Solvency II

Demystifying Internal Models for Underwriters

The constraints that Solvency II will imposeon business management will feed directlythrough to how underwriters select andprice risks, and how their performance ismeasured. The required systems andprocesses are just beginning to bedeveloped, so now is the time forunderwriters to influence how theirbusinesses respond to these challenges and how they will be able to write insurancebusiness after Solvency II implementation.

Solvency II is bringing an increasedrisk focus at management levelBusinesses will need a demonstrable riskfocus. They will be required to develop and use risk metrics in business decisions,in addition to existing financial metrics.Underwriting decisions will need to evidencetheir consistency with the firm’s riskmanagement approach, and its overall risk metrics.

Underlying risks will not change; however,the methods used to evaluate and monitorthem will. Without the active involvement ofunderwriters, firms run the risk of developingsystems and processes that are not

appropriate for their business and, therefore, taking the wrong financial or riskdecisions in the Solvency II world.

Under the Solvency II regulatory framework,a firm’s Internal Model is at the heart of riskevaluation and will therefore be a key inputto a wide range of business decisions. Thisis going to be a significant extension ofscope for most existing capital models.

What is the ‘Internal Model’ in practice?There is no exact regulatory definition of the‘Internal Model’ and Solvency II givesinsurers a large degree of flexibility indeveloping an Internal Model that isappropriate for their business. Broadlyspeaking, however, the Internal Model is thecollection of processes, systems andcalculations that together quantify and rankthe risks faced by the business.

Once the Solvency II framework, includingthe Internal Model is in place, managementwill be obliged to demonstrate that they useits results in real business decisions – the‘use test’. It is therefore paramount that

underwriters ensure that modelled resultsare sensible and an accurate reflection ofthe business before performancemeasurement and investment decisions aretaken using them.

The use test is going to mean that insurershave to adopt new business practices inorder to gain model approval and avoidpenal capital charges. Around half of thesuggested uses in the latest Solvency IIcommunications from European regulatorsinvolve capital allocation or a move towardssome other equivalent form of risk-adjustedperformance measurement. This makes itlikely that Internal Model results will have tobe used to allocate capital and thereforedetermine cost of capital loadings to include in pricing.

Model structure and parameters willtherefore have a direct impact on keybusiness functions such as reportedperformance (e.g. as combined ratio isreplaced with Return on Allocated Capital)and pricing (as profit targets are variedaccording to allocated capital). In order thata fair allocation is achieved, and realisticprofit targets applied to different lines ofbusiness, it is important that underwritersare engaged in these decisions, fromdefining what ‘risk’ means to the company,to how this feeds through to ranking thelevel of risk in different lines of business and setting required profit loadings as aresult of this.

Solvency II continues to proceed at an ever increasing pace through the insurance industry in Europe. Regulators are looking to have greaterscrutiny across a wider range of the practices and processes of insurancebusinesses than ever before, and shaping the business response to this is a critical challenge.

Why should Underwriters engage in the Internal Model process?

1. To get it right

The underwriters in an insurance business generally have the deepestunderstanding of the risk and reward profile of their insurance portfolio. In order that the model results can be relied upon, it is important to capturethis knowledge and understanding.

2. To ensure consistency

Risk appetite (i.e. balancing the potential upsides and downsides in aninsurance business) is what underwriters do on a day-to-day basis withintheir lines of business. It is, therefore, necessary for underwriters to

significantly contribute to how this is decided at a business level and measured/monitored at operational level.

3. The ‘use test’

This is the key reason that drives the need for underwriter involvement with the Internal Model. In order to avoid potentially penal capital charges,management will have to demonstrate that the model is a key tool formaking a wide range of business decisions. This means that model results will be used to assess performance and to determine strategy going forward. Underwriters should be leading the drive for developingbusiness uses for the Internal Model to ensure that these are truly valuableto the business, and not just a significant compliance burden on alreadystretched resources.

Solvency II Demystifying Internal Models for Underwriters

How should Underwriters engage inthe Internal Model process?Figure 1 shows some key questions to askat various stages of model life. In engagingwith the process, underwriters shouldconsider the following two stages:

1.Understand

How are model units developed?

How does my line of business fit into the model structure?

Are there any implications for existingmodels arising from the Solvency II quality standards?

What data has been used to determineparameterisation? What adjustments andjudgments have been applied to this data?

What are the key assumptions made foreach line of business, and how were theseselected? What were the alternatives?

How are risk types aggregated? Whatimpact does this have on the overall result?How are diversification benefits sharedbetween lines of business?

2.Challenge and validate

Does the range of results feel right? Arelosses arising from appropriate sources formy business. For example, how much of themodelled loss arises from catastrophes?

What are the metrics that are important tome? What does the model say about theaverage, and the potential range, of these

metrics for my line of business? Is thissensible for the modelled time horizon?

Does the modelled ranking of risks feel right(e.g. between business lines)?

Are relevant sections of the modelconsistent with other models (e.g.pricing/aggregate monitoring/cashflowforecasting)? How does the model interact with these?

What external/industry data is there thatmodel results could be compared to? Howdo the modelled results compare withindustry historical data?

When should underwriters engage withthe Internal Model?

The short answer is immediately. Timescalesfor implementation are tight, with manyregulators planning model approval dry runsfor the middle of next year. This timetablemeans that companies are alreadydeveloping, implementing and starting touse models in order to be able to create therequired level of documentation andevidence to support model approval. Inmany cases, this is a significant extension ofthe current model capability, so models arenow being developed and extended to addthese new capabilities. Therefore, decisionsare currently being made that will materiallyaffect the results of models, and theconsequences of the use test means thatthese decisions will have a direct impact onthe post Solvency II underwriting process.

Underwriters must not lose the opportunity

to influence how these models aredeveloped and how they are used withintheir business. Current models have somesignificant limitations when it comes todescribing real-world insurance risks, andunderwriters are best placed to identifysome of these limitations, and to ensure thatmodel results are not used blindly wherethey are inappropriate. This is a substantialrisk for European insurers and it can only bemitigated if underwriters are bought in to themodel development from an early stage.

The evolving Solvency II regulations aregoing to bring about many changes to theunderwriting activity of companies. One ofthe largest of these will be the need (or atleast strong preference) to use an InternalModel for capital purposes, and therefore in other business processes in order tosatisfy the use test. Actuaries and riskprofessionals are currently working atinterpreting guidance and operationalisingrequirements to use Internal Models withinthe business. To ensure that their workmatches underwriting requirements it isessential that underwriters understand thepotential changes and have a voice inmaking the key decisions.

Bryan JosephPricewaterhouseCoopers (UK)44 20 7213 2008bryan.rp.joseph@uk.pwc.com

Jim BichardPricewaterhouseCoopers (UK)44 20 7804 3792jim.bichard@uk.pwc.com

David WongPricewaterhouseCoopers (UK)44 20 7804 3587david.l.wong@uk.pwc.com

www.pwc.co.uk/solvencyII

If you would like to discuss any of theareas covered in this paper as well asthe implications for yourself and yourfirm, please contact:

Figure 1: Key stages of model life

Analyse theenvironment

Source: PricewaterhouseCoopers

- What are key risk drivers of my business?- What data/analysis is available to help measure these risk drivers?

Design- Is risk mitigation reflected appropriately?- Do different sources of loss contribute reasonbly (e.g. large / cat losses)?

Build - How is diversification benefit calculated? - How is this split between lines?

Parametise - What data is used? - Are appropriate changes made for trends/future expectations?

Validate- How do the worst, and best, results in my career fit into the modelled range?- Does the average P&L look sensible?- What about the 1 in 10 yr, the 1 in 50 yr?

Use- Where can I use model results day-to-day?- Where and how are management using model results relating to my line of business?

Review - What are the shortcomings of the model in reflecting the risk in my business? - How can these be addressed? © 2009 PricewaterhouseCoopers. All rights reserved.

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