The ORSA: Binding the Solvency II framework together
The Own Risk and Solvency Assessment (ORSA) – Binding the Solvency II Framework together
The ORSA process is at the heart of Solvency II and should be at the core of an insurer’s risk management system. Its purpose is to ensure that you engage in a process to assess all of the risks inherent in your business and to help determine the corresponding capital needs. To achieve this you need to have robust processes to assess, monitor and measure your risks and solvency needs, and ensure that the output from the assessment is embedded into the decision making processes. It also needs input from across the whole organisation.
The assessment of your solvency needs should reflect the way you propose to manage the risks you face through the allocation of capital or other mitigation techniques. It should incorporate an assessment of your risk profile, approved risk tolerance limits and overall business strategy.
Senior management’s role
The risk management function plays a key role in the ORSA process by identifying, assessing, monitoring, managing and reporting internal and external risks, emerging risks and risk scenarios that could damage the business. It provides senior management with a comprehensive risk assessment of the risks the insurer is exposed to or could face in the future
Senior management’s role is to challenge this and also to consider the effectiveness of any risk mitigation plans. It is also senior management’s responsibility, taking into account the insights gained from the ORSA process, to approve long and short term capital planning, in light of the agreed business and risk strategies.
In looking at capital, senior management will need to consider a range of scenarios to ensure that solvency needs can be met, even under unexpectedly adverse circumstances. They will also need to challenge the assumptions behind the calculation of the Solvency Capital Requirement (SCR) to ensure the calculations correctly reflect the agreed risk assessment.
Senior management will need to understand and be able to reconcile the differences between their assessment of the entity’s capital requirement and that required by the SCR. This will require an understanding of those additional risks which are considered to be part of the firm’s own capital but which are not modelled in the standard formula SCR and considering any differences in the methodologies used and assumptions applied in calculating the different capital measures.
Guideline 1- Principle of proportionality to Article 45(2) of the Solvency II Directive states that ‘the undertaking should develop its own processes for the ORSA, tailored to fit into its organisational structure and risk management system with appropriate and adequate techniques to assess its overall solvency needs, taking into consideration the nature scale and complexity of the risks inherent to the business.’ Accordingly, EIOPA has embedded proportionality into the Solvency II framework; this must be good news for smaller insurers.
EIOPA has produced guidelines as to what an effective ORSA process should include; but this is not prescriptive. Accordingly, when developing the ORSA, insurers need to go back to the fundamental principles which underpin the Solvency II regulatory framework and ensure that these are addressed. The scope and design of the ORSA will depend on the scale and complexity of your business. EIOPA recognises that there is a world of difference between the simple model a small insurer might use to help with the assessment of its capital needs and the full blown internal models that larger insurers are in the process of developing.
For the smaller mutual insurer there is considerable latitude in what they are required to do. Rather than starting with a blank sheet of paper, firms should look at what they are currently doing. If you are subject to the Individual Capital Adequacy Standards (ICAS) regime, this might mean building on this framework as a number of the concepts are similar to those that are being introduced by Solvency II. You will, nevertheless, need to look at some of the more qualitative aspects of the business, for example operational risk, to ensure your ORSA process is up to standard.
Our experience is that for smaller insurers, one of their biggest challenges is embedding the ORSA process into the management of the business. For a well run firm with a strong risk management function and good governance practices, moving into the Solvency II environment will be an evolutionary step. For less well run firms the impact is likely to be more revolutionary in nature.
Insurers should review their decision making processes and consider what information is currently reported to senior management, particularly relating to the assessment of the firm’s capital requirements.
Firms should also perform a gap analysis to identify any additional information they will be required to report under the new rules. They should consider how this information will be produced and how it will be used by senior management to inform their strategic thinking.
In this respect the production of the ORSA Report, which is the formal articulation of the way in which the insurer identifies and assesses present and future risks, its risk mitigation strategies and the way in which it has calculated its regulatory and own capital requirements, will be key as it will define much of the additional information that is required.
Your ORSA Report should include consideration of:
- The identification and assessment of risk and the effectiveness of your risk mitigation strategies under a stressed scenario.
- The assessment of your capital requirement.
- The way in which your capital requirement has been calculated – this needs to be forward looking, linked to your key risks and reflect your risk tolerance limits. It also needs to be tested for robustness through stress and scenario testing and for accuracy through back testing against previous experience.
- The reconciliation of your solvency assessment against the SCR.
- External factors such as economic conditions, the legal environment and technical developments, and the way in which these may impact on the insurer’s capital requirements.
- Potential action that can be taken in the event of adverse developments, including contingency planning.
As such the ORSA Report should demonstrate that you have engaged in a rigorous and robust process of assessing all the risks inherent in the business and determined the corresponding capital needs. It is the document that binds all the elements of the Solvency II regulatory framework together and will help show compliance with the new regime.
Philip Alexander is a partner in Littlejohn’s insurance practice and can be contacted on 020 7516 2444 or email@example.com