Since the early 1990s, we have witnessed remarkable advances in

financial engineering and financial innovation. These innovations in

financial products have also given rise to some new challenges for
market participants and their supervisors. Risk- sensitive capital
standards, the development of improved risk management practices
and the greater role that a firms own internal model for the measure-
ment and management of risk in the definition of capital
requirements in both insurance and banking are examples of this
shift. More specifically, internal models have also been used increas-
ingly for external purposes, such as in communicating information
about an institutions risks to creditors, shareholders, regulators and
rating agencies.
The 200708 financial crisis has led to questions about the use of
internal models for the calculation of regulatory capital both in
banking, where they are widely used, and in the forthcoming
European insurance regulatory regime that is Solvency II.
1
The finan-
cial crisis exposed the limitations of banking models and the way
they failed to measure extreme financial events, capture all risks to
which firms were exposed to and overstated the effect of risk mitiga-
tion, diversification and fungibility of capital.
In fact, in 2008 the financial markets experienced extreme move-
ments beyond the range of internal models predictions and
expectations. This showed up in changes both in the volatility of
individual market risk factors and in correlations between risk
factors. As co- dependencies under a stressed scenario are different
from a non- stressed scenario, historic relationships between markets
ceased to hold. Models were not calibrated to cater for these severe
scenarios and/or did not cover all relevant risks. Firms experienced
significant losses on positions that (based on historical experience)
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Introduction
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were deemed to bear immaterial risks. These immaterial risks
were often modelled by simplified methods or omitted.
The effects of risk mitigation were often overstated. As a result,
when needed, management actions could not be implemented. In
other cases, counterparty risk was not taken properly into account.
Moreover, market liquidity dropped sharply, making it impossible
to price certain assets, as well as calibrate internal models.
The financial crisis also heightened concerns about the fungibility
of capital within groups, particularly as some regulators restricted
the flows of internal dividends to protect local interests. As a
response, management at firms tried to release the level of prudence
embedded in models to reduce capital requirements, further exacer-
bating supervisory concerns about the use of models.
SHOULD INTERNAL MODELS STILL FEATURE IN A
REGULATORY FRAMEWORK?
As mentioned, evidence from the use of models in the banking
regime seems to indicate that internal models are of dubious utility
and should not feature in a regulatory framework. It has often been
argued
2
that internal models have become so complex that firms
themselves do not adequately understand them. Therefore, their use
within a regulatory framework should not be allowed without
appropriate safeguards. To this end, the Basel III reforms
3
have intro-
duced a simple, transparent, non- risk- based leverage ratio to act as a
supplementary measure to the risk- based capital requirements that
firms would have to meet in addition to the capital requirement
calculated by the internal model.
CAN THE SAME ARGUMENTS BE USED FOR INSURANCE
INTERNAL MODELS?
The answer to this question is not so straightforward. It would be fair
to say that the history, and indeed meaning, of approaches desig-
nated by the emotive label internal model is quite different in
insurance from that in banking. In particular, the label internal
model is not used in insurance to refer to the same thing under the
Basel framework as it is for Solvency II.
An insurance internal model need not be based on complex math-
ematics. It may simply be a formula adapted to the specificities of a
particular specialist type of insurance, often with the same or similar
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formulas used for the whole of an insurance sub- sector. It may also
be a set of more or less standard stress tests applied, such as of speci-
fied natural or man- made disasters, or changes in macroeconomic
variables (eg, interest rates, general equity prices, inflation).
The focus of non- life insurance models tends to be on the proba-
bility and severity of possible future seismic, metrological,
epidemiological and industrial events. The focus of life insurance
models tends to be on demographic (mortality and morbidity)
events and macroeconomic shocks. Therefore, insurance models
with the exception of life insurers economic modelling do not
contain the same sort of feedback loops or drive the same sort of
behavioural change as banking models, principally because the exis-
tence of the model does not drive change in the nature of the
phenomena being modelled.
4
This means there is less potential for
insurance models to give rise to systemic risk. They also tend to
concentrate on low probability but high- impact events, and have to
take into account much less complex hedging structures. Even where
insurers are exposed to similar sorts of risks to banks (such as market
risk), behaviours are likely to be different, as asset allocation is
driven principally by the need to match assets to liabilities, rather
than by a desire to optimise their capital position under a model.
Insurers have therefore been using models for many years
5
to
manage the non- economic factors that drive their business, and these
have generally proved robust in the face of actual experience. Life
insurers modelling of risks to their balance sheets arising from
economic shocks is more recent, only gaining significant momentum
after, and due to, the 2003 equity values crisis. These models are
almost all based on one of four external models, and are susceptible
to non- model comparison to simple stress tests.
It should also be noted that an internal model regime allows for a
much greater degree of supervisory judgement than a standardised
one, in that it allows for wider discussion of what is acceptable and
what is not. For example, under the Solvency II standard formula, all
European Economic Area (EEA) sovereign debt attracts a capital
charge of zero, whereas an internal model compliant with Solvency
II must cover all material risks to which insurance companies are
exposed,
6
and supervisors might therefore take a different view
from that implied by the standard formula where the impact is
deemed material. More generally, this means that an internal model
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regime gives supervisors much more flexibility to respond to issues
that directly threaten firms viability than is the case under the stan-
dard formula.
SO, WHAT CAN WE CONCLUDE? CAN WE IGNORE WHAT
HAPPENED ON THE BANKING SIDE?
Certainly not ... However, the Solvency II internal modelling frame-
work was developed during the financial crisis and has already
benefited from lessons learned during that period. Examples of this
shift are a stronger emphasis on the governance (eg, policy for model
changes) and validation of the internal model. It is important to
recognise that there are no correct models, only appropriate or
inappropriate models. Deciding on the appropriateness of a model is
in the end a judgement call by the supervisor. Supervisors should
only approve the use of models to calculate the capital requirements
if they are satisfied that the systems for identifying, measuring,
monitoring, managing and reporting risks are adequate and, in
particular, if the model fulfils the tests and standards set out in the
Solvency II framework.
WILL THIS BE ENOUGH?
No, having a good regulatory framework where lots of emphasis is
placed on striving to ensure that only appropriate models are
approved for use is a necessary, but insufficient, condition for an
appropriate internal modelling regime. For example, while the
supervisory authorities and firms focus is on the work needed to
review/submit an internal model application, it is important to use
the knowledge and learning gained during the model develop-
ment/review process to develop systems that would enable both
firms and supervisors to monitor the ongoing appropriateness of a
firms internal model post- approval. This is often forgotten, and
leads to a risk that standards of solvency deteriorate over time.
Following approval, firms are responsible for ensuring the ongoing
appropriateness of the internal model by ensuring that the internal
model meets the tests and standards, and reflects the firms risk
profile. Supervisors need to be assured that firms have put in place
systems that ensure that the internal model operates properly on a
continuous basis. Supervisors also need to be confident that the
controls put in place are adequate and effective at all times, including
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stressed market conditions or crises. At a market level, it is important
that supervisors monitor the movement of insurance sector capital
over time.
To avoid nasty surprises during turbulent times, it is in the interest
of supervisors and senior management at firms to ensure that a suite
of tools that can help them to ensure that, after approval, internal
models and capital requirements calculation remain appropriate on
an ongoing basis at both a firm and system level, and are developed
and used as a sense check for the results of the internal models.
To be effective, these tools should capture the risks to which the
firm is exposed to from a different perspective than the one used in
the internal model. Namely, they should be based on metrics that are
independent from the internal model calculations, not based on the
firms modelled capital requirement.
7
This calls for tools that are
simple in their construction, calibration and application, avoiding
complexity and, if breached, trigger an immediate response both by
the firm and the supervisor. This is the path that several supervisory
authorities are following and is, in a nutshell, what will be illustrated
by this book.
WHO IS THIS BOOK FOR?
Insurance firms and groups are preparing for the implementation of
Solvency II, with some following the internal models pre- application
process, as structured by their supervisory authorities. The intention
of Internal Models and Solvency II is to present the reader with a near
exhaustive spectrum of topics on internal models for insurers.
This book deals with these issues in detail, with the aim of
providing the building blocks for an appropriate development,
review and monitoring of an internal modelling framework. To this
end, it provides a unique insight regarding the spirit and rationale of
the requirements for the use of internal models to calculate the
capital requirements under Solvency II. This is complemented by
practical solutions to daily challenges that both practitioners and
supervisors face when developing, implementing, monitoring and
reviewing models for internal and regulatory purposes.
The views reflected in the book come directly from people that
contributed to the development of the Solvency II internal modelling
framework, on both the supervisory and/or the industry/practi-
tioner side.
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The legislative material on internal models is not easily accessible
or digestible for non- regulators; therefore, this book will give practi-
tioners (actuaries and quants) and senior executives a practical
interpretation of the internal modelling requirements. It will also
provide support to managers charged with implementing the
internal modelling framework at firms. Insurance supervisors who
review a companys application for the use of internal models for the
calculation of capital requirements will find the book useful when
looking for clarifications of the requirements, and practical solutions
to challenges faced during the review work. Finally, the book is for
those interested in gaining a better understanding about the use of
internal models for regulatory purposes, as well as their history,
challenges, philosophy and future prospects.
The book looks particularly at the application of internal models
for Solvency II purposes (ie, Europe). The principles developed in
this framework build on what should be good practice, and this
applies to any internal modelling framework. As Solvency II is an
emerging standard for insurance supervision that is inspiring
modernisation of the regulatory regimes of several jurisdictions
(South Africa, Israel, Mexico, China, etc), the book should be helpful
to both supervisors and practitioners working in these countries.
ORGANISATION OF THE BOOK
The book starts with a look at basic internal model principles, before
moving on to more complex concepts, supporting explanations with
examples that illustrate the challenges facedboth by firms andsuper-
visors during the development, implementation, review and
monitoring of internal models. It stresses the need for firms to seek to
go beyond a simple regulatory box- ticking exercise, reflecting
internal management priorities and covering all material aspects of
theinternal model environment. Theinternal model approval process
aims not only to assess howthe internal model meets the Solvency II
requirements in isolation, but also considers any potential interrela-
tion between these requirements. The review process should
therefore include the necessary steps and tools to ensure supervisory
authorities are able to satisfy themselves that these requirements are
met. It is essential that the methodologies, components and inputs
used by firms are appropriate for the internal model and its use, and
enable them to identify, measure, monitor and report risks
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adequately. Complying with the internal models standards is not a
one- off exercise. Standards have to be met on an ongoing basis, and
the bar should be raised over time to take into account both internal
and external developments. To this end, an ongoing dialogue
betweenfirms andregulators is not required, but essential.
Chapter 1 lays out the foundations for the Solvency II internal
modelling framework. It provides a high- level review of the
Solvency II balance sheet, and illustrates how assets and liabilities
are to be valued under this framework. It explains the role of the
solvency capital requirement (SCR), and describes how it should be
derived as a difference between the net asset values of the balance
sheet at the valuation date (pre- stress) and one year forward (post-
stress). It also defines an internal model in the Solvency II context,
discussing the potential costs and benefits arising from its develop-
ment and use for both supervisors and firms. Finally, the concept of
proportionality and how it applies to internal models is explored.
In Chapter 2, Juan Antonio Lumbreras provides details about the
Solvency II partial internal modelling regime. He defines the scope of
application of a partial internal model, and compares and contrasts
the use of partial internal models in Solvency II and the Basel/CRD
framework. The concept of the major business unit is explained, and
a number of examples of partial internal models are provided. The
specific provisions that apply to partial internal models, the rationale
for these measures and the use of transitional plans to extend the
scope of the models are also discussed. Finally, firms challenges to
capture those risks that are not explicitly covered by the standard
formula are covered.
In Chapter 3, Stefano Pasqualini presents an overview of the
procedure to be followed for the approval of an internal model.
Particular attention is paid to internal models application for
groups, where cooperation between different national supervisory
authorities is critical for the effective review of the application. The
chapter also highlights the importance of firms contingency plans,
were the internal models application to be unsuccessful.
In the next chapter, Christian Kerfriden describes the policy for
model changes, and highlights its role within the overall governance
of the internal model. Chapter 4 also discusses the elements that
need to be covered by the policy, including the changes and sources
of changes. The practical issues faced by firms when setting and
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implementing the policy are discussed, as well as the classification of
changes between minor and major. Finally, the supervisory approval
of major changes to the model is examined.
In Chapter 5, Agnieszka Groniowska, Perrine Kaltwasser and
Regis Weisslinger discuss the challenges faced by the implementa-
tion of the group internal modelling regime. They explain the option
provided by Solvency II to calculate the group solvency and, in
particular, the implications and challenges raised by the accounting
consolidation or deduction and aggregation methods; the treatment
of entities located outside the EEA is also considered. The challenges
of home and host supervisors, as well as the role of the supervisory
college and EIOPA during the review and assessment of applications
for the use of an internal model for groups, are considered. Finally,
the chapter considers the application of the concept of materiality in
a group context.
Following that, Christopher Chappell, Elliot Varnell and
Coomaren Vencatasawmy describe the Solvency II requirements for
the use test. Chapter 6 proposes a case study that discusses the chal-
lenges related to its implementation (eg, governance, alignment of
business metrics), and includes some practical solutions on how to
evidence the requirements.
In Chapter 7, Markus Bellion, Christopher Lotz and Peter Mller
look at the internal model statistical quality standards in the light of
the implementation efforts of both firms and supervisors as observed
during the internal model pre- application phase. The main statistical
quality standards implementation challenges and issues are
presented. The examples are specific to a particular risk category or
model component, although the approach used can be easily trans-
ferred to other internal modelling areas.
In the next chapter, Dean Buckner explores some of the common
confusions surrounding data governance, as well as some of the
common traps and pitfalls to avoid. These include the difficulties of
distinguishing data governance from the science of information tech-
nology, the problem of measuring and controlling data quality, and
the purpose of a data directory. Chapter 8 identifies two serious
obstacles to successful data governance, namely the fragmentation of
systems caused by the growth of end- user computing in the late 20th
century and the failure to recognise common principles of data
governance, leading to failure to develop it as a discipline in its own
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right. The examples relate to asset risk management, longevity risk
management and catastrophe risk management.
In Chapter 9, Ishtiaq Faiz and Paolo Cadoni introduce the
Solvency II internal model calibrations standards. They clarify the
purpose of these often- misunderstood requirements and how they
apply to firms that are calibrating their internal models using
different risk measures (eg, tail value- at- risk, VaR) and time horizons
from those set out in the Solvency II directive. They go on to provide
an insight on how both supervisors and firms are dealing with these
requirements during the internal models development, implemen-
tation and review.
In Chapter 10, Andrew Candland and Christopher Lotz describe
the profit and loss (P&L) attribution process. They present examples
of the results of P&L attribution exercises, and examine the prerequi-
sites for a successful P&L attribution. The chapter also explains its
use in model validation and risk management, and the issues and
challenges around P&L attribution.
Following that, Ravi Bharos, Christian Kerfriden and Vesa
Ronkainen provide a regulatory perspective on model validation in
Chapter 11. The authors explain the importance of an appropriate
model validation process, its governance, and the planning and
execution of the model validation activities. Examples of some of the
tools that can be used to validate a model and the reporting of the
outcome of the model validation activities are also provided.
In Chapter 12, Ben Carr presents an industry perspective on
model validation. He offers an industry interpretation of the
Solvency II validation requirements, illustrated by an example of
how the regular cycle of model validation could be organised by an
insurance company to ensure the model validation process is imple-
mented pragmatically and add real value to the company.
In Chapter 13, Dermot Marron provides a critical analysis of the
Solvency II internal model documentations requirements. The
chapter explains the importance of the scope, form and review of
documentation, and gives examples of how firms should go about
documenting the outputs of the model, its methodologies, expert
judgement and external models. This is complemented by other
examples of how firms should document the validation process and
its outcomes and, most importantly, how documentation should be
validated.
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In the next chapter, sa Larson proposes a definition for external
models. Chapter 14 explains the typology of external models, the
principles to be applied when reviewing data and external data for
use in the internal model, the requirements and challenges from
a supervisory and firmperspective (eg, use test, statistical quality
standards, calibration, P&L, validation, documentationandconfiden-
tiality), andthe interface betweeninternal andexternal models.
In Chapter 15, Paolo Cadoni and Christian Kerfriden introduce a
paradigm to deal with internal models limitations, present an illus-
tration of the typical sources of limitations and stress the importance
of a good governance framework to identify potential issues and
manage them appropriately. They explain how to deal with the
ongoing monitoring of internal model performance, and describe
those instances, post- approval, where the use of the internal models
stops satisfying the Solvency II requirements. Finally, they provide
an illustration of the internal models supervisory reporting and
public disclosures requirements.
I hope that, after reading this important book, the reader will have
a broad and clear perspective on the relevant issues and thinking on
internal models, and of how these leading authors see the practice
evolving in the future.
Paolo Cadoni
1 For further details, see European Parliament and the Council of the European Union (2009).
2 For further details, see Haldane and Madouros (2012).
3 For further details, see Basel Committee on Banking Supervisions (2013).
4 Thus, the presence of a model that seeks to understand such phenomena (eg, equity risk)
could drive decisions around asset allocation, hedging strategies, etc, which in turn change
the underlying nature of the risk itself. By contrast, a model that seeks to understand the
impact of natural catastrophes or shifts in mortality patterns might drive changes in a
companys exposures to those risks, but would not give rise to changes in the nature of the
risk itself.
5 For instance, the use of some modelling to estimate technical provisions was introduced in
the UK by the Assurance Companies Act 1909. Historical modelling has mainly been on the
liability side of the balance sheet (eg, mortality tables, which essentially are simple models),
whereas the use of models for the derivation of capital requirements is relatively new and
still being tested.
6 For further details, see Article 121 of the European Parliament and the Council of the
European Union (2009).
7 It is worth mentioning that this does not mean being independent from the risks borne by
the firm.
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INTRODUCTION
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REFERENCES
Basel Committee on Banking Supervision, 2013, Revised Basel III Leverage Ratio
Framework and Disclosure Requirements, consultative document, June.
CEIOPS, 2005a, Answers to the European Commission on the First Wave of Calls for
Advice in the Framework of the Solvency II Project, June.
CEIOPS, 2005b, Answers to the European Commission on the Second Wave of Calls for
Advice in the Framework of the Solvency II Project, October.
European Parliament and the Council of the European Union, 2009, Directive
2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the
Taking- up and Pursuit of the Business of Insurance and Reinsurance (Solvency II)
(recast).
Haldane, A. G. and V. Madouros, 2012, The Dog and the Frisbee, paper delivered to the
Federal Reserve Bank of Kansas Citys 36th economic policy symposium, Wyoming,
August.
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