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Model approval process
Firms will shortly start to move from the phase of the regulator's process called ‘pre-application’ to the submission phase. The submission phase shadows to the maximum extent possible what a final application will look like, recognising that, first, the FSA does not yet have the legal power to accept an application under Solvency II or make a decision in relation to it, and, second, that the policy position in some areas is not completely settled and the FSA is working with draft text. At a later date, the regulator will then accept formal applications from firms. The FSA believes that this date will be at some time in 2013.
Feedback on internal model review
The first point is in relation to methodology and assumptions, particularly in pitching these at an appropriate level so that they are adequately reflective of risk without being too complex. In many cases, firms have not considered up-front the extent to which certain issues may or may not be material to their overall position, and then applied an appropriate degree of rigour.
Similarly, the regulator has seen issues with model scope. Some firms with very material catastrophe exposures have tried to claim that the catastrophe models which underpin all of the assumptions in this area are out of the scope of their internal model and one should therefore not look at them or how they are used. The FSA does not regard this as being tenable, and will clearly need to look at the underlying catastrophe models where these are material. What is important in all cases is that firms can demonstrate how they have made choices about materiality, and how the judgements they have made have fed through to the level of complexity they have used in their model.
The second area where the regulator thinks it would be useful to give feedback relates to aggregation and dependency assumptions. The amount of diversification credit a firm seeks to take is obviously critical to the overall output of its model, and in particular whether it presents a capital number which is adequately reflective of risk.
The regulator expects firms to be able to explain the choices and assumptions which have been made in this area, and to have validated them accordingly. The FSA also expects firms to carry out sensitivity testing on their diversification assumptions, so that they and the FSA can understand better which assumptions are the most important drivers of the overall result. The regulator's experience to-date is that firms have spent less time in this area than it would have expected and their work has been less convincing as a result.
The regulator has made a number of separate observations in the area of validation and validation policies. The first and overarching point is that some of the validation policies the FSA has seen have been so vague that it has not been able to draw any assurance from them. More specifically, the regulator has seen a number of validation policies where judgements as to the materiality of certain elements have been made without necessarily being justified, or with little or no supporting analysis. The FSA would expect decisions about materiality thresholds for validation to be more clearly articulated and justified. The importance of a challenging governance process has also been highlighted in this area.
Turning away from validation, another important issue is the Use test. It is fundamental to the spirit of the Directive that an internal model is fully embedded within the business and that this can be demonstrated. The final point is a specific one in relation to the London market, and catastrophe-exposed business in particular. Catastrophe modelling has increased in sophistication in recent years, but it is still to some extent restricted to traditional perils in well-understood catastrophe zones. The increasing importance of emerging markets means that the nature of catastrophe exposure is changing, as is the ability of standard modelling techniques to understand it.