Validating your
internal model? Don’t forget the top-down view

Our viewpoint

It’s becoming increasingly important to show that your board understands and trusts your internal model, through a process called “top-down validation”. I explained the concept in my recent article in InsuranceERM. This blog summarises the main things you can do to help your board:

1. Help them ask the right questions

The board should be actively questioning the model. We have developed a bank of over 40 questions based on our experience of what keeps (or should keep) board members awake at night, including:

  • What are our five most material expert judgements and how could we reduce our reliance upon them?
  • Are we taking the right amount of diversification credit in the right places?
  • How would we know if there were significant data problems affecting the reliability of the model?

The top-down validation test is this: could a board member easily find the answer to the question without having to ask an expert? It’s not enough for the necessary evidence to exist somewhere in the model documentation. It’s got to be readily accessible and explained in terms the board can understand.

2. Make sure they know what “turns the dials”

The board should be clear on what assumptions make the most difference to the required capital. To answer this, you need to:

  • Perform wide-ranging sensitivity testing, including tests of plausible alternative assumptions as well as extremes
  • Find a way to put different sensitivity tests on a level playing field, ie “stretch” the assumptions to a consistent degree
  • Make it clear what sensitivities are currently the most important and how this may change in future

3. Help them understand the limitations of the model

The model should play an important role in strategy. But all models have limitations. Without understanding how these limitations affect the results, the board can’t be expected to use the model with any confidence.
A helpful solution is to create a “design decision matrix”. This is a board-level summary of the main model design features and limitations, and the steps you are taking to address the limitations.

This can improve understanding and help the board prioritise areas for future model development.

If you want to avoid regulatory challenge in this area, now is a good time to start building the top-down view into your regular validation process.

Click here to read the full article in InsuranceERM