5.3.1. Approval by AFSA

The AFSA may, by written notice, allow an AIFC-Incorporated Takaful Operator to use its own internal model to calculate a component or components of its PCR.

Guidance

Note that the AFSA is not currently in a position to consider applications for the use of internal models. The AFSA will notify Takaful Operators when this position changes.

5.3.2. Criteria for approving use of internal models

The AFSA will only consider allowing an AIFC-Incorporated Takaful Operator to use its internal model if it is satisfied that the model:

(a) operates within a risk management environment that is conceptually sound and supported by adequate resources;

(b) addresses all material risks to which the AIFC-Incorporated Takaful Operator could reasonably be expected to be exposed and is commensurate with the relative importance of those risks, based on the AIFC-Incorporated Takaful Operator’s business mix;

(c) is closely integrated into the day-to-day management process of the AIFC-Incorporated Takaful Operator;

(d) is supported by appropriate audit and compliance procedures;

(e) is subjected to, as a minimum, three tests: “statistical quality test”, “calibration test” and “use test”, the results of the which demonstrate that the model is appropriate for regulatory capital purposes; and

(f) is subject to adequate processes established by the AIFC-Incorporated Takaful Operator to validate the accuracy of the calculations made using the internal model, as well as for monitoring and assessing its ongoing performance.

5.3.3. Statistical quality test

An AIFC-Incorporated Takaful Operator seeking approval for its internal model must demonstrate:

(a) that the PCR or component(s) of the PCR calculated using the internal model addresses the overall risk position of the AIFC-Incorporated Takaful Operator subject to the nature, scale and complexity of the AIFC-Incorporated Takaful Operator and its risk exposures;

(b) the theoretical validity of the internal model including:

1. (i) the suitability of model structure, data (including completeness and accuracy), and estimation within the AIFC-Incorporated Takaful Operator’s business context;
2. (ii) the appropriateness of the internal model basis within the industry context, including methodological benchmarking to alternatives and best practice;
3. (iii) the appropriateness of the parameter estimations. It should be demonstrated that the parameter estimations are appropriate within the market and industry context and parameter uncertainty is addressed to the extent possible; and
4. (iv) the consistency, soundness and justification of the methodologies, distributions, aggregation techniques and dependencies (within and among risk categories) adopted.

(c) the analytical validity of the internal model including:

1. (i) the statistical process for validating that the results of the model are fit for the purpose for which they are used;
2. (ii) the implementation of the model given the theoretical basis, goodness of fit, forecasting capability for out-of sample observations (backtesting), sensitivity to changes in key underlying assumptions and stability of outputs;
3. (iii) the backtesting applied at various levels of the business activity;
4. (iv) the sensitivity analysis undertaken, which should validate the parts of the internal model where expert judgement is used and should examine whether the model output is sensitive to changes in key assumptions;
5. (v) the convergence of the model to demonstrate that model outputs are statistically significant;
6. (vi) the processes of monitoring the model’s performance; and
7. (vii) where possible, benchmarking the model results and techniques with peers, available literature and research.

5.3.4. Calibration test

An AIFC-Incorporated Takaful Operator must demonstrate that the PCR or component(s) of the PCR produced by its internal model is consistent with the specified modelling criteria.

5.3.5. Use test

(1) An AIFC-Incorporated Takaful Operator must demonstrate that the internal model (its methodologies and results) is fully integrated within its risk and capital management and system of governance processes and procedures.

(2) An AIFC-Incorporated Takaful Operator’s Governing Body is required to:

(a) have overall control of and responsibility for the construction and use of the internal model for risk management purposes;

(b) have sufficient understanding of the model’s construction at appropriate levels within the AIFC-Incorporated Takaful Operator’s organisational structure;

(c) have an understanding of the consequences of the internal model’s outputs and limitations for risk and capital management decisions.

(3) An AIFC-Incorporated Takaful Operator must have adequate governance and internal controls in place with respect to the internal model.

5.3.6. Documentation

(1) An AIFC-Incorporated Takaful Operator must document, at a minimum:

(a) the design, construction, modelling criteria and governance of the internal model;

(b) the justification for and details of the underlying methodology, assumptions and quantitative and financial bases;

(c) if applicable, why it has chosen to only use a partial internal model for certain risks or business lines; and

(d) if applicable, the reliance on and appropriateness of the use of external vendors/suppliers.

(2) The documentation must be sufficiently detailed to demonstrate compliance with the statistical quality test, calibration test and use test.

(3) The documentation of the internal model must be timely and up to date.

5.3.7. Ongoing validation and supervisory approval of the internal model

An AIFC-Incorporated Takaful Operator using an internal model must:

• (a) monitor the performance of its internal model and regularly review and validate the ongoing appropriateness of the model’s specifications against the criteria set out in 5.3.2 to 5.3.5;
• (b) notify the AFSA of material changes to the internal model made by it for review and continued approval of the use of the model for regulatory capital purposes;
• (c) properly document internal model changes;
• (d) report information necessary for supervisory review and ongoing approval of the internal model on a regular basis, as determined appropriate by the AFSA