05 June 2013

Risk.net: Fears volatile model warning indicators could lead to unjustified action

Insurers fear that the capital ratios used by the indicators, designed to detect a downward drift in their capital buffers, will be extremely volatile, prompting unjustified supervisory reviews that might lead to firms having to make changes to their business models and increase capital buffers.

The PRA is planning to use EWIs after expressing concerns about firms fine-tuning their internal models to pare capital requirements down to below Solvency II's 99.5 per cent value-at-risk threshold.

The regulator set out its implementation plans for EWIs in a letter to firms at the end of May. The regulator proposes to use ratio between the modelled Solvency Capital Requirement (SCR), and the pre-corridor Minimum Capital Requirement (pMCR), a standardised formula based on Solvency II technical provisions. Supervisory action will be triggered if the ratio falls below a pre-determined threshold, set at different levels for life and general insurance businesses.

But experts say the ratio between the SCR and pMCR is likely to fluctuate as the SCR is a sensitive measure that will change in line with variations in market factors, such as equity prices or bond yields, while the MCR might not change to the same extent.

There are also concerns under the PRA's currently proposed ratio strategies to protect the business and decrease risk could also cause an insurer to breach the intervention threshold, as de-risking would result in a reduction of modelled solvency capital requirements. Standard Life's Porteous comments: "You can be penalised for managing their risks. That does not make sense."

The PRA has stressed it is trialling the use of the EWIs and will review them ahead of the full implementation of Solvency II. But there are already calls for indicators that move more sensibly in line with economic conditions and the shape of their business.

One option for the PRA is to move away from pre-defined ranges and tailor the thresholds upon agreement with the calibrations of the individual internal models but this may conflict with the PRA's ambition to use these indicators, in part, as a way to detect movements in model calibration over time, suggests William Coatesworth, consulting actuary at Milliman in London.

The regulator also appears to have changed its stance on using the standard formula to benchmark insurers' internal models, experts say. The PRA is asking insurers to provide information to compare the capital requirements calculated using their internal model and requirements under the standard formula.

Full article (Risk.net subscription required)

© Risk.net