Internal Model Validation: The Regulatory Perspective

Ravi Bharos, Christian Kerfriden and Vesa Ronkainen

Validation is a fundamental requirement for institutions wishing to qualify for an internal model to determine regulatory capital requirements. It requires institutions to demonstrate that they have in place a rigorous process¹¹ For further details, see Article 44 of the European Parliament and the Council of the European Union (2009). by which to establish whether their internal model framework is sound or if improvements are necessary. Different and distinct, this should not be confused with the process that supervisors undertake when approving a model for use.

This chapter aims to provide insight into the validation standards for internal models. It will show that a correct application of the validation process contributes to reducing the misalignment of the interests of the insurance industry and the regulator.

Internal model validation is possibly the most important step in the model building sequence. Even in the absence of regulatory requirements, it should be good practice for firms to review and validate their internal models to ensure that appropriate risk and capital management processes are in place. As part of the internal model design, supervisory authorities