7 minute read 10 Dec 2020
Are internal models or Undertaking Specific Parameters right for you?

Are internal models or Undertaking Specific Parameters right for you?

Authors
Ludovic Theate

EY Belgium Actuarial Executive Director

Actuarial expert with a passion for insurance in general. Loves the numbers and the models but prefers the stories behind. In constant search for intellectual challenges. Father of Louise.

Katrien De Cauwer

EY Belgium Actuarial and CFO Consulting Partner

Seasoned Actuary and Insurance Professional. Entrepreneur. IFRS 17 expert. Devoted to helping talents define the legacy they want to build. Mother of three. Passionate about photography.

Maarten Bocksteins

EY Belgium Financial Services Actuarial Consulting Executive Director

Seasoned insurance and actuarial professional who strives to ‘connect the dots’. Passionate about team work and collaboration. Loves running. Father of two daughters.

7 minute read 10 Dec 2020
Related topics Insurance Financial Services

Solvency II proposes 4 possible approaches to determine an insurance company’s capital requirement: which one is right for you?

In brief:

  • The Solvency II Directive proposes four possible approaches to determine a company’s capital requirement.
  • How do you balance the need for an accurate reflection of your risk-profile, and the corresponding complexity and operational charge that arise when straying from the Standard Formula Approach?
  • Internal models (Partial or full) and Undertaking Specific Parameters : are those for you?

In a recent article we have introduced our EY Solvency II Benchmarking Tool and analysed some of the trends that we have observed on the Belgian market. In this new article, we focus on one specific domain: the use of internal models (Partial or full) and Undertaking Specific Parameters (USPs) in Belgium.

Approaches for determining regulatory capital requirements

As shown in Figure 1, the Solvency II Directive proposes four possible approaches to determine a company’s capital requirement,. This allows undertakings to select the right trade-off between an accurate reflection of their risk-profile, and the corresponding complexity and operational charge coming from the implementation, the ongoing maintenance and the approval process of approaches other than the Standard Formula Approach. 

Figure: Approaches for determining regulatory capital requirements

Figure 1: Different approaches to the Solvency Capital Requirements.

The application process for a (partial) internal model is more complex and heavy than for USPs. Although both have ongoing requirements post-approval, the use of a (partial) internal model is definitely much more onerous because of a multitude of requirements such as P&L attribution, independent validation, use test, etc. (see section 4).

1. Situation in Belgium and comparison with Europe

If we look at the situation in Belgium at year-end 2019, our benchmarking (covering 34 companies representing 96% of the market premium1) shows the following results:

  • Full Internal Model: 3 companies have received regulatory approval to use a full internal model (AXA, Yuzzu and Euler Hermes);
  • Partial Internal Model: 3 companies have received the approval to use a partial internal model (Cigna Europe, Cigna Life and Ageas/AG Insurance);
  • Undertaking Specific Parameters: 6 companies have received the approval to use the undertaking-specific parameters (Assurances du Notariat, AMMA, Inter Partners Assistance, Euromex, Europe Assistance and DAS);
  • Standard Formula Approach: 28 of 34 companies use the default calculation approach.

2. Impact on capital requirements?

Most companies experience a material decrease in required capital when moving towards the use of a (partial) internal model (P)IM or Undertaking Specific Parameters. In our experience, a reduction in solvency capital requirements (SCR) ranging between 10% and 25% on the non-life underwriting risk have been observed for companies who are using USPs instead of the default Standard Formula approach. For (P)IM companies, the reduction in required capital is potentially even bigger depending on the extent to which the company’s risk profile deviates from that of the average European insurer and on the modelling choices made.

The positive impact in terms of capital requirements is clearly an incentive for companies to opt for USPs or (P)IM. Obviously, the intent of applying for USPs or a (P)IM should not be driven by the will of reducing pillar 1 capital requirements. In essence, choosing USPs, PIM or IM is a decision based on the trade-off between (i) a more accurate reflection of the company’s risk profile, allowing for better decision-making, and (ii) (the burden of) complexity. This trade-off must be evaluated by the Board and the management in light of the company’s risk appetite and the mid- to long-term ambitions of the undertaking.

While larger composite insurance companies often turn directly towards the implementation of an internal model when they seek to better tailor their capital model to their risk profile, moving straight from the standard formula to such a model implies a long and often burdensome process. Using a USP as a first step towards a (P)IM can prove efficient. The USP application file and the governance around the use of USPs can help the risk management departments to get prepared for the organisational and governance requirements of an internal model.

3. And what about USPs?

The general concept behind USPs is to allow a company to replace a subset of the standard formula parameters by parameters specific to the undertaking. More concrete, this approach allows the companies to tailor the general standard formula to their own risk profile, while benefitting from a lighter approval process than those characterizing internal models.

Belgian companies using USPs are mainly non-life mono-liners or companies with one prevailing line of business. In Europe we see a slightly different picture. 

Country Companies using the USP
United Kingdom BUPA, Domestic & General, Sabre Insurance, The Warranty Group
France AG2R, LM, MACIF, Europ Assistance
Italy Sara Assicurazioni, Cattolica Group, HDI, Vittoria Assicurazioni
Spain Linea Directa, Sanitas, ASISA, Segurcaixa Adeslas

Table 1 - Examples of companies applying USPs across Europe

While most of these companies provide solely non-life business, it is interesting to see that some of them are composite insurers with a more diversified portfolio compared to the mono-liners applying USP’s on the Belgian market. Clearly, companies other than pure mono-liners could also consider the use of USP’s.

4. How to proceed with applications and what are the differences?

What should management decide then? We have supported various companies with their journey towards USP or Internal Model Approval Processes (IMAP) approval, and based on that experience we have developed a clear view on the most common pitfalls of USP and/or (P)IM applications

IMAP or USP applications are often considered as onerous processes. Luckily, with Solvency II in force since the beginning of 2016, most companies have in the meantime put various elements in place that facilitate (P)IM and USP approval. A typical process takes between 6-12 months for a USP approval, and 6-24 months for an internal model approval, depending on the maturity of the company. 

Companies considering a (P)IM application should start with assessing the need for a model based on their specific business and risk profile, and develop a model strategy that allows for a sound argumentation on the reasons why an internal model is needed. Not only for calculation of the capital requirements, but also for business steering and decision-making as will be demonstrated in the context of the Use Test. The company will need to have a sound model governance (incl. independent model validation and the P&L Attribution), and obviously the model will need to satisfy the required statistical quality standards. 

Perceived success factors and common pitfalls when implementing a (Partial) Internal Model are:

Area SuccessFactors and/or pitfalls

 

General

  • Strong program management,
  • Clear communication strategy with relevant stakeholders (Board, Executive Committee, business, supervisors,…),
  • Dedicated resources.
Use Test
  • Strong buy-in from senior management and a sound ‘tone from the top’ because of the significant impact on how business is being managed,
  • Cultural changes,
  • Training for senior management (up to Board).
Documentation
  • Stringent document requirements,
  • Developed in such a way that it will be a solid basis for independent validator.
Data
  • Rigorous data quality standards with additional data quality controls, data directory, data flows, control points, data governance to be in place,
  • Significant point of focus of regulator.
External Models and External data
  • Perceived as internal data (many external providers know by now what the regulatory expectations are and are able to provide materials).
Governance & risk management
  • Significant model governance requirements,
  • Model change policy,
  • Sound outsourcing requirements.
Model development
  • Clear need for stable model, full compliance with statistical quality standards and calibration standards,
  • Model testing execution as important input for the IMAP pack.
Validation and P&L Attribution
  • Rigorous validation standards, including validation policy and independent validation process (either internally- or externally-sourced).
Partial Internal Model
  • Clear model strategy (avoid ‘cherry picking’).

Factors for a successful USP application are:

  • A clear indication and argumentation that the risk profile of the company (or part of the undertaking) differs from the pan-European set used to calibrate the standard formula approach,
  • The availability of sufficient data to re-calibrate the SF parameters based on company specific data,
  • A sound internal governance that allows for approval of the outcome of the re-calibration exercise.

Conclusion

The use of Undertaking Specific Parameters or (Partial) Internal models allows insurance companies to calculate regulatory capital requirements that reflect the company’s risk profile more appropriately and, as such, it allows for better business steering and decision-making. Several building blocks for USP or (P)IM approval are already in place thanks to the Solvency II regulation in force since early 2016. Nevertheless, the approval process must be prepared with caution. A good program management, good embedding of the (P)IM in decision-making, strong model governance and validation approach are key. The insurer will also need to demonstrate that there is no cherry-picking and that the group models are locally appropriate. As a first step, insurers could consider USPs as a preparation towards an Internal model because of some overlap between both approval processes.

 

[1] AG Insurance, Allianz, AMMA, Argenta, Asco, Assurances du Notariat, Athora, AXA, Baloise, Belfius Insurance, Cigna Europe, Cigna Life, CPH Life, Crelan, DAS, DKV, Ergo, Ethias, Euler Hermes, Euromex, Europ Assistance, Fédérale, Fidea, Integrale, Inter Partner Assistance, KBCV, L’Ardenne Prévoyante, MvBH, NN, P&V, Yuzzu

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Summary

The Solvency II Directive proposes 4 possible approaches to determine an insurance company’s capital requirement: the Standard Formula Approach, Undertaking Specific Parameters, the Internal Model (Partial or full). Which one is right for you? It all comes down to finding the right balance between the need for an accurate reflection of your risk-profile, and the corresponding complexity and operational charge that arise when straying from the Standard Formula Approach.

About this article

Authors
Ludovic Theate

EY Belgium Actuarial Executive Director

Actuarial expert with a passion for insurance in general. Loves the numbers and the models but prefers the stories behind. In constant search for intellectual challenges. Father of Louise.

Katrien De Cauwer

EY Belgium Actuarial and CFO Consulting Partner

Seasoned Actuary and Insurance Professional. Entrepreneur. IFRS 17 expert. Devoted to helping talents define the legacy they want to build. Mother of three. Passionate about photography.

Maarten Bocksteins

EY Belgium Financial Services Actuarial Consulting Executive Director

Seasoned insurance and actuarial professional who strives to ‘connect the dots’. Passionate about team work and collaboration. Loves running. Father of two daughters.

Related topics Insurance Financial Services