Prudential Regulation Authority Rulebook

11.1

A firm must ensure that its internal model and, in particular, the calculation of the probability distribution forecast generated by it, complies with 11.2 to 11.13.

[Note: Art. 121(1) of the Solvency II Directive]

11.2

The methods used to calculate the probability distribution forecast must be:

1. (1) based on adequate, applicable and relevant actuarial and statistical techniques;
2. (2) based upon current and credible information and realistic assumptions that make adequate allowance for uncertainty; and
3. (3) consistent with the methods used to calculate technical provisions, except where this would result in the firm failing to comply with 11.6.

[Note: Art. 121(2) of the Solvency II Directive]

11.3

A firm must be able to justify the assumptions underlying its internal model to the PRA.

[Note: Art. 121(2) of the Solvency II Directive]

11.4

1. (1) Data used for the internal model must be accurate, complete and appropriate.
2. (1A) Data used in the internal model shall only be deemed complete for the purposes of 11.4(1) where data are available for all relevant internal model parameters and no such relevant data are excluded from use in the internal model without justification.
3. (2) A firm must update the data sets used in the calculation of the probability distribution forecast at least annually, and collect, process and apply data in a transparent and structured manner.

[Note: Art. 121(3) of the Solvency II Directive]

11.5

Without limiting the operation of 11.2, irrespective of the method chosen to calculate the probability distribution forecast, the ability of the internal model to rank risk must be sufficient to ensure that it is widely used and plays an important role in the system of governance of the firm, in particular in its risk-management system and decision-making processes, and capital allocation in accordance with 10.1.

[Note: Art. 121(4) of the Solvency II Directive]

11.6

The internal model must cover all of the material risks to which the firm is exposed, including at least the risks set out in Solvency Capital Requirement – General Provisions 3.3(1).

[Note: Art. 121(4) of the Solvency II Directive]

11.6A

For the purposes of 11.6, a firm must assess, at least on a quarterly basis, whether the internal model covers all material quantifiable risks within its scope. The assessment must take into account an appropriate set of qualitative and quantitative indicators.

11.6B

The qualitative indicators referred to in 11.6A must include any risks identified in the ORSA that are not included in the coverage of the internal model.

11.7

In its internal model, a firm must:

1. (1) accurately assess:
1. (a) the particular risks associated with financial guarantees and any contractual options, where material; and
2. (b) the risks associated with both policyholder options and the firm’s contractual options,
2. taking into account the impact that future changes in financial and non-financial conditions may have on the exercise of those options; and
3. (2) take account of all payments to policyholders which it expects to make, whether or not those payments are contractually guaranteed.

[Note: Art. 121(7) and (9) of the Solvency II Directive]

11.8

A firm’s internal model must only take into account:

1. (1) as regards diversification effects, dependencies within and across risk categories, if the firm’s system for measuring those diversification effects is adequate;
2. (2) the effect of risk-mitigation techniques, if and to the extent that credit risk and other risks arising from the use of risk-mitigation techniques are properly reflected (in accordance with 11.10) in the internal model; and
3. (3) future management actions, if and to the extent that:
1. (a) they are future management actions that the firm would, in a manner consistent with Technical Provisions – Further Requirements 8.1 – 8.5, applied in the context of this Part, reasonably expect to carry out in specific circumstances; and
2. (b) the firm makes allowance in its internal model for the time and expenses necessary to implement those actions.

[Note: Art. 121(5), (6) and (8) of the Solvency II Directive]

11.9

A firm’s system used for measuring diversification effects referred to in 11.8(1) shall only be considered adequate where it:

1. (1) identifies the key variables driving dependencies; and
2. (2) takes into account all of the following:
   1. (a) any non-linear dependence and any lack of diversification under extreme scenarios;
   2. (b) any restrictions of diversification which arise from the existence of a ring-fenced fund or matching adjustment portfolio; and
   3. (c) the characteristics of the risk measure used in the internal model.

11.10

In order to comply with 11.8(2), a firm must not include risks arising from any of the following situations:

1. (1) the contractual arrangements relating to the risk-mitigation technique are, in any relevant jurisdiction, not legally effective and enforceable or do not ensure that the transfer of risk is clearly defined and incontrovertible;
2. (2) the firm does not have a direct claim on the counterparty in the event of the default, insolvency or bankruptcy of the counterparty or other credit event set out in the transaction documentation to the arrangements relating to the risk-mitigation technique; and
3. (3) the legal arrangements underlying the risk-mitigation technique do not contain an explicit reference to a specific risk exposure clearly defining the extent of the cover provided by the risk-mitigation technique.

11.11

Where the risk-mitigation technique referred to in 11.10(3) does not cover the risk exposure of the firm in all cases, a firm must ensure that its internal model takes into account the reduced effectiveness of the risk-mitigation technique resulting from this deviation of risk exposures, in order to comply with 11.8(2).

11.12

Where a risk-mitigation technique is subject to a condition, the fulfilment of which is outside the direct control of the firm and which could undermine the effective transfer of risk, a firm must ensure that its internal model takes into account the effect of the condition and any reduced effectiveness of that risk-mitigation technique, in order to comply with 11.8(2).

11.13

1. (1) Where a firm uses in its internal model parts obtained from a third party, in order for the internal model to be considered adequate the firm must be able to demonstrate a sufficient understanding of those parts, including their limitations, such that the firm can:
   1. (a) provide meaningful challenge in order to ensure that those parts operate to achieve the overall purpose for which they were developed; and
   2. (b) explain how the operation of those parts enables the internal model and, if the context requires, the firm to comply with the internal model requirements and Solvency Capital Requirement – General Provisions 3.3 and 3.4.
2. (2) Where a firm uses in its internal model data obtained from a third party, in order for those data to be considered to be appropriate, a firm must be able to demonstrate a sufficient understanding of those data, including their limitations.