If recent claims experience is suggesting increasing risk when models are not, that should raise questions for management. The risk of misuse of models might be particularly acute when an insurer buys in a model from a third party. Its people have not developed the model and become familiar with its limitations. Management might be tempted to put too much trust in the reputation of the supplier and assume that if many other insurers are using the model, ‘it must be fine’. The Senior Managers and Certification Regime requires insurers to allocate certain prescribed responsibilities to individual senior managers. Responsibilities for managing capital, funding and liquidity and for the Own Risk and Solvency Assessment, for example, entail a good understanding of an insurer’s internal capital model. In practice however, it is unrealistic to expect that everyone using a model will fully comprehend how it works. The crux of good model risk management is to ensure that decision makers know enough. My former boss, Andrew Bailey summarised this when discussing our expectations of boards in 2015, “the challenge is to reduce complexity to simplicity, so that Board members feel that they understand:  where is the model expected to work well;  in what circumstances is it likely to break down;  is the overall model output credible;  what “moves the dial” in terms of key assumptions or judgements; and  are those assumptions and judgements reasonable?”8 LIBOR Transition  Before I conclude, I would like to spend a moment on a different subject, LIBOR transition.

Second, some life insurers with internal models have been growing in areas where the standard formula over-states the risks: in particular, illiquid assets within Matching Adjustment portfolios. Third, life insurers have been expanding unit-linked business and transferring an increasing proportion of longevity risk on new annuities business through reinsurance, both of which would tend to lead to faster growth in the best estimate of liabilities than capital requirements. In summary, the two benchmarks against which we compare internal model capital might not have been fully reliable measures of changing risks. Our ‘bottom up’ analysis of internal model outputs has also not suggested any generalised dilution of standards. Nonetheless, the significant reduction in internal model capital compared to the standard formula is not a trend we would expect to continue over time. We will be watching it carefully. 2  See Monitoring Model Drift and Standard Formula SCR Reporting for Firms with an Approved Internal Model, Prudential Regulation Authority, Supervisory Statement 15/16. 3 See Solvency II Regulatory Reporting: Internal Model Outputs, Prudential Regulation Authority, Supervisory Statement 25/15. 4  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  4  One counter-balance to any selectivity in insurers’ model development is the PRA having its own model change agenda. For example, over the past couple of years, we have asked life insurers to adapt their interest rate modelling to include the possibility of negative rates and we have pushed them to improve their modelling of default and downgrade risks in Matching Adjustment portfolios.