9/14/2011. Internal model validation: a Solvency II perspective. Overview: Solvency II regulatory framework. Solvency II requirements for validation

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1 Internal : a II perspective Seth Patel Casualty Loss Reserve Seminar 16 September 2011 Overview: II regulatory framework Pillar 1 Valuation principles capital (SCR) Internal governance & use test Model Internal approval Pillar 2 Own Risk & Assessment (ORSA) Overall governance arrangements Supervisory review process (SRP) Pillar 3 Disclosure solvency & financial condition report Market discipline Page 1 II s for II Directive Article 124: Insurance and Reinsurance undertakings shall have a regular cycle of to demonstrate to their supervisory authorities that the resulting capital s are appropriate. This includes, but is not limited to: Monitoring the performance of the internal Reviewing the ongoing appropriateness of its specification Testing the forecasted distributions using various quantitative and qualitative methods Impact: Validation is a critical part of demonstrating that the internal is suitable for setting capital for regulatory purposes, i.e., to get internal approval for regulatory capital setting purposes. Validation is a critical element of the Use test i.e. risk adjusted decisions are more credible based on a validated. The process is ultimately owned by the board. Page 2 1

2 Elements of internal capital Validation policy Data Policy Validation /principles/tools Validation report Findings and Conclusions Page 3 Examples of internal gaps compared to the II Validation policy: Lack of governance, no escalation procedures, roles and responsibilities unclear Lack of governance between legal entities and group (i.e., Who runs the? Who validates what?) Frequency of unspecified Lack of consistency between and across legal entities No principles of materiality established to identify material items or non-material items No principles of proportionality established Validation /principles/tools: No or principles or tools for validating the results No or principles for calibration and parameterization Level of granularity of is unclear Independence: No independent review or appropriate governance for independent review in place Independent review is carried out occasionally if requested by regulators or by senior management but not on a regular basis Validation documentation/reports: No documentation or documentation standards for results Page 4 Validation policy sample of key items Scope of What? What risk types to include (i.e., premium, reserving, etc.)? What is excluded (e.g., exclude tornado/hail, data quality)? Principles of materiality and proportionality How do you establish material items vs. non-material items (i.e., objective vs. subjective vs. combination)? How do you to establish principle of proportionality (i.e., are more material items validated at a more granular level)? Granularity of How deep? How far and how detailed should the be for a given risk type X item? Leverage principles i of proportionality and materiality Limitations and future developments Outline known limitations of current process Outline planned developments to improve Frequency of process How often? How often will the process be carried out (i.e., are more material items checked more frequently)? Which tools should be applied at what time? Thresholds What is the threshold for quantitative that would be viewed as a failed result? How to ensure consistency across all risk types? How do you evaluate qualitative? Validation Items (i.e., quality vs. Assumptions appropriateness) Parameterization IT/systems Validation of expert judgments Use test Governance of process Who owns the process? Who evaluates results? What is the role of the risk-type owner? What is the escalation criteria and procedure? Documentation Validation policy Validation Validation process: individual roles and responsibilities Reporting Validation report specifications How often? Independent review Internal independence of function Are responsibilities and reporting structures consistent with independence? Role of external independent review Remuneration structures for external review Page 5 2

3 s 9/14/2011 Validation : quantitative and qualitative tools Quantitative aspects of the Validation of Validation of assumptions Validation of parameter and parameter Validation of expert judgments Quantitative tools Back-testing (against experience) Sensitivity testing Stability testing Stress and scenario testing P&L attribution Change Analysis Reverse stress testing Comparison to standard formula Comparison to other capital s Qualitative aspects of the Validation of data, data feeds and IT systems Validation of documentation Validation of governance Validation of use test Qualitative tools Industry benchmarking Third-party review Written justification of methods chosen Written justification of strengths vs. weaknesses in Explanation of alternative methods considered Page 6 Quantitative tools 1. Back-testing Use hold-in/hold-out data Use actual vs. expected Compare actual vs. expected/ed Use statistical testing such as Goodness of Fit, Parameter Estimation, etc. 2. Sensitivity testing Analyze sensitivity of the results to changes in key parameters and underlying assumptions Be consistency across s and risk types Identify most significant key drivers, assumptions and parameters of the 3. Stability testing Target level of acceptable simulation error Quantify number of simulations need to target simulation error 4. Stress and scenario testing Assess the impact of a single event stress testing Assess the impact of a combination of events scenario testing 5. P&L attribution Implement change in own funds by creating mini P&L statements (e.g., Risk type X Business Unit) Compare ed P&L to realized P&L Identify ed vs. uned risks, double counting Validate overall and profit / loss emergence 6. Change analysis Analyze changes of capital results over time Explain differences of changes that breach threshold 7. Reverse stress testing Determine a target loss to surplus and evaluate types of scenarios that could lead to the target loss Evaluate likelihood of such scenarios 8. Comparison to standard formula Compare internal results to standard formulas: solvency capital s (SCR) and minimum capital s (MCR) 9. Comparison to other capital s Compare internal results to other capital s frameworks (e.g., rating agency) Run more than one capital (e.g., EC light ) Page 7 Sample roadmap for a process Identify risk type Identify types of items to validate Prioritize Create Validation results Decisions Stage Select a risk type to focus What to validate? Validation is focused on most important items in a consistent manner according to materiality How to validate? Produce results, reports and action items Evaluate results Key activitie Premium Reserving Nat CAT Man-made CAT Life liability Market/ALM Investment credit Reinsurance credit Operational risk Aggregation components: Key steps Model logic Assumptions Parameterization Calibration Expert judgment Key outputs of risk-type eg e.g., reserving risk distribution to feed capital Input data Internal data External data (Appropriateness vs. data quality) Repeat for all risk types Rank each item in dimension #2 as critical, high, medium, low Set clear number of overall items to validate. (i.e., total items not to exceed 100 for all risk types) Allocate number of items to each risk type according to principles of materiality Select allotted number of items per risk type (i.e., reserving risk, 20 items; premium risk, 15 items, etc.) Create quantitative and qualitative tools Leverage current Formalize any that is being done in an nontransparency manner Enhance current Create new solutions where: No exists New solutions are needed of Validation report specification Produce Initial results consistent with Produce report according to report specification of Identify breach of thresholds as outlined in the policy Escalate breaches to appropriate parties as per policy Short Term Impact: Make changes and improvements Long Term improvement planning Outcome Matrix dimension #1: risk type Comprehensive list of what to validate Dimension #2: what to validate? (finalized) Dimension #3: how to validate a selected item X risk type Validation Report Improved internal capital Page 8 3

4 Sample roadmap: putting it all together How? What? Risk types: 1, 2,..., N-1 Gaussian Copula Risk type N: Aggregation Final validated key output Free capital Risk type 1 Aggregation Market value assets capital Other liab. RM(1) +... RM(n) Discounted mean of liabilities BEL(1)+... BEL(n) capital (SCR) Technical provisions Insurance risk (premium & reserving) Market/ALM Credit Operational Best estimate of liabilities + risk margin Risk type N-1 Opening economic balance sheet SCR = Var(99.5%, one year) of basic own funds Page 9 Validation is a process Continuous improvement: each subsequent cycle should be more comprehensive and granular than the prior cycle Use test: the process is critical to foster strategic decision-making, e.g., risk-adjusted returns, capital allocation and so forth Initial Dry-run development and and calibration initial results Strategic decisions Validation Policy Apply tools and processes to dry-run results Final result production and reporting Validated/ improved development and calibration Analysis of results; conclude with improvements Page 10 Conclusion Internal is an essential part of good risk management The process is just as useful as the result Minimizes operational risks Internal enhances the use test risk-adjusted performance decisions can be made using a more transparent and credible. Internal is a critical element for internal approval for regulatory capital-setting purposes (outside of the US). Internal is likely to become a key part of NAIC ORSA. Internal is central to rating agency evaluations of internal s. Page 11 4

5 About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. Ernst & Young is a leader in serving the global financial services marketplace Nearly 35,000 Ernst & Young financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, Ernst & Young is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Office today includes more than 4,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. Ernst & Young professionals in our financial services practices worldwide align with key global industry groups, including Ernst & Young s Global Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, Ernst & Young s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. It s how Ernst & Young makes a difference Ernst & Young LLP. All Rights Reserved. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. 9/14/2011 Ernst & Young Assurance Tax Transactions Advisory 5

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