Further PRA reform of Solvency II implementation – internal models and reporting

This article was first published on Thomson Reuters Regulatory Intelligence on 17^th January 2018.

On 12 December 2017, the PRA published the second in a series of three consultation papers on reforms to the Solvency II regime (CP27/17).  The PRA's proposals are intended to reduce how often an insurer must apply for approval of changes to its internal model, specifically where approval is needed for an accumulation of minor changes. A process for quarterly model change reporting is also proposed.

The third, and final, consultation paper in the series (CP2/18) was published on 12 January 2018 and proposed some changes to reporting requirements.

CP21/17, the PRA's first consultation paper in this series, concerns the matching adjustment and is open for comments until 31 January 2018 (see our blog entry of 17 November 2017).

Other aspects of Solvency II that the PRA has confirmed it is looking at are:

• recalculation of the Transitional Measure on Technical Provisions – the PRA is looking at further simplification of the recalculation process; and
• external audit of Solvency and Financial Condition Report – the PRA is gathering evidence on whether its approach remains proportionate, particularly for smaller firms.

Responses to CP27/17 and CP2/18 are required by 20 March 2018 and 13 April 2018 respectively. This article looks, in particular, at changes proposed by CP27/17[1].

Wider context

The PRA's proposals reflect a commitment made to the House of Commons Treasury Committee to consider ways of reducing the regulatory burden imposed on insurers by the Solvency II regime.

In a report published on 27 October 2017, the Committee recommended that the PRA look at a number of areas, working in collaboration with industry.  On reporting, for example, the PRA should:

"set out proposals which reduce the amount of data required from firms to the level that the PRA can clearly demonstrate is proportionate and necessary for prudential safety".

Proposals in CP2/18 are intended to reduce the reporting burden imposed on smaller firms, in particular, in line with this recommendation.

Of particular relevance to CP27/17, the Committee advised that the PRA should:

"develop proposals for improving the sophistication and usefulness of internal models by (a) maximising the proportionality allowed in the [Solvency II] Directive for the approval of internal models and (b) simplifying the approval process for changes to models".

Evidence provided to the Committee argued that a particular concern for insurers was that "the process for gaining approval of changes to their models is … onerous and is expected to take several months".

The PRA's proposals in CP27/17 do not do much to change the process for obtaining approval for major changes to internal models, although they are designed to limit how often approval is needed.

PRA review of model change related processes, policies and reporting

Also published by the PRA on 12 December 2017, a statement sets out the results of a review of:

• the time it has taken to assess model change applications since the Solvency II regime came into force - the PRA reports that it approved 26 model change applications between 1 January 2016 and 7 December 2017. All of these were assessed within the six month time limit set by Solvency II legislation. On average, the PRA took just under four months to reach a decision;
• how firms had completed the Common Application Package (CAP) when making model change applications; and
• how firms have defined model changes in model change policies – the PRA looked in particular at how well firms have complied with EIOPA guidelines which state that model change policies should cover "all relevant sources of change" that would impact the SCR.

These findings have informed the changes now being proposed by the PRA.

CP27/17 proposals

Firms with an approved internal model must obtain PRA approval for the following types of change:

• a major change to an existing approved internal model – for these purposes, a "major change" can be one or more individual major changes or major change triggered by an accumulation of minor changes;
• an extension of scope to an approved internal model;
• a change to a firm's approved internal model change policy.

The same process is used for applications relating to major changes to a model or extensions in its scope; a standalone review process applies to applications to alter the internal model change policy.   Detailed guidance has been issued by the PRA on the model change process (see Supervisory Statement (SS) 12/16 ‘Solvency II: Changes to internal models used by UK insurance firms’) and on internal model change policies (see SS17/16 ‘Solvency II: internal models – assessment, model change and the role of non-executive directors’).

The PRA's latest proposals, which will be implemented via changes to this guidance, are as follows:

• Model change accumulations – The PRA proposes an annual reset of the internal model to reflect minor model changes accumulated throughout the year where those changes do not, in aggregate, trip a "major change" application and are not linked to a major model change. The purpose of this reset would be to reduce the frequency with which minor model changes trigger the requirement for a "major change" application. Firms are nonetheless invited to discuss minor changes accumulated throughout the year with their supervisor to avoid any misunderstanding.  Those discussions should be considerably less burdensome than making a new application. The PRA anticipates that firms will need to adjust their internal model change policies to allow for an annual reset. This will itself be subject to supervisory approval, following the procedure set out in paragraph 2.14 of SS12/16.

• Model change policies – A change to SS17/16 on the scope of firms' model change policies will make it clear that the PRA expects firms to define model changes in a way that covers a sufficiently broad range of potential sources of changes. Following its review of current practice (see above), this additional wording is expected to improve the consistency with which firms identify and report model changes.

• Minor model change reporting – SS17/16 already establishes that firms are expected to provide a quarterly summary of minor model changes to the PRA. In CP27/17, the PRA provides firms with an optional reporting template for those reports and aims to align the process for the submission of those reports with other Solvency II reporting obligations. The PRA argues that, whilst the use of a standardised template may slightly increase costs for firms, it expects them to have the same information to hand internally as part of their ongoing monitoring of adherence to model change policies. The additional burden for firms should, therefore, be minimal.

The updated guidance on the model change process and model change policies is expected to apply from the second quarter of 2018. The PRA expects that the changes in relation to minor model change reporting to take effect from June 2018.

Wider EU reform of Solvency II regime

The scope of the PRA's current programme of reform is, of course, constrained by the need to comply with Solvency II legislation. In evidence to the Treasury Committee, the PRA emphasised that there were aspects of the regime that it would like to change but could not.  The Committee recognised that the PRA could not always act on its own initiative and that it may look to discuss some changes as part of EIOPA's ongoing review of Solvency II.  However:

"the overriding priority is to develop a system of regulation which is right for the UK insurance industry, and which meets all the current and future needs of consumers, providing a prudent regulatory structure without stifling competition and innovation. We would expect the UK regulators—with close input from the industry and HM Treasury—to work on this task. It will be desirable to keep in step with the EU and other international initiatives as far as this is possible."

Post-Brexit, Solvency II constraints may be less relevant, of course, although the need to maintain equivalence of regulation may remain an important feature of the regulatory landscape.

[1]        Please note that this article was written before the publication, on January 16, 2018, of the PRA's interim response to the House of Commons Treasury Committee's report on Solvency II.