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Model Risk Management 20 Years in the Making

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Model Risk Management 20 Years in the Making DeRisk CRISIL’s insights and analyses of regulations, macroeconomic factors, guidance and trends affecting the insurance industry January 2020 Model risk management 20 years in the making Global Research & Analytics 1 Global Research & Analytics Such events have transformed the way Tracing two decades regulators and financial institutions in various countries deal with risk, particularly in the Many events have shaped model-risk MRM area. management (MRM) as we know it today. In the US, some insurers, especially the big The Gramm-Leach-Bliley Act of 1999 broke ones, had adopted MRM practices by 2012, due down the wall separating commercial and to the pressure from the Federal Reserve in SR investment banking, giving the US banks 11-7 (Figure 1). In 2014, the regulator classified greater autonomy. Another key event with wider some insurers as systemically important repercussions was the crisis after the dotcom financial institutions (SIFIs). The same year the bubble, which marked the start of a strategic FSB introduced its own classification of global shift towards solid risk management practices, systemically important insurers (G-SIIs). While particularly with the growth of more complex the SIFI insurance designation for insurers was financial models and systems. diluted, the focus on MRM compliance and additional reporting remains. This separation of commercial and investment banking created a period where the Financial In Europe, MRM adoption in 2015 was mostly Stability Board (FSB), the European Central influenced by the expected Solvency II Bank (ECB), the US Federal Reserve (Fed), the directive that took effect in 2016. By 2016, the UK Prudential Regulation Authority (PRA) and demarcation between SIFIs and G-SIIs had other regulators were focused on establishing a appeared to be diluted, but MRM practices new stability-focused monetary policy strategy gained traction. and a broad operational framework. While banks and insurers have adopted MRM A key trigger for the change was the US Office at varying speeds, insurers accelerated their of the Comptroller of the Currency (OCC) adoption of industry practices in 2016. Some of 1 Bulletin 2000-16 that provided guidance them were influenced by the actuarial practice to mitigate ‘model risk’. The focus of banks and learning from banks in MRM. In Europe, started to shift to model risk. The information insurers started to foresee the implications revolution was followed by years of profits of risk management practices with the and prosperity for banks. Bank profits were introduction of Solvency II by the European strong for more than a decade with no bank Insurance and Occupational Pensions failure until 2007. However, various warning Authority (EIOPA). The regulation aimed to signs started appearing in 2007, culminating in review the prudential regime for insurance the 2008 global financial crisis. By 2009, G20 and reinsurance undertakings in the European leaders had decided to fix the financial system. Union. In particular, the Pillar II of Solvency II They tasked the Financial Stability Board (FSB) focused on governance and risk management, with addressing the challenges of ‘too big to including internal-model development and fail’ companies (banks or insurers) and building validation requirements. a more integrated financial system worldwide. 1Office of the Comptroller of the Currency’s (OCC) on risk modeling: https://ithandbook.ffiec.gov/media/resources/3676/occ-bl2000-16_risk_model_validation.pdf 2 Figure 1: Regulatory timeline of key MRM guidance in Europe, the UK, the US and Canada The Gramm–Leach–Bliley Act (GLBA): This Financial Services Modernisation regulation triggered mergers 1999 R and acquisitions, along with a wave of business transformation for banks and insurers. OCC 2000-16: The first definition of model and model risk came into the picture, shifting the focus from 2000 R process risk into model risk for financial institutions 2001 O The burst of the dot-com bubble lasted from March 11, 2000, to October 9, 2002 The Sarbanes-Oxley Act, or SOX compliance, for public company accounting reform introduced 2002 R considerable model-development requirements for public companies and transparency for banks and insurers The BIS speech by Malcolm D Knight at the International Conference of Banking Supervisors, looking for 2004 O greater convergence and common challenges within the financial industry BCBS and CEBS G10 new validation requirements: Capital Measurement and Capital Standards 2006 R incorporates various aspects of internal model risk management Global Financial Crisis. The collapse of the housing market was at the centre of the 2008 financial crisis 2007 O (Lehman Brothers bankruptcy) 2008 O Global financial crisis. US government economic bailout of 2008 European debt crisis: Several Eurozone member states (Greece, Portugal, Ireland, Spain and Cyprus) were 2009 O unable to repay or refinance their government debt The Dodd–Frank Wall Street Reform and Consumer Protection Act. The law overhauled financial 2010 R regulation, and various models were reviewed to ensure better transparency, particularly around liquidity risk 2011 R Introduction of the leverage ratio as a safeguard against model risk OCC-Fed (SR 11-7): This SR 11-7 guideline opened the door to MRM practices that transformed the 2011 G banking and insurance industry EBA CRR and EBA RTS on Prudent Valuation: Capital Requirements Regulation (CRR) sets out 2013 R requirements relating to prudent valuation adjustments of fair-valued positions. This regulation mandates the EBA to prepare draft regulatory technical standards (RTS) in this area. EBA convergence in the supervisory review and examination process (SREP): Convergence starts. For 2014 G example, banks in Spain need to consider valuation adjustments for model risk. Polish Supervision Financial Authority: The Polish supervisor drafts Recommendation W. This includes 2016 G MRM for banks OSFI E-23: Guideline E-23 outlines the minimum prudent practices for internal-model development, 2016 G review, approval, use and modification, which can be applied by financial institutions reliant on models. EIOPA Solvency II: The project aims to review the prudential regime for insurance and reinsurance 2016 R undertakings in the European Union. Particularly, Pillar II focuses on governance and risk management, including internal-model development and validation requirements. PRA stress testing: Stress Test Model Management Principles and the first biennial survey research for 2017 R insurers’ stress testing practices 2017 R ECB TRIM: Targeted Review of Internal Models for Banks and structure of three lines of defense (3LOD) APRA CPS 220: The Australian Prudential Regulation Authority (APRA) issued these requirements and 2018 R included the need for an institution and group to have a risk management framework that is consistent and integrated with the risk profile and capital strength of the organisation MRM practice note: Various accepted practices for actuaries to follow in MRM are provided in the 2019 G American Academy of Actuaries practice note issued in May OSFI E-25: Internal-model guideline that applies to the risk oversight frameworks that property and 2019 G casualty insurers need to use Banking / Insurance Banking Insurance R: Regulation G: Guideline O: Other Event Type 3 Global Research & Analytics In March 2017, the Australian Securities and Investment Commission (ASIC) issued Leveraging MRM in internal the Regulatory Guide 259 to deal with risk models management systems. RG 259 provides specific guidance to financial institutions to have in place The adoption of MRM practices will remain a risk management system, as well as processes a priority topic in the modelling agenda for for identifying, managing and assessing risks. insurers, as they spread at a faster pace across The guide relies considerably on the International the industry due to the increased interest of the Standard ISO 31000:2009, the objective of which regulators and practitioners in executing model is also risk management. development and validation activities more efficiently and transparently. Internal models In July 2018, the Australian Prudential Regulation are immediate candidates for increased MRM Authority (APRA) issued its Prudential Standard oversight by technical (actuarial) and corporate CPS 220 Risk Management in scope to authorised business units. This model-centric approach is deposit-taking institutions, general insurers, life understandable, because internal models are insurers and private health insurers to maintain critical to perform an assessment of risk and an appropriate risk management framework. The capital requirements for insurers that regulators framework would enable them to develop and use to measure insurer strength. implement policies and procedures to manage different types of material risks, and provide the Many regulations worldwide require MRM board a comprehensive institution-wide view of activities for internal models. In fact, Solvency material risks consistent with the business plan. II requires model validation for several model components. Under these circumstances, it is By the end of 2018, model risk management clear why there is an increased interest in the practitioners working for insurers had already adoption of MRM practices by the insurance put in place a broad set of accepted practices industry, as they have proven to be a good worldwide. In May 2019, the American Academy modelling practice. Additionally, over the 20 years of
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