, temporarily opting out as they realise they are unlikely to meet the Solvency II go-live date of January 1, 2016, while others have thrown in the towel, concluding that the potential benefits of calculating their regulatory capital with an internal model is simply not worth the cost and effort of getting through the approval process.

Specialist insurer Hiscox has a foot in both camps. Its retail division has pulled out of the model approval process, while its Lloyd’s business is pressing ahead. “As the [Solvency II] standard formula developed and it became clearer how it would measure catastrophe risk, we were able to assess that it would be suitable for the risks our UK retail insurance company writes. These are mainly UK and European risks, and the standard formula is European focused, so it matches quite well and gives a reasonable estimate as to our capital requirements,” says Jason Doughty, head of economic capital at Hiscox, who is based in London.

A secondary consideration was the cost of implementing an internal model – not only in getting over the approval hurdle, but also the ongoing costs of maintenance. “Looking at benefits that Hiscox would have derived from having an internal model for the insurance company versus the costs, we felt it was better to withdraw,” says Doughty.

The situation is different for the Lloyd’s operation of Hiscox. Not only has it a much larger catastrophe exposure, but most of this is in the US. Furthermore, Lloyd’s requires that its members apply for model approval – a decision that Hiscox supports fully, says Doughty.

In the case of London and Cape Town-based Old Mutual, changes in its business strategy and in the calibration of the standard formula in the South African regulatory regime, rendered its internal model approval application redundant (see main story).

As for the other drop-outs, it is mostly down to practicalities, says Richard Care, London-based actuarial partner at KPMG. “The decline in model approval applications in the last couple of years is mostly [down to] the cost and effort that would be required to get across the line in time for January 1, 2016,” he says. “If a firm has to do a project like this quickly, it is going to cost more money because they will have to get extra expensive resources in to help.” And even if they do invest in the resources, there is no guarantee they will get approval from the regulator. Therefore, a number of firms have decided to step back and take a more measured, longer term approach to developing their models, says Care. However, others have reappraised the costs versus benefits and ditched the idea altogether.  

A mid-sized UK life insurer, speaking to Insurance Risk, says it is withdrawing because of “the overly stringent approval process”, and the fact that its internal capital level is set higher than the Solvency II solvency capital requirement. The company had got so far as to develop a capital model and associated risk management processes by the time it decided to withdraw from the approval process, although it had not yet addressed Pillar III reporting, says the company’s chief actuary. The company will continue to use its model to calculate economic capital for its own business purposes, but has no plans to re-apply for model approval in the future. No doubt there are firms that share this view about the excessive demands of the approval process. However, others say there has to be a higher bar for models used for regulatory purposes.

“It is right that there should be a different standard when you are using models to measure how much capital is required to protect consumers and policyholders, compared with the company calculating its own view of its risks,” says Doughty of Hiscox. “The increased validation and other aspects of the approval process for a Solvency II model is appropriate, given the purpose that is going to be used for.”