Circular 4/2017: Guidance Notes on Changes to the Internal Model by Insurance Undertakings under BaFin Supervision

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Guidance notes on changes to the internal model by insurance undertakings under the supervision of the Federal Financial Supervisory Authority

27.04.2017

A. Preliminary remarks

This circular applies to all primary insurance and reinsurance undertakings as well as to all undertakings specified in section 262 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG ) for which use of a full or partial internal model has been approved for calculation of the solvency capital requirements (sections 111, 262 of the VAG ).

B. Guidance notes on changes to the internal model by insurance undertakings under the supervision of the Federal Financial Supervisory Authority

Those insurance groups, primary insurance and reinsurance undertakings that have obtained supervisory approval for their internal model have been able to use this since early 2016 for the purposes of calculating their solvency capital requirement. The scope of the approval is, however, limited to the model as set out in the documentation submitted with the application. Changes to the internal model can only be implemented with due consideration of specific requirements under supervisory law. The Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin ) therefore expects that insurance undertakings that implement changes to their internal model or their guidelines for model changes that have already been approved in accordance with section 111 (2) and (3) of the VAG , or in conjunction with section 262 (1) and section 261 (1) sentence 3 of the VAG (hereafter model changes), will observe the requirements set out below:

I. Summary

Changes to an internal model are treated in different ways under supervisory law (see Implementing Regulation ( EU ) 2015/460). In addition to model extensions ( e.g. incorporation of additional risk categories or business units), a distinction is also made between minor and major model changes. In addition to this, model changes can also be implemented to the guidelines for model changes. The following table provides an overview of the status of the current legal requirements for model approvals and extensions and for major and minor model changes.

Model approval and model extension
Application to use an internal model in accordance with section 111 of the VAG or in conjunction with sections 262 (1), 261 (1) sentence 3 and (2) of the VAG; documentation must be submitted in accordance with Article 2 of Implementing Regulation (EU) 2015/460 and, if applicable, in accordance with Article 343 et seq. of Delegated Regulation (EU) 2015/35, and the EIOPA Common Application Package must also be used. Major model change (as well as accumulation of minor model changes to form one major one) Application for a model change in accordance with section 111 (3) sentence 1 of the VAG; Article 7 of Implementing Regulation (EU) 2015/460 applies to the documentation to be submitted (in conjunction with recital 7 of Implementing Regulation (EU) 2015/460 for insurance groups), i.e. all documentation related to the model approval (see above) must be submitted which has been amended by the model change applied for.

This includes in particular the EIOPA Common Application Package as well as all documentation stated in Article 2 of the Implementing Regulation. As part of the self-assessment by the insurance undertaking, evidence must be provided that the internal model still fulfils all of the requirements for approval, including with due consideration of the changes implemented and requested. With group models or group internal models, the documentation affected by the model change must also be submitted in accordance with Article 343 or Article 347 respectively of the Delegated Regulation.

Minor model change
Quarterly report with cover letter, including documentation that explains the model change (Guideline 8 of the Guidelines on the use of internal models, EIOPA-BoS-14/180 EN) Change to the guidelines for model changes Applications for these are based on section 111 (3) sentence 1 of the VAG, Article 8 of the Implementing Regulation

There is also the option of merely updating the internal model without implementing a change in the aforementioned sense. In order to distinguish between this and minor model changes, however, this is only possible within a very narrow framework, such as with changes to parameters (see section 1.19 Guideline 6 of the Guidelines on the use of internal models, EIOPA -BoS-14/180 EN).

II. Differentiating between model extensions and major and minor model changes

Model extensions or a (partial) return to the standard formula do not represent a model change. A model extension can be assumed in all cases if major business units not taken into account up to now are to be incorporated within the scope of the internal model. This also includes the legal entities belonging to the group that had not previously been covered by the scope in the case of group models (Article 343 of the Delegated Regulation) or group internal models (Article 347 of the Delegated Regulation). The incorporation of additional risk modules or sub-modules also constitutes a model extension. The insurance undertakings must undergo a complete approval process for this in accordance with section 111 of the VAG and submit all documentation in accordance with Article 2 of the Implementing Regulation. (The Implementing Regulation also applies to insurance groups by way of recital 7). Any new submission of the documentation already provided can be waived following consultation with BaFin or the other supervisory authorities involved in or affected by the process. This applies in particular to the examples given in Guideline 10 of the Guidelines on the use of internal models, EIOPA -BoS-14/180 EN, for which the model change procedure applies in the same way as under Article 7 of the Implementing Regulation. The same applies to the extent that legal entities e.g. fall outside the scope of the internal model following a sale.

By contrast, model changes do take place if the insurance undertaking implements changes to its approved internal model within the scope of the internal guidelines for model changes.

Section 111 (2) sentence 2 of the
VAG distinguishes between major and minor model changes. An application for a model change is required for major model changes in accordance with section 111 (3) sentence 1 of the VAG . All documentation related to the model approval which has been amended by the model change application, must be enclosed with the application (Articles 7 and 8 of the Implementing Regulation). An estimation of the solvency capital requirement calculated with the standard formula at the lowest level of the standard formula for the last possible point in time before the date of the application must also be submitted in any case.

The insurance undertaking must stipulate which model changes are to be categorised as major and minor model changes in its internal guideline for model changes for its undertaking. The internal guideline for model changes must also determine the cases in which an accumulation of minor model changes constitutes a major model change.

Although only major model changes are subject to approval, BaFin must still be notified of minor model changes at least quarterly (Guideline 8 of the Guidelines on the use of internal models, EIOPA -BoS-14/180 EN).

A special case for model changes must be assumed whenever new laws, supervisory interpretative decisions or valuation methods are to be observed that have a corresponding influence on the internal model and whose implementation is mandatory, including at short notice in some cases. The extent to which this involves a major or minor model change must be evaluated in accordance with the internal guidelines.

If inconsistencies arise here between the method for calculating the probability distribution forecast and the methods for valuation of assets and liabilities in the solvency statement, then these must be documented and the effects must also be evaluated when viewed both in isolation as well as combined. In the case of a major model change, this must be communicated without undue delay to BaFin in accordance with III. together with the information stated above, with a model change application submitted directly after this.

If further applications are submitted to
BaFin with an approved internal model ( e.g. application for use of the volatility adjustment) that impact its modelling (sections 116 to 118 of the VAG ), its validation (section 120 of the VAG ), its integration into the organisation (sections 113 and 121 of the VAG ) or its use test (section 115 of the VAG ), then any such approval may also result in a major model change. An additional corresponding application must be submitted in these cases.

III. Interaction with
BaFin regarding major model changes

BaFin expects that an insurance undertaking will notify it as soon as possible of planned model changes and developments in the internal model. Once an insurance undertaking believes that a major model change (or several major model changes) is/are conceivable, it should therefore contact the BaFin unit responsible for the undertaking and provide the following information at a minimum:

a brief explanation of the intended model change(s), the reasons for the model change(s), the potential effects on the internal model (quantitative and qualitative), the intended schedule for submitting the application and for use, an illustration of whether and how major model changes relate to each other or to minor model changes and to the extent that model changes will lead to further model changes in future, the model change application should include an indication of these subsequent changes, and at least a rough schedule for their implementation.

A subsequent pre-application phase will generally be sensible for complex major model changes. Wherever possible, the content should be coordinated as part of this pre-application phase and it should be determined which documents the insurance undertaking should submit with the application.

Insurance undertakings should structure their internal processes in such a way that applications for model changes are only submitted to BaFin once per year wherever possible. This application may also be for multiple individual major model changes that are reviewed in one application procedure. It should be noted here that there may also merely be partial approvals granted in such cases with respect to individual model changes. This requires a detailed description of the qualitative and quantitative effects of each individual major model change on the approved internal model and its results (Article 7(2) of the Implementing Regulation) as well as in the overall consideration of all changes requested. The insurance undertakings should also be capable of submitting these types of analyses subsequently at short notice in those cases in which individual model changes are assessed as not eligible for approval during the six-month application phase.

At the same time, there may be a need to submit more than one application per year, e.g. with unexpected developments ( e.g. transactions that result in a significant change to the existing risk profile). Application procedures that overlap in terms of time must be avoided in such cases.

Major model changes may generally only be implemented and applied in the internal model following their approval. In individual justified cases, however, the amended model may be applied during the application procedure for approval of a major model change for internal company decision making processes ( e.g. fulfilment of the use test). BaFin must be expressly notified of this use with a detailed justification supplied together with the resolution from the Board. However, only the internal model approved before the reporting date may be used in all cases for the purposes of calculating the solvency capital requirements to be reported to BaFin under supervisory law as well as the supervisory publications.

IV. Interaction with
BaFin regarding the reporting and accumulations of minor model changes

At a minimum, the following documents have to be enclosed with any quarterly notification of minor model changes to BaFin (the principle of proportionality applies in particular to this section):

a cover letter signed by at least two individuals, with one of these being the person responsible for the risk management function, including

a list of the legal entities affected by the relevant model change; contact information for the relevant staff of the insurance undertaking from whom additional information can be requested regarding the relevant model change; a schedule of the model changes (in the event of multiple model changes)

o that clearly identifies the individual model change (identification code or similar), o that references the documents associated with the relevant model change, o and that states the reference date of the solvency capital calculation for which the model change has been used for the first time;

a description of the model changes and their implementation along with the reasons ( e.g. strengths, weaknesses and limitations) that have led to the decision on the model change; comprehensible reasoning for the categorisation as a minor model change and information on the internal approval procedure, including validation of the model change.

The effects of the model change are also to be explained, i.e. wherever possible

quantification of the model change (relevant
SCR figures with and without the model change) should, in addition to the solo levels and the group level, also be carried out at further levels relevant for use of the internal model ( e.g. management units, risk categories), with information being provided regarding how these quantifications were reached (complete model run-through, qualified estimate (details), aggregation level considered, etc. ); any improvement in risk identification and coverage as a result of the model change should be explained; and any improvement in risk decisions as a result of the model change should be described.

Furthermore, the insurance undertaking is required to outline the arrangements for integrating the model change into the insurance undertaking's risk management and internal control system, including the IT systems affected.

The notification must be provided prior to the quarterly reporting of the solvency capital requirement (QRTs). Shorter deadlines may be agreed between the insurance undertaking and BaFin .

BaFin also expects the insurance undertaking to maintain internal processes that implement the combination or accumulation of the reported minor model changes in accordance with the guidelines for model changes and monitor any transgression of the thresholds or qualitative criteria implemented in the guidelines for model changes that trigger a major change. BaFin must be notified as soon as an undertaking is able to foresee that a threshold may be exceeded and the measures stated under III. must be implemented.

In the event of a combination or accumulation of model changes, within the scope of the specifications in the guidelines on changing the model, the insurance undertaking must take the following aspects into account, provide justification for the procedure and, in cases of doubt, agree on the procedure with BaFin :

How to deal with minor model changes while the application phase is ongoing; The splitting up or merging of model changes as well as the issue of which model changes are to be accumulated and how; The point in time for the end and inception of a new accumulation, particularly in association with ongoing applications.

Unless the internal guideline stipulates otherwise, any suitable combination (accumulation) of minor model changes must already be implemented before an application for a major model change is submitted. The issue of whether there is a major model change involved as a result of a combination of minor model changes or if this is otherwise a major model change is irrelevant here. With approval of the major model change or of one of these for which an application is made, the date of the application shall be the new reference point for a new combination of the minor model changes implemented from this time onwards.

Nevertheless, there may be a supervisory requirement to take into account the combined qualitative and quantitative effects of minor model changes beyond a particular reference point.

V. Simultaneous applications for model changes and extensions

Simultaneous applications for model changes and extensions must be avoided, as there may be different results reached in the approval procedure. The situation may arise, for instance, where the application for an extension is categorised as eligible for approval while the application for a model change is not. The version of the model for which the application for an extension is supposed to apply must, however, be clear at all times. It is also not permissible under general procedural principles under administrative law to submit an application for an extension while stipulating that said application is only being submitted for the event that the application for a model change is approved. Applications for extensions should therefore only be submitted in reference to a "stable" version of the model, i.e. with no overlaps with applications for model changes.

VI. Changes to the guidelines for changing the internal model

Applications for changes to the guidelines for changing the internal model are governed by section 111 (3) of the VAG as well as Article 8 of the Implementing Regulation.
Aside from the application for a change signed by the management board of the insurance undertaking, it is expected that the application also contains

a new version of the change guidelines with tracked changes, a detailed justification for the model changes and a backtest, in the event of changes to the thresholds or quality-related criteria for differentiating of major and minor model changes, as well as for process changes, a declaration that the new processes will continue to guarantee that the internal model will consistently fulfil the requirements stated in sections 111 and 113 to 121 of the VAG , and those stated in section 112 of the VAG in the case of a partial internal model.

Insurance undertakings should address any further questions to their relevant contact at BaFin .

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