Navigating Regulatory Capital Submissions in Lloyd’s Market: Common Issues and Practical Tips
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September 05, 2024
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The prospect of regulatory capital submissions requires a strategic approach that aligns with evolving regulatory expectations and dynamic market conditions. Such an approach is challenging, however, and particularly during peak capital submission season, which is inevitably characterised by tight deadlines and competing priorities.
Based on our experience supporting clients with SCR submissions over the past Capital Planning Groups (“CPG”) seasons, we've identified common issues that impact Lloyd’s syndicates and that not only hinder their submission processes, but also lead to regulator feedback and, in some cases, loadings.
We have crystalised our observations into seven common challenges and categorised our recommendations for surmounting them:
‘do’ – critical actions to take,
‘do not’ – pitfalls to avoid,
‘could’ – best practices that would further enhance the capital submission processes.
Understanding Risk Profile Changes
Lloyd’s capital guidance places great emphasis on the importance of understanding the impact of changes on a syndicate’s capital risk profile, noting that “a key focus for all submission items is how the capital reflects the up-to-date syndicate risk profile, with the expectation that capital responds in an intuitive way to the evolution of this”1.
Although business profile changes relating to the prospective year are well understood from the Syndicate Business Forecast (“SBF”) process, changes in risk profile relating to prior Year of Accounts (“YoAs”) may not be as easily identifiable.
Broadly, there are two sources of risk profile change on the prior YoAs: firstly, changes in composition of reserves earned as at the previous submission due to reserve run-off or revisions in projected ultimates on prior YoAs; and, secondly, a change in the mix of business across reserve and premium risks due to the earning through of the more recent YoAs between submissions.
These sources of change have the potential to lead to material and sometimes non-intuitive impacts on capital that would require extensive drill-down analysis to better understand and rationalise.
Practical Tips:
- Do set up an analysis that shows the impact of mix change across class of business and/or YoAs on risk vs exposure metrics for insurance risk types.
- Do set up an analysis of change that allows drilling down of top-level non-intuitive changes to class/YoAs.
- Do have a high-level view of the relative volatility of the syndicate’s overall risk profile from a business perspective and assess the modelled capital and risk movements against the high-level expectation.
- Do not simply assume that impact of data changes (e.g. Technical Provisions Update) are acceptable without any justification or documentation.
- Could attempt to approximate the impact of local changes at total level through approximate diversification methods to drive out any unexpected changes
Justifying Parameter Selections
A common issue that attracts feedback points, or loadings, is insufficient justification for parameters or key expert judgements. This issue often links to a lack of challenge and sign-off on model assumptions or a lack of documentation of such a review. While having the business engaged may sound obvious, it can be very challenging to implement effectively, especially when you consider the complex nature of the capital modelling and wider business planning processes and tight timelines of the capital submission cycle.
Practical Tips:
- Do automate the first-cut parameter update and data driven adjustments as much as possible, leaving time for a material business review.
- Do invest the effort to translate key model assumptions and results into concepts or visualisations that are intuitive for business teams to understand and challenge.
- Do maintain a parameter justification document - separate from the Analysis of Change (“AoC”) report - setting out rationales of key model assumptions and relevant business challenge/sign-offs. This document could be referenced by the AoC for justification of material changes to the parameters.
- Do think of calibration as falsifying invalid assumptions rather than as a mechanical exercise to get to ‘the right’ number.
- Do not justify parameter changes with simply mechanical descriptions of how the parameters were derived.
- Do not change model parameters just for the sake of it – have a clear reason as to why current model assumptions better reflect the syndicate’ s risk profile.
- Could have a clear plan on when and how late cycle material changes in the business profile (e.g. SBF changes) would trigger escalating parameter reviews.
Validating Model Changes
Lloyd’s capital guidance requires that “any LCR resubmission must be accompanied by validation that is proportionate to the nature and level of model change”.2 In reality, many validation exercises follow a three-year validation plan comprised of pre-determined validation tests, with little time left for in-cycle, ad hoc validation that targets material – but not necessarily major – model changes that are not sufficiently covered by the validation plan. It‘s not uncommon for these ‘material but not major’ model changes to be insufficiently challenged by the second line, leading to regulator feedback or loadings.
Practical Tips:
- Do review the validation plan in conjunction with the first line team to ensure all model changes are validated and documented appropriately. Providing the validation team with all model changes in a timely manner through regular meetings will help.
- Do consider setting out explicit guidance for any ad hoc validation, such as a materiality threshold and clear validation approach, for ‘material but not major model changes’.
- Do not leave validation tests until the last minute, which does turn validation into a box-ticking exercise rather than an effective ‘second pair of eyes’.
Managing Simulation Variability
Simulation variability could result in unintuitive model movements, particularly on a post-diversified basis. These can have a profound effect in certain areas: for example, on credit risk where third-party defaults are modelled as binary events with extremely low probability. To a certain extent, this problem can be attributed as a measurement issue due to focusing on movements at one point rather than across the entire distribution. If simply left unmanaged, these unintuitive movements could become material and lead to questions over the appropriateness of the modelled contribution to capital.
Practical Tips:
- Do prove that movements are driven by simulation variability when claiming so.
- Do not accept simulation variability as a fall-back explanation for material risk movements.
- Do demonstrate that consideration has been applied to seed selection to minimise distortions from simulation variability within submission documents where the impact is material.
- Do perform targeted stability testing to better understand the confidence interval of model outcomes for areas susceptible to high simulation variability.
- Do consider alternative capital allocation approaches to better reflect each risk type’s contribution to capital post diversification.
Improving Analysis of Change
AoC has been a long-standing area of headache for both syndicates and the regulator. Time and effort are spent on writing up the AoC document during a capital submission cycle, incorporating previous feedback points, yet syndicates could still get feedback on lack of detail in new areas previously not covered. The document can easily end up longer, but not necessarily more useful.
Practical Tips:
- Do take a top-down approach to writing up the AoC – spend more time justifying material changes that drive capital and volatility movements.
- Do explain key drivers of movements in risk vs exposure where relevant, rather than just drivers of absolute movements in the SCR.
- Do explain key drivers of movements in diversified capital, in addition to just movements in standalone risks.
- Do sign post to validation or other IM documents to further support movement justifications where necessary.
- Do not just look at risk, also consider the breakdown into mean profit and stress.
- Do not write a long and unstructured AoC that details every single model change, blindly and without a clear storyline.
- Do not justify movements with simple descriptions of the mechanical changes made, and without explanation of how the model results are deemed to appropriately reflect the syndicate’s risk profile.
- Do notsimply update the AoC based on what was done in the previous submission – the AoC should tell the story of what happens for each specific submission.
- Do not leave the AoC until the end of the submission process. Often documenting the change can force alternative ways of looking at and understanding the model and the results, and identifying residual issues which may be too late to fix at that stage.
Addressing Regulator Feedback
Feedback is crucial for both the regulator and syndicates. But sometimes it can be somewhat overwhelming to receive regulator feedback, especially if the list is long. Unaddressed, or poorly managed feedback could lead to concerns over the effectiveness of the Syndicate’s governance and controls, leading to a vicious cycle of feedback or even loadings. It is of utmost importance that a Syndicate takes a positive attitude and effective approach to addressing regulator feedback to ensure a seamless relationship.
Practical Tips:
- Do reach out to the regulator to clarify feedback points before responding where there are doubts over what is required.
- Do provide the regulator with early, regular and proactive communications around plans to address prior feedback points, especially when there are anticipated delays.
- Do have an action plan on how to address the feedback including priorities and effort estimates in order to best understand how to get the best return on the available time.
- Do engage with the regulator when feedback can’t be addressed within the timescales required.
- Do not try to fix everything.
- Do not ignore feedback points.
- Do not leave communications until the last minute.
Balancing Competing Priorities
It can be difficult to get everything right in a capital submission when there are multiple competing priorities. These can include “business as usual” updates clashing with a shift in the business plan, or major model changes to better reflect risk landscapes. If these changes occur late in the submission cycle it can exacerbate any timeline pressure and place a strain on internal resources. Striving for perfection in every aspect can be counterproductive; it is imperative that you prioritise some facets, which is in itself a challenge.
Practical Tips:
- Do perform preliminary analysis to understand the relative materiality of changes prior to any implementation.
- Do prioritise implementing change that will have the most material impact on capital, leaving less material changes for further development if limited by time/resource constraints.
- Do communicate the plan with the validator and/or regulator ahead of the submission if in any doubt.
- Could strive to deliver much of the value across a range of issues, rather than all the value over a small set.
- Could consider proactively using management loadings to address issues which are too large to fix during the current submission cycle and have a plan to properly address them before the next submission.
- Could use the limitations log more effectively – it doesn’t always have to be empty.
- Could think about what the process would look like in a Standard Formula world (where the model update process is simpler and allows easier understanding of the bigger picture) and get some inspiration from there.
- Do not spend disproportionate time on immaterial updates simply because ‘they have always been done’.
What This All Means for You
In our experience, syndicates who effectively address the common challenges above share some overarching principles in their approaches:
- An efficient process, as automated as possible will minimise ‘what must be done’ and leaves more space for ‘what’s important this time’.
- Adopting an agile principle rather than waterfall with more regular updates on capital. Do remember to draft key documents early and update as you go, as this will avoid any late surprises and improve model understanding.
- Proactive management of model limitations – this helps work prioritisation and regulatory engagement.
Footnotes:
1: Lloyd’s Capital Guidance (February 2024), p. 21.
2: Lloyd’s Capital Guidance (February 2024), p. 24.
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Published
September 05, 2024
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