Prudential Regulation Authority Rulebook

8.1

The PRA’s quantitative framework for model assessment, in the context of the overall model review process, is structured around the internal model requirements and calibration standards. The PRA’s assessments are framed around these requirements so that the PRA is able to satisfy itself that the model meets the internal model requirements and calibration standards. In its assessments, the PRA applies a series of qualitative and quantitative tools to help identify areas of review focus. One of those tools is the quantitative framework for model reviews, which includes the use of specific quantitative indicators (‘QIs’) where risks are sufficiently homogeneous.

8.2

The PRA’s decision-making process will use a risk-based approach to determine areas of focus on a firm-by-firm basis. In this assessment process the PRA uses a series of indicators to determine the focus of review: these are both qualitative (eg a view on the embedding of the model from previous supervisory engagement) and quantitative.

8.3

The requirements which relate to calibration standards are set out in Solvency Capital Requirement – General Provisions 3.3 to 3.4. An assessment of these requirements is geared towards ensuring that the SCR produced by the model corresponds to the value at risk (VaR) of the firm’s basic own funds at the 99.5% confidence level over one year.^[13]

8.4

The PRA uses its quantitative framework as:

1. (a) a diagnostic tool to help assess model rigour and capital adequacy and hence highlight areas of potential concern;
2. (b) a prioritisation tool, to help inform where review teams should direct their attention, eg by identifying risks or correlations which may be under-calibrated; and
3. (c) one contributor to decision making at internal model permission application stage as to whether a firm has met the internal model requirements and calibration standards, and therefore whether permission to use the internal model for the purpose of calculating the SCR should be granted, including whether the PRA should impose any safeguards.

8.5

Internal models are required to be calibrated to the standard specified in Solvency Capital Requirement – General Provisions 3.4. Where risks are homogeneous, a PRA quantitative assessment of the calibration of individual risks and their dependency structures can give an efficient diagnosis of whether there are areas of potential concern where the model has not been calibrated adequately to meet the internal model requirements and calibration standards. Where the risks are largely (but not totally) homogeneous, the PRA will tailor its quantitative assessments to reflect a firm’s specific risk profile.

8.6

Quantitative tools are also important in helping the PRA to prioritise areas for early review where firms may not have calibrated their risks or correlations adequately. However, they are not determinative of the PRA’s final view of a model or model component. It is also worth noting that the PRA looks at the calibration of any model as a whole, as well as in its constituent parts, with particular consideration being given to whether the model remains appropriate in a range of conditions and over time when the balance of risks may change.

8.7

Finally, the outputs of this quantitative analysis constitute one of the many indicators that are taken into account by the PRA in concluding whether the model meets the internal model requirements and calibration standards. Specifically, while the PRA’s quantitative analysis assists in verifying that the calibration standards have been met it does not negate the need for other aspects of the model to be reviewed, including SQS in Solvency Capital Requirement – Internal Models 11.

8.8

As set out above, the operation of the quantitative framework does not yield a mechanistic ‘pass/ fail’ decision. It is worth highlighting once more that the PRA’s decision on whether or not to grant permission to use an internal model does not hinge on meeting any particular quantitative criterion. It hinges on the internal model itself, in conjunction with any safeguards to mitigate residual non-compliance with the internal model requirements and ensure compliance with calibration standards. It must also be emphasised that the use of the tools underlying the PRA’s quantitative framework is always tailored having regard to a firm’s own risk profile.