When Chris Moulder, the PRA’s Director of General Insurance spoke at the Worshipful Company of Insurers’ iNED Forum in April, he repeated a common PRA refrain: the PRA is worried about internal model drift; and the risk that some firms will focus “on areas where the model is … ‘conservative’ (rather than on areas where capital might be … less adequate), [and] capital requirements [will] trend inappropriately downwards…” He went on to stress that the PRA would be monitoring that risk, and urged Boards to do the same. What he didn’t say was that the PRA was working on a new solution to this problem (if a problem’s what it is).
In Consultation Paper 22/16, “Solvency II: Monitoring model drift and standard formula SCR reporting for firms with an approved internal model“, the PRA is consulting on a proposed Supervisory Statement, which describes the PRA’s “expectation that firms with an approved internal model [will] privately report their standard formula SCR information on an annual basis” (emphasis supplied), before attaching a template, to “make it simpler” for them to do so.
If a firm reports this information, the PRA will use it as a way of monitoring solo, sector and industry-level internal model drift risk; and it will do this by comparing every firm’s internal model SCR against its (a) standard formula SCR; (b) pre-corridor MCR; (c) net written premiums; and (d) best estimate liabilities. The PRA will also calculate “model drift ratios from the point of model approval and re-base [them] following a change in risk profile or major model change [to] ensure that any drift is identified consistently and monitored over time“. If a firm’s model drift ratios deteriorate, this won’t generate an automatic capital add-on (as the PRA once seemed to suggest), but it might still lead to a supervisory review, so the PRA can better understand why the ratios have deteriorated, and whether further regulatory action is required.
These arrangements sound a lot like the PRA’s “Early Warning Indicators” of yesteryear, but – if that’s what they are – they seem to rest on new and firmer ground. Many commentators had argued that the EWIs; and (what sounded like) an automatic capital add-on, were likely to be unlawful “gold-plating” of a “maximum harmonising” Directive. The PRA’s proposals suggest that these criticisms have been heard, and the PRA has taken them at least partially into account, as it makes these proposals. This is because, for example, Supervisory Statements only “set flexible frameworks for firms, incorporating new and existing expectations … They do not set absolute requirements which are contained in rules”, so they cannot be directly enforced by the PRA or anyone else (see, for example, here). The difficulty, of course, is that supervisory expectations and rules feel like one and the same thing in practice. The PRA may not therefore be quite out of the woods yet.
The PRA’s consultation closes on 17 August 2016. Comments and enquiries should be sent to CP22_16@bankofengland.co.uk