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In its first set of Solvency II guidelines, published on June 2, the European Insurance and Occupational Pensions Authority (Eiopa) provided guidance for firms on internal models, including details on validating and documenting models, and their use of external data. But confusion remains on the status of so-called reactive parameters in an internal model and whether changes to these will have to be classified within a firm's model change policies.
Reactive parameters are figures used in a model that change in a defined way as market conditions evolve. For example, if a firm incorporates a counter-cyclicality mechanism in its internal model, the parameters for credit risk or equity risk might alter automatically in response to changing financial markets.
The European Insurance and Occupational Pensions Authority (Eiopa) admits the way in which reactive parameters should be classified within firms' internal model change policies is still under consideration by its internal model committee.
For example, some supervisors could define reactive parameters to include only externally sourced figures, such as a data point from Bloomberg, that are inputted without alteration into a firm's model. Others, however, might say that externally sourced figures to which some expert judgement has been applied would also qualify as reactive. Eiopa suggests there is no consensus as yet on a universally recognised definition.
Experts are divided on where the line should be drawn. Stephen Makin, senior insurance consultant at Hymans Robertson in London, says: "Provided the parameter changes are only because of evolving market conditions, and not data or judgement, then I would expect these not to need to be covered by model change policies. [But] there may instead be a need for triggers and reporting to capture exceptional market conditions".
Parameter changes can count as either major or minor changes within an internal model, according to Eiopa's guidelines. A major change requires the insurer to subject their model to supervisory approval. Minor changes must be aggregated and reported to the supervisor on a quarterly basis.
Rob Collinson, London-based global product leader for property and casualty modelling at Towers Watson, says it is important that firms clearly define how parameter changes will fit into their internal model change policies ahead of Solvency II implementation and how they will report changes to regulators efficiently.
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