Model Drift  Model drift is the risk that the capital requirements calculated using an internal model may gradually weaken over time such that they no longer reflect the risks to which the firm is exposed. No measure of model drift is perfect. The PRA tracks movements in internal model capital compared to the standard formula and the net best estimate of liabilities.2 The first benchmarks the tailored risk calibrations in an insurer’s internal model against the ‘off the peg’ measures of risk specified in Solvency II. The second compares them to the size of the insurer’s balance sheet – a sort of insurance ‘leverage ratio’. Supervisors supplement these aggregate measures with ‘bottom up’ analysis to compare the outputs of internal models, looking at calibrations risk by risk, over time and across insurers.3  (see Chart 2)  In 2016 and 2017, the aggregate capital requirements of UK general insurers with internal models increased more or less in line with the standard formula and best estimate of liabilities. That is the outcome I would expect, other things being equal. No generalised model drift was apparent. For life insurers in aggregate, by contrast, both standard formula capital and best estimates of liabilities rose considerably more than internal model capital. At face value, this looks like considerable model drift. For a couple of reasons, though, we are not yet ringing the alarm bells. First, it is only two years of data. We will need a longer period to draw strong conclusions about trends.

Model use and misuse Speech given by David Rule, Executive Director of Insurance Supervision  Association of British Insurers Prudential Regulation Seminar 14 May 2019  I am grateful to the following for contributions to this speech: Liam Clarke, Chintan Patel, Paul Collins, Amanda Istari, Brian Howell, Sarah O’Sullivan, Anu Ralhan, Peter McIntyre and David Phillips. 1  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  I would like to start by thanking the ABI for the invitation to make this keynote address. Today I want to talk about insurance models and the growing importance of model risk management. In doing so, I will describe some recent findings from the PRA’s work to guard against weakening over time of capital requirements calculated from internal models or ‘model drift’. A model applies theories, techniques and assumptions to process input data into quantitative estimates for a particular purpose.1 Make that purpose providing insurance and it is close to a definition of what insurers do. No surprise therefore that insurers are big users of models. But models can go wrong. They might have fundamental errors. Probably more commonly, they can be misused: for example, because management do not understand the limitations of a model. In insurance, a model going wrong might mean under-pricing of products, under-reserving against risks or treating certain customer groups unfairly. In the particular case of internal models used to calculate regulatory capital requirements, it could result in insufficient capital to protect policyholders. Insurance Capital Models  Let us start with capital models.