PRA intensifies internal model scrutiny for UK insurers
The PRA today set out plans for more intensive and structured scrutiny of insurers’ internal models, combining streamlined approval rules with a new ongoing review regime under its Solvency UK reforms.
The proposals are contained in Consultation Paper CP12/23 on adapting Solvency II to the UK insurance market, published in June 2023.
New internal model framework and faster approvals
The PRA is proposing a new internal model framework that would streamline requirements for firms seeking approval to use their own models to calculate regulatory capital.
In line with this, the PRA is reducing the number of tests that need to be met as part of internal model applications, moving towards what Grant Thornton described as a more flexible approval framework.
The PRA has also strengthened its commitment to respond to new internal model applications in a timely fashion and to communicate outcomes within six months.
In addition, it will be possible for the PRA to approve internal models that still have residual model limitations, by applying capital add-ons where necessary.
Ongoing review regime and model limitations
Alongside the front-end changes, the PRA is introducing an Internal Model Ongoing Review framework, or IMOR, which will consist of four strands and build on existing supervisory tools including firm-specific deep dives, supervisory engagement, thematic reviews and model drift analysis.
Within this framework, the PRA expects firms to make all reasonable efforts to safeguard against or remediate model limitations, and plans to use one strand of IMOR to monitor the appropriateness and effectiveness of these safeguards and remediation efforts.
A related supervisory statement sets out the PRA’s expectations for how firms should meet internal model requirements under the revised regime.
As part of the model validation process, firms are expected to assess both the quality and the independence of validation, with the PRA setting out factors that should be considered when assessing independence.
Reporting simplifications for SCR
The PRA is proposing that firms report only one template for the Solvency Capital Requirement, regardless of whether they use the standard formula, a partial internal model or a full internal model.
At group level, the PRA is also proposing to delete the requirement for insurance groups to report the Solvency Capital Requirement by risk module, noting that this information is already reported elsewhere.
Focus on funded reinsurance and collateral
The PRA is planning further supervisory work on funded reinsurance, including targeted work on collateral risk management and internal model approaches used for these structures.
From 15 June 2023, the PRA set a threshold requiring firms to notify it promptly of each material funded reinsurance transaction entered into, with a gross premium of £200m or more treated as material for these purposes.
Broader supervisory priorities and risk focus
The PRA set out its priorities for insurance supervision in a Priorities Letter dated 10 January, which frames the internal model changes within a wider supervisory agenda.
For the life insurance sector, the PRA referred in that letter to increased exposure to credit and concentration risk, especially for insurers using internal models, driven by widening credit spreads, rating downgrades and higher default levels.
Over the next three years, the PRA expects insurers to demonstrate their ability to operate in a range of “severe but plausible” scenarios, including cyber attacks, as part of its broader resilience expectations.
The PRA also plans to consult in 2023 on whether existing expectations on orderly exit should be strengthened into a formal requirement for all insurers to produce exit plans, building on Fundamental Rule 8.
Context
The internal model proposals form part of the PRA’s wider review of Solvency II for the UK market, set out in CP12/23 as it develops the Solvency UK regime. The combination of streamlined approval tests, time-bound decisions, ongoing review through IMOR and targeted work on areas such as funded reinsurance reflects the PRA’s evolving approach to model-based capital under that review.
--- Sources: https://www.bankofengland.co.uk/prudential-regulation https://www.cliffordchance.com/content/dam/cliffordchance/briefings/2023/07/pra-publishes-solvency-UK.pdf https://www.bankofengland.co.uk/prudential-regulation/publication/2023/june/review-of-solvency-ii-adapting-to-the-uk-insurance-market
