Ongoing supervision of internal models under Solvency II

Internal models are one of the key new features of the Solvency II supervisory system that entered into force on 1 January 2016. BaFin has authorised a range of insurance undertakings, upon application, to calculate their solvency capital requirement using their own internal models developed for this purpose, as opposed to the prescribed standard formula. By the end of 2016, BaFin had approved a total of 36 internal models from individual undertakings. Their market share illustrates the significance of internal models (see Table 7 "Approved internal models"). In addition, five German insurance groups use an internal model to calculate their solvency capital requirement at group level.

Table 7 Approved internal models

Approved internal models

* Volume calculated using the technical provisions in accordance with the solvency statement. Source: BaFin

Models in ongoing supervision

In each instance, the approvals were the result of a six-month decision-making process preceded by a pre-application phase that extended over several years in some cases and involved a large number of on-site inspections. Through its approval, BaFin confirmed that the insurance undertakings met the relevant statutory requirements as of the application date.

The capability of an internal model changes, for example with the risk profile of the undertaking. This in turn depends on a considerable number of factors that are both internal and external in nature. Following approval, too, the internal model must remain sufficiently effective in the long term. To ensure this, BaFin must, in the course of the supervisory review process under section 294 of the Insurance Supervision Act (Versicherungsaufsichtsgesetz), review on a regular basis whether the undertaking's internal model continuously complies with the applicable requirements (sections 111-121 of the Insurance Supervision Act).

BaFin conceived this element of the supervisory review process – ongoing supervision of internal models – in 2015. Since the beginning of 2016, BaFin has been in contact with the undertakings and gradually developed this concept. Individual agreements on regular exchanges of information on the internal model are agreed, among other things.

Changes to models
An integral part of ongoing supervision is the review of changes to models. In 2016, the first year following initial approval, nearly all undertakings submitted an application for the approval of major adjustments to their internal models, and also notified BaFin of more minor changes. An unexpectedly large proportion of the ongoing supervision was occupied by processing model changes. This was due on the one hand to the comprehensive reworking by the undertakings in direct connection with the initial approval. For example, insurers remedied minor defects, implemented improvements in their models that they had postponed due to the application, and expanded the internal model's limited scope of application. On the other hand, trends in the (capital) market environment necessitated changes to the models. Time constraints meant that it was not possible in all cases to prepare the decision in a formal application process by means of a pre-application phase.

Comprehensive ongoing supervision

Simply reviewing model changes is not nearly enough, however. To comprehensively assess whether insurers comply with the applicable requirements, BaFin must also review whether the undertaking took an appropriate decision to confirm the model in other areas without amendment. The scope of ongoing supervision of internal models must therefore be appropriately broad.

Congruent requirements for undertakings and supervision

Efficient ongoing supervision builds on knowledge of the model and the experience gained (at present mainly from reviews of the pre-application and application phase), and makes the best possible use of the results of approved internal processes and analyses that determine further development of the model. Legislators therefore designed the above-mentioned duty for BaFin and the requirements on insurers under section 120 (1) of the Insurance Supervision Act to regularly validate their models in a largely congruent manner.
Under the validation, undertakings themselves review their models for weaknesses and identify the resulting need to make adjustments. They submit a detailed self-assessment to BaFin on compliance with the legal requirements. They also notify BaFin in a transparent manner of their decisions to change or not change the model. The validation report, which must be prepared by the undertakings at the minimum on an annual basis, thus presents BaFin with a core starting point for ongoing supervision. BaFin must verify and scrutinise the results.

Broad base of information

BaFin must ensure that, at all times, it has detailed knowledge not just of the internal model, but also – and in particular independently of the model – of the undertaking's risk profile and risk management system. This knowledge is gained from sources such as the own risk and solvency assessment (ORSA), regular supervisory report (RSR) and quantitative reporting templates, as well as from BaFin's own surveys. In addition to this, BaFin has agreed with individual insurers that they will regularly provide a package of information on the calibration of their models.

Benchmarking: a promising instrument

In 2016, BaFin began to evaluate the information under Solvency II that undertakings started to provide on a regular basis during the year. BaFin discusses the results of specific analyses carried out as part of the ongoing supervision of individual undertakings on an overarching basis and integrates these into a benchmark comparison. Such peer reviews can provide valuable insights for the undertaking subject to supervision, for instance when it is necessary to assess undertaking-specific results in comparison with the industry. These analyses can be just as worthwhile for the industry as a whole, for instance when developing methodological approaches to risk measurement or evaluation. In addition, they contribute to consistent supervisory evaluation and practice, and also take into account macro-prudential perspectives.

BaFin also participates in the pan-European benchmark reviews carried out by the European Insurance and Occupational Pensions Authority (EIOPA). The 2016 market risk benchmark study and the two studies on mapping the dynamic volatility adjustment and the risks from government bonds will be completed during the course of the year.

Efficiency

It is not just the critics of internal models who are aware of their high degree of complexity and individuality, even if this is required to a certain extent. However, what are crucial are the opportunities and new chances that BaFin derives from monitoring these tailor-made risk management tools.

Supervising – and refining – the models on an ongoing basis is unquestionably a costly and challenging task. For BaFin and the undertakings, what matters is ensuring that the exchange of information and associated processes are as efficient and effective as possible, in compliance with all legal requirements. This also – and primarily – applies in view of the limited resources. The experience gained in practice (regarding the interdependent model validation and change processes, for instance) must be leveraged and room for improvement identified. In the long term, efficient and effective ongoing supervision will contribute to the success and market acceptance of internal models.