The validation exercise is a requirement of Solvency II. The purpose of the validation exercise is to ensure that the internal model provides a realistic and robust assessment of all the material risks faced by the insurance company or syndicate at the relevant point in time. It provides the Board with independent assurance that the modelling undertaken appropriately allows for the risks to the business and is compliant with Solvency II tests and standards.
Internal Model topics (ORSA, SII Reporting, IM Validation) will inevitably appear on the risks registers and internal audit universes of all Lloyd’s Syndicate managing agents (https://lloyds.com/market-directory/managing-agents), and insurance companies that have chosen to adopt an IM, as opposed to using the Standard Formula to determine regulatory capital.
For the internal audit of IM Validation, some internal audit teams will have dedicated specialist actuarial resource but many won’t have. Possible solutions are:
- Outsource or co-source to an external provider – this will be very expensive and no guarantee of internal audit quality
- Co-source from Group Internal Audit where the local IA team leads the audit and has technical support from the Group IA function
- Co-source with the local Actuarial or Actuarial Risk Management function where the local IA team leads the audit using an audit program derived from say Lloyd’s Minimum Standards (MS14) and has technical support from the Actuarial or Risk Management function. The remainder of this blog focuses on the practical application of this final option.
Internal Model Validation MS14
A great starting point is Lloyd’s Minimum Standard MS14, ‘Validation’. This provides a very useful internal audit program across all Validation topics, as follows:
- Validation Policy
- Validation Governance
- Validation Process
- Validation Tools
- Validation Report
- Risk Indicators
JCBFL has provided a checklist for adherence to all the provisions contained within MS14 (Internal Model Validation MS14 – gap analysis Template). This could be used to perform a gap analysis as part of the internal audit planning, for internal audit and co-sourced skills and resources scheduling as well as an outline internal audit program.
A few words on the validation topic Universe
Lloyd’s provides a very useful and contemporaneous guide to IM Validation (Internal Model Validation Guidance – December 2020).
The frequency and range of testing should be proportionate to model risk materiality and changes in the risk profile, i.e., it is not necessarily required to run all tests in all validation exercises. Lloyd’s, for example, requires that each component of a Managing Agent’s IM is reviewed in detail at least once every three years, this means that less material components do not require detailed validation every year (in the absence of change).
Tests that will usually be required every year are:
- Assessing the overall movements in the SCRs, in particular with reference to the underlying movements in the risk profile and validation of any model changes.
- Risk ranking, and any movements in the ranking compared with previous SCRs.
- Assessment of materiality of parameters (part of risk ranking) in order to assess the level of core validation necessary.
- Back-testing historical events or near-misses.
- P&L attribution.
- Stress and Scenario Testing, including Reverse Stress Testing.
- Stability/convergence testing.
- Model output must be validated every year.
The list is long but some examples might be
- Operational Risk
- Credit Risk
- Outwards reinsurance programmes
- Catastrophe Risk
- Events not in data (ENIDs)
- One year validation
- Expert judgment
- Dependencies and aggregation.
If you need assistance with any aspect of your internal auditing service offering, JCBFL can help.