Model validation, claims inflation and pressure to keep the number stable
Hartwell Insurance is a £1.2bn-reserves general insurer submitting its internal model to the regulator in three weeks. The model uses a claims inflation assumption of 4.2% for casualty, built from a third-party construction-cost index. Validation found the index lags claims by about nine months and excludes litigation funding and social inflation; observed paid severity in the casualty book has run at 6.8% for six quarters. The model owner resists changing the assumption, arguing the index is 'independent' and that a change would add £45m to reserves and cut the solvency ratio by 14 points. The CFO has asked you, as the actuary asked to sign off the model, to 'keep the number stable until after the submission'. The model risk policy requires validation findings above £20m to be escalated to the Audit Committee. You have a draft finding.
1. What does the Actuaries' Code require of you in this situation?
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The Actuaries' Code. The relevant principles are Integrity, Competence and Care, Impartiality, Communication, and Professionalism. Signing off a model with an assumption I believe is wrong would breach Integrity and Competence and Care. The CFO's instruction to 'keep the number stable' is not a basis for an actuarial assumption.
What the Code requires.
- Act objectively and not allow pressure from senior management to override technical judgement.
- Use reliable data and methods; document the validation findings.
- Communicate the findings clearly to those who rely on them.
- If a material issue is not being addressed, escalate to the appropriate governing body (Audit Committee, Board) and, if necessary, to the regulator.
- Keep a record of the advice and the response.
Application. The validation finding is material (£45m, 14 points of solvency). The model risk policy requires escalation above £20m. I would complete the validation report, give the model owner a chance to respond, and escalate to the Audit Committee. I would not sign the model as it stands. I would offer a qualified sign-off with an explicit adjustment or a reservation.
Pressure. If the CFO repeats the request, I would say: 'I can sign a model that uses the adjusted assumption, or I can sign a qualified opinion that explains the disagreement. I cannot sign an unqualified opinion that I believe is wrong.' If the deadline cannot be met, request an extension from the regulator; a late submission is better than a false one.
2. How would you test and potentially adjust the 4.2% claims inflation assumption?
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Test the index against observed claims.
- Regress paid severity on the index with lags of 0–12 months. The validation found a nine-month lag; test whether the lag is stable across accident years.
- Compare the index to alternative measures: CPI, average weekly earnings, legal costs, court awards, and the company's own paid severity.
- Decompose the 6.8% observed into frequency, severity, mix and large losses. If the 6.8% is driven by a few large claims, the underlying trend may be lower. If it is broad-based, the 4.2% assumption is too low.
- Use expert judgement: litigation funding, social inflation, and the legal environment are not in a construction-cost index.
Quantify. For £1.2bn of reserves, a 1% change in the inflation assumption might change the liability by £15m–£25m, depending on duration. A move from 4.2% to 6.0% could be £27m–£45m. The £45m estimate is plausible. I would build a range: central 5.5%–6.5%, with a risk margin for model uncertainty.
Adjustment. Rather than replacing the index, use it as a starting point and add a spread for the missing components. Test the sensitivity of the SCR and the reserves. If the data are credible, adopt the higher assumption; if not, disclose the range and hold a prudent central estimate.
Model documentation. Update the model risk register, record the validation finding, the model owner's response, and the Audit Committee's decision.
3. What escalation and communication steps would you take, including if the CFO continues to resist?
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Escalation path.
- Send the draft finding to the model owner with a deadline for response.
- If unresolved, issue a formal validation report to the CFO and the Chief Actuary.
- Escalate to the Audit Committee under the model risk policy. Provide the report, the minutes, and the quantified impact.
- If the Audit Committee does not act, consider informing the PRA. The Actuaries' Code and the PRA's Senior Managers and Certification Regime support this.
Communication. Keep it factual: 'The index has a nine-month lag and excludes litigation funding. Observed severity is 6.8% over six quarters. The 4.2% assumption is not supported. The impact is £45m and 14 points of solvency. I recommend adjusting the assumption or disclosing a reservation.' Avoid attributing motive to the CFO.
Documentation. Retain emails, the draft report, the model owner's response, and the Audit Committee papers. If pressured, confirm the instruction in writing: 'To confirm, you are asking me to sign off the model without the adjustment. I am recording my objection.'
Outcome. Ideally the model is adjusted before submission. If not, the submission should include a qualified sign-off and a remediation plan. The actuary's duty is to the users of the model and the public interest, not to the CFO's timetable.