PRA sets out draft approach to UK insurers' technical provisions and internal models under Solvency II regime

The regulator's draft supervisory statement (8-page / 149KB PDF) sets out its expectations of firms in relation to the calculation of capital requirements and their use of 'internal models', meaning their own compliance systems. Its final approach will depend on any further regulations or guidelines issued by the EU market supervisor the European Insurance and Occupational Pensions Authority (EIOPA). However, it is publishing the document now to "enable firms to consider the PRA's expectations as part of their planning and preparation for the new regime", it said.

The statement clarifies requirements in the Solvency II Directive that 'technical provisions', intended to cover the economic value of insurers' liabilities, be calculated using "realistic assumptions" and "adequate methods". It also sets out what firms using internal models need to take into account to ensure that "all material risks" to which they are exposed are covered.

Last week, the European Parliament voted to approve the Omnibus II Directive, which completes and finalises the new Solvency II framework for insurance regulation and supervision in the EU. The directive must now be formally adopted by member states. The new regime is expected to be transposed into national laws by 31 March 2015 and to come into force on 1 January 2016.

Solvency II sets out broader risk management requirements for European insurers and dictates how much capital firms must hold in relation to their liabilities. Approval of the legislation, which was originally scheduled to come into force in 2012, has undergone multiple delays leading to considerable confusion from the insurance industry and national regulators. The final text contains compromises on the size of the capital buffer that insurers would need to hold to guarantee long-term liabilities, and transitional provisions on third country equivalence.

Once the new regime is in force, firms will be permitted to develop internal models in order to calculate their liabilities or will be able to use a 'standard' model, which will likely mean higher capital charges. Internal models would have to be submitted to the PRA for approval. The directive requires that internal models cover "all material risks" to which firms are exposed, and that the method used to calculate model technical provisions is consistent with that used for the full technical provisions calculation.

The PRA's draft supervisory statement makes it clear that firms should only use historical data to inform their internal models where that data will take into account all material risks. They should also take particular care when using third party models to adapt them to cover all material risks in their own risk profile, and to avoid the use of assumptions selected by default. As an example, firms that use a third party model for earthquake exposure should also ensure that the model covers related risks, such as corresponding tsunami exposure, the statement said.

Firms should also allow for estimation errors where these are material and it is practicable to do so, according to the statement. They should also be careful to take account of calendar year effects, such as claims inflation, as part of their internal models unless their results would appropriately reflect the volatility introduced by these effects without doing so.

The statement would also require firms to consider whether their methods used for calculating technical provisions include the risk margin. According to the statement, the PRA considers the risk margin to be a "significant part" of the technical provisions calculation. Again, firms should not limit themselves solely to use of historical data in their calculations.