Fears volatile model warning indicators could lead to unjustified action

UK regulator urged to reconsider proposed early-warning indicators to reflect better changes in economic conditions and not penalise insurers’ de-risking strategies

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The UK's Prudential Regulation Authority (PRA) is under pressure to reconsider its plan to use early-warning indicators (EWIs) in its supervisory work amid concerns that they would undermine insurers' Solvency II internal models.

Insurers fear that the capital ratios used by the indicators, designed to detect a downward drift in their capital buffers, will be extremely volatile, prompting unjustified supervisory reviews that might lead to firms having to make changes to their business models and increase capital buffers.

"The proposed ratios may apply to the moment they are calibrated, but as conditions change they might become inappropriate," says Bruce Porteous, head of Solvency II and regulatory development at Edinburgh-based Standard Life.

The PRA is planning to use EWIs after expressing concerns about firms fine-tuning their internal models to pare capital requirements to below Solvency II's 99.5% value-at-risk threshold.

The regulator set out its implementation plans for EWIs in a letter to firms at the end of May. The regulator proposes to use a ratio between the modelled Solvency Capital Requirement (SCR) and the pre-corridor Minimum Capital Requirement (pMCR), a standardised formula based on Solvency II technical provisions. Supervisory action will be triggered if the ratio falls below a pre-determined threshold, set at different levels for life and general insurance businesses.

But experts say the ratio between the SCR and pMCR is likely to fluctuate as the SCR is a sensitive measure that will change in line with variations in market factors, such as equity prices or bond yields, while the MCR might not change to the same extent.

"I expect the concern for some is that the SCR has the potential to be volatile between valuations. Firms want a measure that is pragmatic, but they do not want it to result in the supervisor coming knocking on their door every three months," says Gavin Hughes, a senior consultant at Towers Watson in Manchester.

There are also concerns that under the PRA's currently proposed ratio strategies to protect the business and decrease risk could also cause an insurer to breach the intervention threshold, as de-risking would result in a reduction of modelled solvency capital requirements. Standard Life's Porteous comments: "You can be penalised for managing their risks. That does not make sense."

The PRA has stressed it is trialling the use of the EWIs and will review them ahead of the full implementation of Solvency II. But there are already calls for indicators that move more sensibly in line with economic conditions and the shape of their business.

One option for the PRA is to move away from pre-defined ranges and tailor the thresholds upon agreement with the calibrations of the individual internal models. But this may conflict with the PRA's ambition to use these indicators, in part, as a way to detect movements in model calibration over time, suggests William Coatesworth, consulting actuary at Milliman in London.

If the regulator sticks to its one-size-fits-all approach, then EWIs might be used to effectively pre-empt the outcome of the undergoing internal model assessment, he warns.

"While the use of pre-defined thresholds appears appropriate for indicative purposes, care would clearly be needed to interpret EWIs appropriately in the internal model approval process. Where a pre-approval internal model that meets all the requirements for approval falls close to or below the specific threshold, actions should clearly be based upon a proper consideration of the context and not just the EWIs," Coatesworth says.

The PRA's focus on internal models comes at the same time as it is reviewing Solvency II's standard formula. The PRA's executive head of insurance, Julian Adams, said in a letter to firms that the regulator was examining a number of areas where the standard formula may not be "appropriate", for example in the calculation of pension risk.

Adams emphasised that firms should ensure that their chosen method to calculate their SCR is suitable and, "where necessary, consider whether it is appropriate to use undertaking specific parameters or a partial internal model, where the standard formula does not adequately reflect the firm's risk profile".

Towers Watson's Hughes says the letters demonstrated that the PRA does not want firms to think of the standard formula as a "default option" and expects firms to prove that the assumptions underlying it are appropriate to the insurer's own individual risk profile.

The regulator also appears to have changed its stance on using the standard formula to benchmark insurers' internal models, experts say. The PRA is asking insurers to provide information to compare the capital requirements calculated using their internal model and requirements under the standard formula.

Milliman's Coatesworth says: "While the PRA has said previously that it will not benchmark internal models against the standard formula, it does consider the use of benchmarking to be a useful tool when reviewing the appropriateness of internal models. As a result, internal model firms may also find themselves needing to calculate capital figures using the standard formula for these purposes."

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