Top three validation priorities for 2021: better insight, lower cost, capital efficiency

At this time of year, many risk and capital teams embark on a new lap of their internal model validation cycle.  Unlike the more exciting underwriting cycle or the more troubling reserving cycle, the validation cycle is more about applying common sense.  Most firms use it to stagger model-testing frameworks.  This helps them to avoid burnout of stretched specialist teams.  It also means that time is specifically allocated to perform deep-dive reviews.

Here are the three questions that we think should be at the front of the CRO’s mind as they plan validation for the year ahead.  Following on from the recent PRA “Dear CRO” letter, this is an area where CROs can demonstrate value:

• What can we do more of?

Good decisions require good model MI.  But in order to rely on the model for additional uses, additional validation may be required.  This brings an associated risk of uncovering errors and inconsistencies.  A balance must be struck between the benefit to the business of these additional model uses and the increased costs of the associated validation.

• Where can we reduce cost?

Many firms struggle with the burden of maintaining their internal model.  Firms can identify opportunities for efficiency savings by focussing on three Ps:

Purpose – ensure clarity as to which decisions are to be taken using the model.  This will avoid project creep, where models are developed and used for interesting but non-essential tasks.

Process – good models have a strong end-to-end flow from data inputs to results; poor ones require extensive management input and iteration, or even manual intervention.

People – smart firms make a strategic, and flexible, use of in-house, contract and consulting resources.

• How can we drive shareholder value?

Good validation tests models for errors; better validation highlights where capital models hold margins.  But the best validation develops credible routes to right-size the SCR while keeping both boards and regulators onside.

Is your annual model validation just a compliance exercise? Are you extracting value for the business from your model validation reviews?