Prudential Regulation Authority Rulebook

2.1

This section should be read in conjunction with SS23/15 ‘Solvency II: supervisory approval for the volatility adjustment’^[5] and SS17/16 ‘Solvency II: internal models – assessment, model change and the role of non-executive directors’.^[6]

2.2

Solvency Capital Requirement – General Provisions 3.6 requires that a firm’s SCR shall not cover the risk of loss of basic own funds resulting from changes to the VA.

2.3

The European Insurance and Occupational Pensions Authority (EIOPA) issued its ‘Opinion on the supervisory assessment of internal models including a dynamic volatility adjustment’ (EIOPA Opinion).^[7] The EIOPA Opinion implicitly accepts that firms that use an internal model to model credit risk may, as a general principle, apply a dynamic volatility adjustment (DVA) by allowing the VA to change when modelling credit spreads during the 1-year forecast of basic own funds.

2.4

As a result, the PRA will consider applications from internal model firms that include a DVA within an internal model.

2.5

The PRA expects firms to treat the DVA as a new element of the model in accordance with EIOPA Guidelines.^[8] As such, any model extension to reflect the DVA is expected to require PRA approval.

2.6

The PRA expects firms to demonstrate that in the applicable stressed scenarios underlying the calculation of the SCR where the DVA is applied, the firm should continue to comply with the three statutory approval conditions for applying the VA as set out in Regulation 43 of the Solvency 2 Regulations. These include a condition that the VA is not applied in such a way as to breach a relevant requirement, and in particular will not breach:
(i) the Prudent Person Principle set out in Investments 2 to 5; and
(ii) the system of governance requirements under the Conditions Governing Business Part of the PRA Rulebook relating to the application of the VA, including:
(a) the adequacy of the firm’s liquidity plan (Conditions Governing Business 3.1(3));
(b) the policy on the criteria for the application of the VA (Conditions Governing Business 2.5(2)); and
(c) the assessment of the effect of the VA as a part of the firm’s asset-liability management (Conditions Governing Business 3.2 and 3.3).

2.7

The Chief Risk function has responsibility for ensuring that the firm meets the system of governance (and other corresponding) requirements outlined in paragraphs 2.6(i), 2(ii)(a) and (c) above that are relevant to the application of the VA. The Chief Risk function is also required to be responsible for the design, implementation and validation of the internal model (Conditions Governing Business 3.7). Validation should be performed in conjunction with Chapter 7 of SS17/16 ‘Solvency II: internal models – assessment, model change and the role of non-executive directors’. The PRA also expects that the relevant EIOPA guidelines will be followed by the Chief Risk function.

2.8

The Chief Actuary function has responsibility for ensuring that the firm meets the system of governance requirements in Conditions Governing Business 6 that are relevant to the application of the VA, which includes contributing to the effective implementation of the risk management system, including the modelling of risks underlying the calculation of the SCR. The PRA also expects that the relevant EIOPA guidelines, and professional guidance for actuaries, will be followed by the Chief Actuary function.