07 May 2013

Risk.net: UK regulator right to retain flexibility to force changes on internal models

The comments come as it emerged that the Prudential Regulation Authority (PRA) is planning to use a system of 'early warning indicators' in its supervisory work on insurers' internal models, which may go beyond the Solvency II framework.

PRA chief executive Andrew Bailey said in a letter to a House of Commons committee that the indicators would be analogous to the leverage backstop for banks featured in Basel rules, and would be used to alert supervisors "as to potential threats to solvency from [Solvency II internal] models being used to pare capital requirements". But experts say there are good reasons for national authorities to be able to identify developing risks that are not properly captured by internal models and preserve the power to ensure that a company's capital buffers remain adequate.

Janine Hawes, head of Solvency II at KPMG in London, says: "If a firm's risk profile changes and the PRA believes the company should have amended its internal model to deal with that, then the PRA wants to be able to spot and address that. There is a lot of sense to that: the capital requirement should reflect the ongoing risks."

Under Solvency II, companies can make material changes to their internal models provided they obtain approval from their supervisor. But it remains unclear whether national regulatory authorities will have discretion to force changes to approved models, says Hawes.

"The big question is how much flexibility national regulators will be allowed. EIOPA [the European Insurance and Occupational Pensions Authority] could build something along these lines into [level 3] guidelines, so all supervisors have to consider how they will assess the ongoing suitability of the model", she adds.

Lawyers say the early warning indicators are not being positioned as a capital requirement, but as a 'traffic light' signal to make supervisors aware of risks. As such, it will be "more difficult to describe it as a derogation" from Solvency II, says Michael Wainwright, partner at law firm Eversheds in London.

This seems to be in line with the PRA's line of reasoning. Bailey said he believed the PRA will be able to implement this supervisory mechanism within the Solvency II framework. However, he promised to do so even if that were not the case and "accept the risk of EU challenge".

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