While model validation as part of the Solvency II IMAP is now considered “business as usual” by insurers, there is more uncertainty around using model risk management (MRM), according to the latest guidance from the IRM’s Internal Model Industry Forum.
According to the Federal Reserve, model risks are the adverse consequences arising from decisions based on incorrect or misused model outputs. Those consequences can include financial loss, poor business or strategic decisions, or reputational damage, for example. (See Federal Reserve letter on Model Risk Management SR11-7.)
The new IRM document Journey from model validation to model risk management, recognises that in a fast-changing environment models need good governance, and therefore model risk management should add value by helping insurers to understand and manage the risk within the models they use for key business decisions.
It states that, fundamentally, model risk management can be used by insurers to implement the right level of controls for all material models supporting their business and decision-making processes.
Put simply, in a world that never stands still, ongoing risk monitoring of all a business’s working models – not just those used for regulatory purposes – is the only way to stay ahead of the game, managing emerging risks and maximising opportunities.
The group argues that model risk is a specific risk type, and as such it should be managed in a similar way to the other risks faced by insurers – with a framework put in place to identify, assess, mitigate and monitor the evolution of model risk across the whole company. This should improve the ability of an organisation to identify models that are not fit for purpose, allowing them to consider and prioritise the model developments required. By integrating model risk firmly within a company’s risk appetite, it becomes more visible and a proper level of attention can be applied to it.
The new IRM guidance document states that “firms can take a lead on the practice of MRM within insurance through being proactive in developing MRM policies and reducing the impact of ‘bad’ models which will ultimately lead to bad decisions”.
The guidance advises on how risk managers can develop their own model risk management framework, tailored specifically to the individual firm’s risks and culture with the intention of improving decision-making, allowing the most efficient allocation of resources and adding significant value.
Phil Whittingham FIRM, Head of Model Validation and Risk Governance at XL Catlin, chair of the IMIF and lead on the project workstream, explained: “Models are an essential tool to help insurers manage uncertainty but users need to be aware of whether they are appropriate for the decisions they are supporting. Best practice is still developing but our project team has come up with some useful industry resources including an example risk classification and an example model risk management policy as a starting point.”