Circular NBB_2016_27 / Circular on guidelines regarding the use of internal models under Solvency II

NBB_2016_27 – 12 May 2016 Circular – Page 1/18 14 Berlaimont Boulevard – BE-1000 Brussels tel. +32 2 221 38 12 – fax +32 2 221 34 01 company number: 0203.201.340 RPM Brussels www.bnb.be

Circular
Brussels, 12 May 2016
Reference: NBB_2016_27 your correspondents:
Dieter Hendrickx / Jérôme Bourtembourg tel. +32 2 221 34 29 / 33 93 – fax +32 2 221 31 04 dieter.hendrickx@nbb.be / jerome.bourtembourg@nbb.be

Circular on guidelines regarding the use of internal models under Solvency II

Scope
Belgian insurance or reinsurance undertakings.
Insurance or reinsurance undertakings forming part of a Belgian group within the meaning of Article 339, 2° of the Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings.
Belgian undertakings forming part of a Belgian financial conglomerate within the meaning of Article 340, 1° of the aforementioned Law of 13 March 2016.
Branches of third-country undertakings carrying on insurance [or reinsurance] activities in Belgium.
This communication applies to mutual insurance companies defined in Article 15, 79° of the aforementioned Law of 13 March 2016. For these undertakings, "the Bank" should be replaced by "the Office for the Supervision of Mutualities and National Unions of Mutualities" as defined in Article 15, 84° of the same Law. This communication does not apply to insurance undertakings referred to in Articles 275, 276 or 294 of the aforementioned Law of 13 March 2016.

Subject
This circular aims to explain the Bank's guidelines on the use of internal models under Solvency II.

Legal References
The Law: the Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings.
Regulation 2015/35: Delegated Regulation (EU) 2015/35 of the Commission of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance.

Circular – Page 2/18 NBB_2016_27 – 12 May 2016

Implementing Regulation 2015/460: Implementing Regulation (EU) 2015/460 of the Commission of 19 March 2015 laying down implementing technical standards with regard to the procedure for the approval of an internal model, in accordance with Directive 2009/138/EC of the European Parliament and of the Council.

Structure
I. Objectives
II. Definitions
III. Additional Information
IV. Entry into Force
V. Guidelines on the use of internal models

NBB_2016_27 – 12 May 2016 Circular – Page 3/18

Madam,
Sir,

I. Objectives
This circular relates to Articles 167-170, 174-188 and 374-375 of the Law and to Title I, Chapter VI, and Title II, Chapter II of Regulation 2015/35.
It aims to provide additional specifications on the considerations to be taken into account by insurance or reinsurance undertakings to enable the Bank to approve and continue to authorize the use of an internal model to calculate the Solvency Capital Requirement in accordance with the requirements of the Law and as specified in Regulation 2015/35. Unless explicitly stated otherwise, all guidelines apply to the use:

• of an internal model, full or partial, submitted for a decision on its use, or currently used, to calculate the Solvency Capital Requirement of an insurance or reinsurance undertaking;
• of a group internal model, full or partial, as defined below, submitted for a decision on its use, or currently used, to calculate the Solvency Capital Requirement.

II. Definitions
For the purposes of the guidelines, the following definitions apply:

• "group internal model(s) (or groups)": both the internal model whose use is solely requested for the calculation of the Solvency Capital Requirement of the consolidated group (referred to in Article 373 of the Law) and the internal model whose use is requested for the calculation of the Solvency Capital Requirement of the consolidated group as well as the Solvency Capital Requirement of at least one affiliated undertaking included in the scope of this group internal model for the calculation of the Solvency Capital Requirement of the consolidated group (designated as the group internal model referred to in Articles 374 and 375 of the Law in the guidelines).
• The notion of "richness of the predictive probability distribution" has two main dimensions: the extent of the undertaking's knowledge of the risk profile, as reflected in the set of events underlying the predictive probability distribution, and the ability of the chosen calculation method to transform this information into a distribution of monetary values relating to changes in basic own funds. The notion of richness should not be reduced to the level of detail of the representation of the predictive probability distribution because even a forecast in the form of a continuous function can be of low richness.
• The "reference risk measure" should be understood as the Value-at-Risk of basic own funds with a confidence level of 99.5% over a one-year horizon as provided for in Article 151, paragraph 3, of the Law.
• The "closed analytical formula" should be understood as a direct mathematical formula linking the risk measure chosen by the undertaking to the reference risk measure, as defined above.
• "t=0" should be understood as the date of calculation of the Solvency Capital Requirement by the undertaking according to its internal model.
• "t=1" should be understood as one year after the date of calculation of the Solvency Capital Requirement by the undertaking according to its internal model.
  In the absence of a definition in these guidelines, terms have the meaning defined in the legislative acts referred to in the introduction.

Circular – Page 4/18 NBB_2016_27 – 12 May 2016

III. Additional Information
This circular is set within the framework of the harmonized implementation of the principles of Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), as this implementation has been determined by the guidelines of the European Insurance and Occupational Pensions Authority. Undertakings may, for information purposes, consult these guidelines at the following address: https://eiopa.europa.eu/publications/eiopa-guidelines.

IV. Entry into Force
This circular applies from 23 March 2016.

V. Guidelines on the use of internal models
Chapter 1: Application
Guideline 1 – Pre-application or ‘pre-application’ To assess the progress of an insurance or reinsurance undertaking in its preparation for an application for the use of an internal model to calculate the Solvency Capital Requirement in accordance with the law and its ability to satisfy the internal model requirements set out in the law, undertakings are strongly encouraged to participate in a ‘pre-application’ procedure as described in the corresponding communication from the Bank.

Guideline 2 – Information to be submitted for an application for the use of group internal models referred to in Articles 374 and 375 of the Law In the event of an application for the use of a group internal model referred to in Articles 374 and 375 of the Law, the applicant should include for each affiliated undertaking requesting the use of the group internal model to calculate its Solvency Capital Requirement, the information referred to in Article 2 of Implementing Regulation 2015/460, specific to that affiliated undertaking, unless this information is already included in the documents submitted by the participating insurance or reinsurance undertaking. The applicant should also explain, for each affiliated undertaking included in the application for the use of the group internal model to calculate its Solvency Capital Requirement, to what extent the development, implementation or validation of the components of the group internal model necessary for the calculation of the Solvency Capital Requirement of the affiliated undertaking are carried out by another affiliated undertaking within the group.

Guideline 3 – Request for additional information in the event of an application for the use of group internal models In the event of an application for the use of a group internal model, a request for the provision of additional information addressed to an affiliated undertaking by the supervisory authorities participating in the assessment of the application, as defined in Article 343, paragraph 2, of Regulation 2015/35, responsible for the supervision of that undertaking, should first be addressed to the group supervisor. The group supervisor should then forward the request to the affiliated undertaking or provide it to the supervisory authority participating in the assessment of the application, if it has already been provided to the group supervisor.

NBB_2016_27 – 12 May 2016 Circular – Page 5/18

In the event of an application for the use of a group internal model referred to in Articles 374 and 375 of the Law, any concerned supervisory authority, as defined in Article 347, paragraph 3, of Regulation 2015/35, should be able to request additional information directly from the affiliated undertaking it supervises in order to assess the compliance of the group internal model with the internal model requirements regarding the Solvency Capital Requirement of that affiliated undertaking. In this case, this concerned supervisory authority should inform the group supervisor of this information request without delay.

Guideline 4 – Intention to expand the scope of an application for the use of group internal models In the event of an application for the use of a group internal model, as part of the justification of the scope of the internal model referred to in Article 343, paragraph 5, or Article 347, paragraph 6, of Regulation 2015/35, the applicant should describe in the application its intention, if any, to expand the scope of the internal model in the future to include, for the purpose of calculating the Solvency Capital Requirement of the group, one or more of the affiliated undertakings under the group's supervisory scope, which are not included in the current application in the scope of the internal model for the calculation of the Solvency Capital Requirement of the group. In the event of an application for the use of a group internal model referred to in Articles 374 and 375 of the Law, as part of the justification of the scope of the internal model, the applicant should also describe its intention, if any, to expand the scope of the internal model in the future to include the calculation of the Solvency Capital Requirement of any affiliated undertaking which is not included in the current application scope to calculate its Solvency Capital Requirement with the group internal model.

Guideline 5 – Technical specifications in the event of an application for the use of group internal models referred to in Articles 374 and 375 of the Law In the event of an application for the use of a group internal model referred to in Articles 374 and 375 of the Law, the applicant should explicitly indicate in its application to what extent the technical specifications of the group internal model may differ when the internal model is used to calculate the Solvency Capital Requirement of the group and the Solvency Capital Requirement of the affiliated undertakings, including:
a) the treatment of intragroup transactions for calculating both the Solvency Capital Requirement of the affiliated undertakings and, where applicable, the Solvency Capital Requirement of the group; b) the list of parameters within the internal model that may be determined differently for different calculations performed with the group internal model, for the purpose of calculating the Solvency Capital Requirement of the group and the Solvency Capital Requirement of individual undertakings; and c) the description of group-specific risks relevant only for the calculation of the Solvency Capital Requirement of the group.

Chapter 2: Model Modifications
Guideline 6 – The scope of the model modification policy When establishing the model modification policy, the insurance or reinsurance undertaking should ensure that this policy covers all sources of modification having an impact on their Solvency Capital Requirement and at least the modifications concerning:
a) the undertaking's governance system; b) the undertaking's compliance with the internal model use requirements; c) the adequacy of the technical specifications of the undertaking's internal model; and d) the undertaking's risk profile.

Circular – Page 6/18 NBB_2016_27 – 12 May 2016

The undertaking should also ensure that the model modification policy:
a) specifies when a modification of the internal model should be considered major or minor and when a combination of minor modifications should be considered a major modification; b) sets out governance requirements concerning internal model modifications, including internal approval, internal communication, documentation and validation of modifications. The insurance and reinsurance undertaking should not consider the inclusion of new elements, such as the inclusion of additional risks or operational units, as part of the internal model modifications in accordance with the internal model modification policy. The inclusion of new elements in the internal model should be subject to the approval of the supervisory authority according to the procedure referred to in Article 7 of Implementing Regulation 2015/460. The insurance or reinsurance undertaking should take into account the updating of internal model parameters as a potential source of internal model modifications.

Guideline 7 – Defining a major modification
Although the quantitative impact of a model modification on the Solvency Capital Requirement or on individual components of the Solvency Capital Requirement may be one of the indicators that the insurance or reinsurance undertaking decides to use to identify major modifications, the undertaking should develop and use a number of other key qualitative and quantitative indicators to define a major modification.

Guideline 8 – Declaring minor modifications and major modifications as a combination of minor modifications The insurance or reinsurance undertaking should declare minor modifications of the internal model to the supervisory authorities every quarter or more frequently, where applicable. Minor modifications of the internal model should be communicated in a summary report describing both the quantitative and qualitative impacts of the modifications and the approximate cumulative quantitative and qualitative effects of the modifications on the approved internal model. The insurance or reinsurance undertaking should use the last internal model approved by the supervisory authorities as a reference to assess whether a combination of minor modifications is considered a major modification, unless otherwise agreed with the supervisory authorities.

Guideline 9 – Model modification policy for group internal models referred to in Articles 374 and 375 of the Law In the case of a group internal model referred to in Articles 374 and 375 of the Law, the participating undertaking and the affiliated undertakings requesting the use of a group internal model to calculate their individual Solvency Capital Requirement should develop a model modification policy. The participating undertaking and the affiliated undertakings requesting the use of a group internal model to calculate their individual Solvency Capital Requirement should ensure that the model modification policy specifies major and minor modifications related to the group as well as each of the affiliated undertakings included in the application for the use of the group internal model to calculate their individual Solvency Capital Requirement. The participating undertaking and the affiliated undertakings requesting the use of a group internal model to calculate their individual Solvency Capital Requirement should ensure that any modification considered major for an affiliated undertaking included in the application is classified as a major modification in the policy.

NBB_2016_27 – 12 May 2016 Circular – Page 7/18

Guideline 10 – Extension of use and extension of the scope of group internal models referred to in Articles 374 and 375 of the Law The following extensions of the group internal model should be submitted to the group supervisor by the applicant applying the same process as that applied to a major modification of the internal model referred to in Article 7 of Implementing Regulation 2015/460:
a) the extension concerning the calculation of the Solvency Capital Requirement of an affiliated undertaking currently included in the scope of the group internal model to calculate the Solvency Capital Requirement of the group but not currently using the group internal model to calculate its Solvency Capital Requirement; b) the extension concerning the coverage of new elements at the group level; and c) the extension concerning the coverage of new elements at the level of an affiliated undertaking currently using the group internal model to calculate its Solvency Capital Requirement, including the extension concerning elements already used at the group level or by other affiliated undertakings.

Chapter 3: Use Test
Guideline 11 – Incentive to improve the quality of the internal model The insurance or reinsurance undertaking should ensure that the internal model is used in its risk management system and in its decision-making processes in a manner that incentivizes the improvement of the quality of the internal model itself.

Guideline 12 – Use test and internal model modifications As part of the improvement of the quality of the internal model, when a major modification has been approved internally by the legal administrative body, the insurance or reinsurance undertaking should be able to demonstrate its compliance with the internal model use test by taking into account:
a) the different components of the use test; b) the different uses of its governance system.
The insurance or reinsurance undertaking should monitor and be able to demonstrate that any gap between the detection of the need for an internal model modification and the effective implementation of the modification is appropriate. In the event of the application of a major modification during the approval period, the insurance or reinsurance undertaking should ensure that the use of the internal model in its decision-making process is appropriate.

Guideline 13 – Understanding the internal model The insurance or reinsurance undertaking should consider different approaches to ensure the understanding of the internal model by the legal administrative body and by the concerned users of the internal model for decision-making purposes. To assess their understanding of the internal model, the Bank may interview persons from the legal administrative body and persons effectively managing the insurance or reinsurance undertaking. The Bank may also examine the documentation of the minutes of board of directors meetings or appropriate decision-making bodies to assess the compliance of the insurance or reinsurance undertaking with the requirements of the internal model use test.

Guideline 14 – Contribution to decision-making The insurance or reinsurance undertaking should ensure that the internal model is used for decision-making and it should be able to demonstrate this use.

---

Circular – Page 8/18 NBB_2016_27 – 12 May 2016

In particular, when calculating the notional amount of the Solvency Capital Requirement for a segregated portfolio, the insurance or reinsurance undertaking should comply with Article 81 of Regulation 2015/35 and explain how it ensures consistency between these results as provided for in Article 223 of Regulation 2015/35.

Guideline 15 – Specificities of the model use test for group internal models referred to in Articles 374 and 375 of the Law

The participating undertaking and the related undertakings requesting the use of a group internal model under Articles 374 and 375 of the Law to calculate their individual Solvency Capital Requirement should cooperate to ensure that the design of the internal model is consistent with their business. They should provide evidence that the governance of the internal model provides for:

a) their individual Solvency Capital Requirement is calculated with the frequency provided for in Article 152 of the Law and whenever necessary within the decision-making process; b) they can propose modifications to the group internal model, notably for components important to them or following a change in their risk profile and taking into account the environment in which the undertaking operates; c) the related undertakings have an adequate understanding of the internal model with regard to the parts of the internal model covering the risks of these undertakings.

Insurance or reinsurance undertakings requesting the use of a group internal model to calculate their Solvency Capital Requirement should ensure that the design of the internal model is consistent with their business and their risk management system, including the production of results, at both the group level and the level of the related undertaking, detailed enough to allow the group internal model to play a sufficiently important role in their decision-making processes.

Chapter 4: Definition of assumptions and expert judgment

Guideline 16 – Relative importance in the definition of assumptions

The insurance or reinsurance undertaking should define assumptions and use expert judgment, notably by taking into account the relative importance of the impact of the use of assumptions with regard to the following guidelines on the definition of assumptions and expert judgment.

The insurance or reinsurance undertaking should assess the relative importance taking into account both quantitative and qualitative indicators and extreme loss conditions. The insurance or reinsurance undertaking should assess the considered indicators globally.

Guideline 17 – Governance of the definition of assumptions

The insurance or reinsurance undertaking should ensure that any definition of assumptions and, notably, the use of expert judgment follows a validated and documented process.

The insurance or reinsurance undertaking should ensure that assumptions are established and used consistently over time and throughout the insurance or reinsurance undertaking and that they are fit for the purpose for which they are intended.

The insurance or reinsurance undertaking should approve assumptions at sufficiently high levels according to their relative importance, ranging from the most important assumptions up to the legal administrative body.

Guideline 18 – Communication and uncertainty in the definition of assumptions

The insurance or reinsurance undertaking should ensure that processes concerning assumptions, and notably the use of expert judgment in the choice of these assumptions, specifically attempt to mitigate the risk of misunderstanding or poor communication between all the different roles related to these assumptions.

NBB_2016_27 – 12 May 2016 Circular – Page 9/18

The insurance or reinsurance undertaking should put in place a formal and documented feedback process between providers and users of material expert judgment and resulting assumptions.

The insurance or reinsurance undertaking should ensure the transparency of the uncertainty of assumptions as well as the variation of final results linked to it.

Guideline 19 – Documentation of the definition of assumptions

The insurance or reinsurance undertaking should document the process of defining assumptions and, notably, the use of expert judgment, so as to ensure the transparency of this process.

The insurance or reinsurance undertaking should include in the documentation the resulting assumptions and their relative importance, the experts who participated in their definition, the intended use and the validity period.

The insurance or reinsurance undertaking should include the justification of the opinion, including the information base used, with the degree of detail necessary to ensure the transparency of both the assumptions and the processes and decision-making criteria used to select the assumptions and reject other alternatives.

The insurance or reinsurance undertaking should ensure that users of important assumptions receive clear and complete written information concerning these assumptions.

Guideline 20 – Validation of the definition of assumptions

The insurance or reinsurance undertaking should ensure that the process applied to retain assumptions and use expert judgment is validated.

The insurance or reinsurance undertaking should ensure that the process and tools used to validate assumptions and notably the use of expert judgment are documented.

The insurance or reinsurance undertaking should track changes in important assumptions in response to new information and analyze and explain these changes as well as deviations of results from important assumptions.

When feasible and appropriate, the insurance or reinsurance undertaking should use validation tools, such as stress tests or sensitivity tests.

The insurance or reinsurance undertaking should re-examine the retained assumptions, based on independent internal or external expertise.

The insurance or reinsurance undertaking should detect the occurrence of circumstances in which assumptions would be considered false.

Chapter 5: Methodological consistency

Guideline 21 – Consistency check-points

The insurance or reinsurance undertaking should ensure consistency between the methods used to calculate the predictive probability distribution and the methods used to value the assets and liabilities of the balance sheet for solvency purposes.

Circular – Page 10/18 NBB_2016_27 – 12 May 2016

The insurance or reinsurance undertaking should check the consistency of the calculation of the predictive probability distribution at the following stages, where they are relevant to the part of the model examined:

a) the consistency of the transition from the valuation of assets and liabilities of the balance sheet for solvency purposes to the internal model for the purposes of Solvency Capital Requirement calculations; b) the consistency of the valuation of assets and liabilities of the internal model at the valuation date with the valuation of assets and liabilities of the balance sheet for solvency purposes; c) the consistency of the projection of risk factors and their impact on monetary predictive values with the assumptions concerning these risk factors used to value the assets and liabilities of the balance sheet for solvency purposes; d) the consistency of the revaluation of assets and liabilities at the end of the period with the valuation of assets and liabilities of the balance sheet for solvency purposes.

Guideline 22 – Aspects of consistency

When assessing consistency, the insurance or reinsurance undertaking should at least take into account the following aspects:

a) the consistency of actuarial and statistical techniques applied to the valuation of assets and liabilities of the balance sheet for solvency purposes, as well as to the calculation of the predictive probability distribution; b) the consistency of the data and parameters used as input data for the respective calculations; c) the consistency of the assumptions underlying the respective calculations, notably assumptions on contractual financial options and guarantees, future management decisions, and future discretionary benefits.

Guideline 23 – Assessment of consistency

The insurance or reinsurance undertaking should carry out regular assessments of consistency on a quantitative basis whenever this is possible and proportionate.

As part of its assessment of consistency, the insurance or reinsurance undertaking should:

a) detect and document any discrepancy between the calculation of the predictive probability distribution and the valuation of assets and liabilities of the balance sheet for solvency purposes; b) assess the impact of discrepancies, both in isolation and in combination; c) check that discrepancies do not result in inconsistency between the calculation of the predictive probability distribution and the valuation of assets and liabilities of the balance sheet for solvency purposes.

Chapter 6: Predictive probability distribution

Guideline 24 – Knowledge of the risk profile

In order to ensure that all events in the predictive probability distribution underlying the internal model are exhaustive, the insurance or reinsurance undertaking should put in place processes enabling it to maintain sufficient and up-to-date knowledge of its risk profile.

In particular, the insurance or reinsurance undertaking should aim to maintain knowledge of risk factors and other factors explaining the behavior of the variable underlying the predictive probability distribution, so that the predictive probability distribution can reflect all relevant characteristics of the risk profile.

NBB_2016_27 – 12 May 2016 Circular – Page 11/18

Guideline 25 – Richness of the predictive probability distribution

When assessing the adequacy of the actuarial and statistical techniques used to calculate the predictive probability distribution [Article 229 of Regulation 2015/35], the insurance or reinsurance undertaking should consider the ability of the techniques to treat knowledge of the risk profile as an important criterion.

The insurance or reinsurance undertaking should choose techniques producing a predictive probability distribution sufficiently rich to take into account all relevant characteristics of its risk profile (Article 229, point e), of Regulation 2015/35) and to contribute to decision-making (Article 226 of Regulation 2015/35).

In accordance with Article 229, point g), of Regulation 2015/35 and as part of this methodological assessment, the insurance or reinsurance undertaking should examine the reliability of unfavorable quantiles resulting from the predictive probability distribution.

Guideline 26 – Assessment of the richness of the predictive probability distribution

In order to form an opinion in accordance with Guideline 25, the Bank takes into account at least:

a) the risk profile of the undertaking and the extent to which it is reflected by the predictive probability distribution; b) the evolution of actuarial techniques and generally accepted market practices (Article 229, point a), of Regulation 2015/35); c) with regard to the level of richness of the predictive probability distribution, any measure that the insurance or reinsurance undertaking puts in place to ensure compliance with each test and standard relating to the internal model referred to in Articles 174 to 188 of the Law; d) for a particular risk examined, the way in which the techniques retained and the predictive probability distribution obtained by the insurance or reinsurance undertaking interact with other risks within the scope of the internal model with regard to the level of richness of the predictive probability distribution (Article 232 of Regulation 2015/35); e) the nature, scale, and complexity of the risk examined as provided for by the principle of proportionality.

Guideline 27 – Enrichment of the predictive probability distribution

The insurance or reinsurance undertaking should ensure that the efforts made to produce a rich predictive probability distribution do not compromise the reliability of the estimation of unfavorable quantiles resulting from the predictive probability distribution.

The insurance or reinsurance undertaking should take care not to introduce into the predictive probability distribution an unfounded richness not reflecting the initial knowledge of its risk profile (see also Guideline 24).

The insurance or reinsurance undertaking should ensure that the method applied to enrich the predictive probability distribution is consistent with statistical quality standards concerning methods, assumptions, and data (Articles 229, 230, and 231 of Regulation 2015/35). If these techniques involve the use of expert judgment, the undertaking should take into account the relevant guidelines on the definition of assumptions and expert judgment.

Chapter 7: Calibration - approximations

Guideline 28 – Knowledge of approximations under extreme loss conditions

When an undertaking uses approximations instead of directly using the reference risk measure, the insurance or reinsurance undertaking should challenge and justify the reliability of the result of these approximations over time and under extreme loss conditions, in accordance with its risk profile.

Circular – Page 12/18 NBB_2016_27 – 12 May 2016

In particular, when an insurance or reinsurance undertaking uses closed analytical formulas to recalibrate its capital requirement from the internal risk measure to the reference risk measure, the insurance or reinsurance undertaking should demonstrate that the assumptions underlying the formulas are realistic and are also valid under extreme loss conditions.

Guideline 29 – Use of another underlying variable

If it uses the variation of an underlying variable other than basic own funds to establish the value of basic own funds for the calculation of the Solvency Capital Requirement, the insurance or reinsurance undertaking should demonstrate that:

a) it is able to reconcile the difference between basic own funds and the underlying variable at t=0; b) it understands the difference between basic own funds and the underlying variable in all situations including up to t=1, particularly under extreme loss conditions, in accordance with the undertaking's risk profile.

Guideline 30 – Management decisions in the case of the use of a period greater than one year

If the insurance or reinsurance undertaking chooses a period greater than one year in its internal model, the insurance or reinsurance undertaking should take into account management decisions in terms of management within the calculation of the Solvency Capital Requirement and should ensure that these decisions have effects on the balance sheet for solvency purposes between t=0 and t=1.

Chapter 8: Attribution of profits and losses

Guideline 31 – Definition of profits and losses

The insurance or reinsurance undertaking should consider profits and losses as modifications during the relevant period:

a) of basic own funds; or b) of other monetary amounts used in the internal model to determine modifications of basic own funds, such as the actual modification of economic capital resources.

For this purpose, the attribution of profits and losses should exclude movements attributable to the raising of additional own funds, the repayment or capitalization of these funds, and the distribution of own funds.

When using a variable other than own funds in its internal model, the insurance or reinsurance undertaking should use this variable for the purposes of the attribution of profits and losses.

The undertaking should define, by means of the attribution of profits and losses, how modifications of risk factors relate to the evolution of the variable underlying the predictive probability distribution.

Chapter 9: Validation

Guideline 32 – Validation policy and validation report

The insurance or reinsurance undertaking should develop, apply, and maintain a written validation policy specifying at least:

a) the processes and methods of internal model validation and their objectives; b) the frequency of regular validation for each part of the internal model and the circumstances triggering additional validation; c) the persons responsible for each validation task; and

NBB_2016_27 – 12 May 2016 Circular – Page 13/18

d) the procedure to apply if the model validation process detects problems concerning the reliability of the internal model and the decision-making process to address these concerns.

The insurance or reinsurance undertaking should document in a validation report the results of the validation as well as the conclusions and consequences resulting from the analysis of the validation.

The insurance or reinsurance undertaking should include in the validation a reference to the validation data sets referred to in Guideline 42 as well as the approval of the main participants in the process.

Guideline 33 – Scope and objective of the validation process

When specifying the objective of the validation, the insurance or reinsurance undertaking should clearly indicate the specific objective of the validation for each part of the internal model.

The insurance or reinsurance undertaking should include both qualitative and quantitative aspects of the internal model in the scope of the validation.

When considering the scope of the validation, in addition to the validation of the different parts of the internal model, the insurance or reinsurance undertaking should consider the validation as a whole and notably the adequacy of the calculated predictive probability distribution to ensure that the level of regulatory capital is not tainted by material inaccuracy.

Guideline 34 – Relative importance in validation

The insurance or reinsurance undertaking should consider the relative importance of the part of the internal model being validated when using relative importance to decide on the intensity of validation activities.

The insurance or reinsurance undertaking should consider the relative importance of the parts of the internal model both in isolation and in combination when deciding how to validate them appropriately.

The insurance or reinsurance undertaking should consider sensitivity tests when determining relative importance as part of the validation.

Guideline 35 – Quality of the validation process

The insurance or reinsurance undertaking should indicate all known limitations of the current validation process.

If there are limitations to the validation of parts covered by the validation process, the insurance or reinsurance undertaking should be aware of them and document them.

The insurance or reinsurance undertaking should ensure that the assessment of the quality of the validation process explicitly indicates the circumstances in which the validation is ineffective.

Guideline 36 – Governance of the validation process

The insurance or reinsurance undertaking should put in place appropriate governance concerning the communication and internal reporting of the results of the validation carried out.

The insurance or reinsurance undertaking should form an overall opinion based on the conclusions of the validation process and communicate it within the undertaking.

The insurance or reinsurance undertaking should define in advance criteria to determine whether the results, or part of the results, of the validation should be escalated within the undertaking.

Circular – Page 14/18 NBB_2016_27 – 12 May 2016

The insurance or reinsurance undertaking should clearly define the escalation path so that the validation process remains independent of the development and implementation of the internal model.

Guideline 37 – Roles in the validation process

If parties other than the risk management function contribute to specific tasks in the validation process, the insurance or reinsurance undertaking should ensure that the risk management function fulfils its overall responsibility referred to in Articles 85 to 90 of the Act and Article 269(2)(a) of Regulation 2015/35, including the responsibility to ensure the completion of the various tasks of the validation process.

The insurance or reinsurance undertaking should formally explain the role of each party in the defined validation process.

Guideline 38 – Independence of the validation process

The insurance or reinsurance undertaking should demonstrate that, in order to objectively challenge the internal model, its risk management function ensures that the validation process is carried out independently of the development and implementation of the model. The undertaking’s risk management function should ensure that validation tasks are described and carried out in such a way as to maintain the independence of the validation process as provided for in Article 241(2) of Regulation 2015/35.

The insurance or reinsurance undertaking should decide on the parties contributing to tasks related to the validation process, taking into account the nature, size and complexity of the risks to which the undertaking is exposed, the function and skills of the persons participating and the manner in which it guarantees the independence of the validation process.

Guideline 39 – Specificities of validation for group internal models referred to in Articles 374 and 375 of the Act

The participating undertaking and the affiliated undertakings included in the application for the use of the group internal model referred to in Articles 374 and 375 of the Act to calculate their Solvency Capital Requirement should develop a single validation policy covering the validation process both at group level and at the level of individual undertakings.

The participating undertaking and the affiliated undertakings should design the validation process of the internal model in the context of the calculation of both the consolidated group Solvency Capital Requirement and the Solvency Capital Requirement of the affiliated undertakings included in the application for the use of a group internal model. The participating undertaking and the affiliated undertakings should explicitly indicate this consideration in the validation policy developed for the group internal model.

Guideline 40 – Application of validation tools

The insurance or reinsurance undertaking should consider using quantitative or qualitative validation tools other than those referred to in Article 242 of Regulation 2015/35.

The insurance or reinsurance undertaking should understand the validation tools it uses and choose the appropriate set of validation tools to ensure an effective validation process.

The insurance or reinsurance undertaking should take into account at least the following characteristics when selecting validation tools:
a) characteristics and limitations of validation tools; b) nature: validation tools should be qualitative, quantitative or a combination of both; c) knowledge required: the extent of knowledge required by the persons responsible for validation; d) information required: possible restrictions concerning the quantity or type of information available for external validation compared to internal validation;

NBB_2016_27 – 12 May 2016 Circular – Page 15/18 e) validation cycle: validation tools relevant to cover each key assumption adopted at the different stages of the internal model, from development, to implementation and operation.

The insurance or reinsurance undertaking should document in the validation report the parts of the internal model validated by each of the validation tools used and indicate why these validation tools are appropriate for the particular purposes by describing at least:
a) the relative importance of the part of the model validated; b) the level at which the tool is applied, from individual risks, to modelling blocks, to portfolio, to operational unit to aggregated results; c) the objective of this validation task; d) the expected result of the validation.

Guideline 41 – Stress tests and scenario analysis

The insurance or reinsurance undertaking should use stress tests and scenario analysis as part of the validation of the internal model.

The insurance or reinsurance undertaking should ensure that the stress tests and scenario analysis used cover the relevant risks and are monitored over time.

Guideline 42 – Validation data sets

The insurance or reinsurance undertaking should ensure that the selected data and expert judgment used in the validation process effectively allow it to validate the internal model over a wide range of circumstances that have occurred in the past or may occur in the future.

Chapter 10: Documentation

Guideline 43 – Documentation control procedure

In order to guarantee the permanent quality of the documentation in accordance with Article 243(3) of Regulation 2015/35, the insurance or reinsurance undertaking should put in place at least:
a) an effective procedure for controlling the documentation of the internal model; b) a procedure for controlling versions of the internal model documentation; c) a clear referencing system for the internal model documentation to be used in the list of documentation provided for in Article 244(a) of Regulation 2015/35.

Guideline 44 – Documentation of methods

The insurance or reinsurance undertaking should produce documentation sufficiently detailed to demonstrate a detailed understanding of the methods and techniques used in the internal model, including at least:
a) the underlying assumptions; b) the possibility of applying these assumptions given the undertaking’s risk profile; c) any shortcomings of the method or technique.

When documenting the theory, assumptions and mathematical and empirical foundations underlying any method used in the internal model, in accordance with Article 187(3) of the Act, the insurance or reinsurance undertaking should include, where applicable, the important steps in the development of the method, as well as any other method considered but ultimately not used by the insurance or reinsurance undertaking.

Circular – Page 16/18 NBB_2016_27 – 12 May 2016

Guideline 45 – Circumstances in which the internal model does not function effectively

The insurance or reinsurance undertaking should include in its documentation a global summary of the significant shortcomings of the internal model, consolidated in a single document, comprising at least the aspects referred to in Article 245 of Regulation 2015/35.

Guideline 46 – Adequacy of documentation to recipients

The insurance or reinsurance undertaking should consider the possibility of having internal model documentation consisting of more than one level of internal model documentation, depending on the different uses and different target recipients.

Guideline 47 – User manuals or process descriptions

The insurance or reinsurance undertaking should put in place, as part of the internal model documentation, user manuals or process descriptions for the implementation of the internal model sufficiently detailed to allow an independent third party with relevant knowledge to implement and operate the internal model.

Guideline 48 – Documentation of model results

The insurance or reinsurance undertaking should retain, as part of the internal model documentation, the model results relevant to satisfy the requirements provided for in Article 174 of the Act.

Guideline 49 – Documentation of software and modelling platforms

In its documentation, the insurance or reinsurance undertaking should provide information on the software, modelling platforms and equipment systems used in the internal model.

When using software, modelling platforms and equipment systems, the insurance or reinsurance undertaking should provide in the documentation sufficient information to be able to evaluate and justify their use and allow supervisory authorities to assess their adequacy.

Chapter 11: External models and data

Guideline 50 – External data

Given the nature of external data, the insurance or reinsurance undertaking should be able to demonstrate an appropriate level of understanding of the specificities of the external data used in the internal model, including any transformation, any change of scale, any significant seasonal effect and any other processing inherent to external data.

In particular, the insurance or reinsurance undertaking should at least:
a) understand the attributes and limitations or other peculiarities of external data; b) develop processes to detect missing external data and any other limitations; c) understand the approximations and treatment reserved for missing or unreliable external data; d) develop processes to verify consistency in a timely manner, including comparisons with other relevant sources to the extent that data are reasonably available.

NBB_2016_27 – 12 May 2016 Circular – Page 17/18

Guideline 51 – Understanding the external model

The insurance or reinsurance undertaking should be able to demonstrate that all parties concerned by the use of the external model have a sufficiently detailed knowledge of the parts of the external model concerning them, including the assumptions and the technical and operational aspects.

The insurance or reinsurance undertaking should pay particular attention to the aspects of the external model most relevant to its risk profile.

Guideline 52 – Review of the choice of external model and data

The insurance or reinsurance undertaking should periodically review its justification for the selection of a particular external model or a particular set of external data.

The insurance or reinsurance undertaking should ensure not to depend unduly on a single supplier and should put in place plans to mitigate the impact of any supplier failure.

The insurance or reinsurance undertaking should take into account any updates of the external model or data allowing the undertaking to better assess its risks.

Guideline 53 – Integration of external models within the internal model

The insurance or reinsurance undertaking should be able to demonstrate that the approach for the integration of the external model within the internal model is appropriate, including the techniques, data, parameters, assumptions adopted by the undertaking and the results of the external model.

Guideline 54 – Validation within the context of external models and data

The insurance or reinsurance undertaking should carry out its own validation of the aspects of the external model that are relevant to its risk profile as well as of the process of integrating the model and external data into its processes and internal model.

The insurance or reinsurance undertaking should assess the adequacy of the selection or non-selection of features or options available for the external model.

As part of the validation, the insurance or reinsurance undertaking should take into account appropriate information and, in particular, the analysis carried out by the seller or any other third party, and in doing so, the insurance or reinsurance undertaking should ensure at least that:
a) the independence of the validation is not compromised; b) the information is consistent with the validation process defined by the insurance or reinsurance undertaking and clearly stated in the validation policy; c) any implicit or explicit bias in the analysis carried out by the seller or any other third party is taken into account.

Guideline 55 – Documentation within the context of external models and data

The insurance or reinsurance undertaking should ensure that the documentation of external models and data meets documentation standards.

The insurance or reinsurance undertaking should produce documentation at least on the following subjects:
a) the aspects of the external model and external data relevant to its risk profile; b) the integration of the external model or external data into its processes and internal model; c) the integration of data, including input data, for the external model, or external model results into its processes and internal model; d) the external data used in the internal model and their source and use.

Circular – Page 18/18 NBB_2016_27 – 12 May 2016

If, as part of its own documentation, the insurance or reinsurance undertaking exploits the documentation produced by sellers and service providers, the insurance or reinsurance undertaking should ensure that its ability to comply with documentation standards is not compromised.

Guideline 56 – Undertaking’s responsibility within the context of external models and data

The insurance or reinsurance undertaking should retain responsibility for the execution of its obligations related to its internal model, the role of the model or external data in the internal model and any other requirement.

Guideline 57 – Role of service providers in the event of the use of external models and data

The insurance or reinsurance undertaking should put in place an outsourcing agreement when it chooses not to implement the external model directly.

Likewise, the insurance or reinsurance undertaking should put in place an outsourcing agreement when it chooses to entrust a service provider with the performance of certain tasks related to external data.

When putting in place an outsourcing agreement, the insurance or reinsurance undertaking should comply with the requirements referred to in Article 92 of the Act and Article 274 of Regulation 2015/35.

A copy of this circular is sent to the commissioner(s), approved auditor(s) of your undertaking.

We ask you to accept, Madam, Sir, the expression of our distinguished sentiments.

Jan Smets
Governor