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Applying the volatility adjustment in internal models
Should insurers use a volatility adjustment (VA) in their internal models that does not change over time, or are they allowed to model a dynamic VA?
When using an internal model to calculate the Solvency II capital requirements, insurers must estimate their technical provisions one year after the reporting date. They may apply a VA in the relevant interest rate term structure, which must then be modelled in an internal model. DNB allows the use of a constant as well as a dynamic VA for modelling purposes. However, for dynamic a VA, which moves with the relevant spreads, certain conditions apply.
Naturally, when an insurer asks DNB for permission to use an internal model, DNB will assess, on a case-by-case basis, whether that insurer satisfies all requirements and applies all good practices with regard to internal models as listed in the Solvency II Directive.
Concerning the VA, DNB will generally assess whether all risks and uncertainties surrounding the modelling, the source data and the parameters relating to the VA and the resulting capital requirement (SCR) are adequately addressed in the modelling process and risk management. When applying for permission to use an internal model, an insurer must demonstrate that it has explicitly addressed these risks and uncertainties or that it has, at least, implicitly done so, for example by limiting the VA (or its application ratio). It must address all model components in relation to the VA.
In assessing the VA, DNB will also consider the modelling of risks arising from government bonds (sovereign exposures). An insurer must make allowance for sovereign exposures in its internal model, taking into account how it has modelled the VA. If an insurer opts to apply an internal model with a dynamic VA, it must incorporate all sovereign risk exposures and other spread-sensitive investments in full.
In particular, DNB will assess whether an insurer has given appropriate consideration to the following issues in its modelling, risk management and public disclosure in relation to the VA.
- The insurer must justify and quantify the estimates it applies in the VA expectations under the various scenarios (including the credit risk adjustment – CRA).
- The insurer must adequately include in its modelling all elements of a dynamic VA as required by the internal model's use test and statistical quality standards and, more particularly, the following elements:
- the correlations used between credit risk and other risk factors in the various scenarios, such as spread narrowing and widening; and
- the representative portfolio of bonds and other fixed-income securities and the reference portfolio of market yield indices for calculating the VA, allowing for differences compared with its own portfolios and possible changes to them (flight to quality) that might occur in exceptional circumstances.
- The insurer must adequately demonstrate that its VA modelling includes incentives for good risk management and explain how it considers these incentives in its risk management.
- The insurer must consistently consider, as part of its risk management, the risks arising from its own investments and from the representative portfolio and the reference portfolio used to calculate the VA.
- The insurer must validate its VA modelling on the basis on a sufficiently granular source analysis, including quantification of the difference between a dynamic VA and a constant VA.
- The insurer must consider a change to the modelling of the VA as a major change within the meaning of Article 114(2)(b) of the Solvency II Directive.
- In managing its risks, the insurer must explicitly take into account the situation where reducing the VA to zero would result in non-compliance with the SCR, and the insurer must have an analysis of the measures it could apply in such a situation to re-establish the level of eligible own funds covering the SCR or to reduce its risk profile to restore compliance with the SCR.
- The insurer must assess and report the sensitivity of its technical provisions and eligible own funds to the assumptions underlying the VA calculation and the possible effect of a forced sale of assets on its eligible own funds.
- In its public disclosure, the insurer must include a statement on:
- the impact of the VA, including its effects on the level of the technical provisions, the SCR, the MCR and the eligible own funds; and
- the method and underlying assumptions used to calculate a dynamic VA.
Pursuant to Article 37(1)(d) of the Solvency II Directive, DNB may consider to set a capital add-on if it concludes that the insurer's risk profile deviates significantly from the assumptions underlying the volatility adjustment.
Related legislation and regulations:
- Article 37 (Capital add-on), Solvency II Directive
- Article 44 (Risk management), Solvency II Directive
- Article 51 (Public disclosure), Solvency II Directive
- Article 114 (Changes to internal models), Solvency II Directive
- Article 120 (Use test of internal model), Solvency II Directive
- Article 121 (Statistical quality standards for internal model), Solvency II Directive