Solvency II reform makes sense through the "use test"!
"Use test", or how to transform a regulatory constraint into a competitive advantage. The Solvency II reform is often criticized for its implementation costs that will have a substantial impact on the pricing of insurance products, despite the fact that insurance companies have overcome the crisis fairly well. However, the reform can also be approached from another angle, more specifically as a vector of competitive advantage for companies that have an effective internal model in place, widely used within every hierarchy level.
Although the directive and EIOPA are quite explicit on this matter, each (re)insurance company stays nevertheless responsible to define its own selection criteria and the priority of implementation, depending on the business stakes (new products launch, profitability...), the operational efficiency (risk management...) and the set up costs.
For every (re)insurance company exploring the opportunities of setting up an internal model, the "use test" is an essential lever to achieve a positive ROI.
Rules highlighted by regulators
Briefly, the "use test" aims to prove that the internal model is not only used for calculating the Solvency II ratio, but also for taking decisions in risk management activities and the allocation of capital. As such, the internal model must serve and support the strategic objectives of maximizing value creation, minimization of capital needs and capital stability over time.
Beyond article 120 of the Solvency II directive "Test relative to the use of the model", the requirements regarding "use test" are very detailed in the level 2 implementation measures of EIOPA (Former Consultation Paper 56), proving the importance of this topic.
The application field of the "use test" can be relatively large because of the different activities it can improve by using it (risk management and monitoring, capital management, internal control). But contrary to Basel II reform for banks, the operational implementation will be limited to operational and executive management. For Basel II reform, the rating process is the key concern of the distribution network to control the level of solvency. In insurance, the stakes are different because the risk is inherent to the product price and the associated level of technical provisions.
Key point for the internal model validation
Solvency II reform is now in a phase of rush for activation, scheduled on January the 1st 2013. While Pillar 1 works (quantitative aspects - solvability ratio measure) are already well advanced and Pillar 3 (publication) contours are still under discussion, preparation of Pillar 2, dealing with risk management enhancement in a company's culture, becomes a priority.
The subject "compliance" includes mainly following aspects:
1. Risk governance
2. ORSA (Own Risk and Solvency Assessment)
3. "Use test"
Unlike the first two subjects, which are prerequisite for any (re)insurance company, the "use test" is only applied to entities with an internal model. As such, the "use test" will be part of the application file to validate any approach to internal model calculation. The way it is addressed in publications of the European Commission, the scope of "use test" can be extremely broad. Therefore preliminary work should be conducted to define the implementation priority.
For insurance companies it is an opportunity to make a profit on their internal model by showing that it is not only used for regulatory purposes, but also to enhance decision making during the execution of certain operational processes. Vis-à-vis the regulators, it will be a trust testimony towards the company's own internal model.
Operational implementation: pitfalls and key success factors
To show that the internal model plays an important role in the governance system, it is necessary to closely involve the "General Management" so they can make both the model's mechanism and results their own. This is a common prerequisite within risk management and ORSA works, where a company's general management has to engage and support the model. Thus, in order to pass the "use test" examination, one of the first actions to initiate is to schedule and prepare formations dedicated to the executive committee and the board of directors.
ORSA will certainly be one of the first bricks of the "use test", as a management tool that must be appropriated by different committees (risk, audit, executive) and ultimately by the board of directors, which will be responsible for ORSA results vis-à-vis legal authority and stakeholders. The ORSA will foster the development of a sensitivity control in relation to the assessment of the creditworthiness and the financial position at short, medium and long term.
The internal model should also be integrated as a tool for risk management activity and capital management.
One might imagine the following uses:
- Economic capital: parameter adjustment and optimization of the reinsurance strategy.
- Risk managers could be challenged regarding their regulatory capital consumption ...
So the application fields are numerous. All of them are not mandatory for the internal model validation, but they will give it certainly more credibility.
Conclusion: the "use test" is a major topic of the Solvency II reform, which will gain on importance in the eyes of the supervisors as the pre-application period goes on. Now it is up to the Solvency II project teams to launch the impulsion to prepare the different managerial stages.
EIOPA, European Insurance and Occupational Pensions Authority