Insurance (prudential standard) determination No. 6 of 2010 - Prudential Standard GPS 113 - Capital Adequacy: Internal model-based method
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Model sufficiency
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APRA will not provide approval for use of the IMB Method unless it is satisfied that the insurer’s ECM and RCM are sufficient to give a reliable measure of required capital.
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An insurer’s ECM and RCM must adequately capture all the material risks of the insurer’s portfolio and business including the following risk categories:
(a) catastrophe risk – natural or man-made events that produce insurance losses from many insureds at the same time;
(b) underwriting risk – the possibility that future insurance exposures (both from business in force and future business) will be loss making;
(c) reserving risk – the possibility that the provisions for claims outstanding will be inadequate to meet the ultimate costs when the business is run off to extinction;
(d) market risk – the risk arising from all aspects of the value of investments and currencies, including interest rate changes, market price changes, counterparty default, exchange rates and liquidity of investments;
(e) credit risk – the risk of loss arising from failure to collect funds from creditors, including reinsurers and intermediaries; and
(f) operational risk – the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This includes legal risk[9] but excludes strategic or reputational risk.
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APRA may direct an insurer in relation to the manner in which each of these material risk categories are dealt with in the insurer’s ECM and RCM, including, but not limited to, altering the matters to be covered under each category and permitting categories to be dealt with in a cumulative manner. APRA may allow a transition period for compliance with a direction.
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It is not necessary for the ECM and RCM to capture risks outside the above definitions, such as strategic or reputation risks. However, material risks that are not captured in the ECM and RCM must continue to be managed under the risk management framework of the insurer[10].
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For each component of risk, the ECM must utilise a distribution with appropriate shape and tail characteristics. In combining components of risk, the model must make appropriate allowance for correlation between risks, particularly correlations in the tail of distributions. An insurer wishing to incorporate diversification assumptions in respect of operational risk must demonstrate an adequate process for estimating dependencies (particularly for extreme losses) and must apply conservatism in its dependence assumptions commensurate with the uncertainty of the estimates.