Is the ORSA the biggest challenge of Solvency II?

The frequency of the ORSA, its forward-looking nature, potential discrepancies between it and the SCR – all these issues were discussed at an InsuranceERM/SAS roundtable where there was general agreement that, despite some key uncertainties, the ORSA is a valuable exercise

Note: this is the first of a two-part report on the roundtable

Trying to define the ORSA

Field: Would you say the own risk and solvency assessment (ORSA) is one of the most challenging parts of Solvency II?

Goddin: I think it is, because it is pulling together so many sub-processes really. You have to get all the underlying process sorted out before the ORSA is really going to mean anything. It does challenge you quite a bit and you then you have a separate challenge in trying to make sure that, having brought together all these sub parts, it then meets primarily the business' need to actually mean something to the board.

Borrett: I think one of the early challenges was that the term ORSA was coined wih very little definition as to what an ORSA was; what the regulator would expect from an ORSA; and whether it should be integrated as a core part of risk and capital management or to what extent it was an additional form of reporting for an organisation. 

Field: Do you think the European Insurance and Occupational Pensions Authority has given enough guidance on this?

Borrett: I think that it is actually right that the organisation drives the approach. Documentation need not be an Encyclopaedia Britannica; it is more of a Reader's Digest. The report pulls out from your dynamic ORSA process the most salient aspects of the risk profile, capital management and capital optimisation.

Deighton: The ORSA should in theory be relatively easy because it is meant to be something that effectively just feeds off the rest of the processes that you are required to build under Solvency II. Secondly, you could argue that actually there is far too much guidance being given already and any more would be unwelcome.

That's because unfortunately, there is also a requirement to file the ORSA with the regulator. They will inevitably apply the same sort of approaches they are applying to every other part of Solvency II. In other words, they will run through that guidance; they will draw up checklist of every single statement in the guidance; and if you do not meet all of them, they will say it is probably not adequate.

Baxter: I would actually hope that we would not have too much guidance around the ORSA as it needs to be a management tool: maybe it is a vain hope.

ORSA vs SCR

Deighton:There is a lot of emphasis on being sure that you are capturing, discussing and assessing all of the risks in the ORSA. But if you are on the internal model route, the requirements of the internal model have made sure that you have actually assessed, quantified - where you can - and thought about all of the risks. So it would be slightly strange if this once or twice a year process suddenly popped up with some other risk that you had completely forgotten about.

If you are a standard formula firm, then there is quite a lot in the guidance about understanding whether the standard formula is actually appropriate to your risks. Therefore, there is a real danger, although it clearly says that the ORSA is not meant to be a capital assessment exercise, that it turns into exactly that for a standard formula firm. In other words, the regulator will focus on all the parts of the ORSA that require you to increase the standard formula and give very little credence to other parts that might actually be suggesting that the standard formula is too strong.

Kirby: Are you concerned that the regulator will actually use the ORSA almost like a stick against you? In the sense that they may look at your SCR [solvency capital requirement] and say, 'Well, your SCR value is down here; your ORSA value is up here: why such a disparity?' And you think they will use that as leverage against you?

Deighton: I think there is a real danger of that even though it's not really playing by the rules of the game.

Field: Is it not different in the time horizon though? The ORSA is much more forward-looking, is it not?

Deighton: Well, it is both, is it not? In order to be forward-looking, you have to start with an assessment of the current position. Actually, the forward-looking aspect is another thing that could be latched on to because, if it shows a deteriorating position, then there may be a lot of pressure from the regulator to put more capital into the business now in order to deal with that rather than rely on a promise that it will get put in when you need to.

Goddin: That would suggest then it is quite important for a firm to be able to reconcile the difference between the ORSA value and the SCR value, and explain very clearly what the differences are so that if the regulator does challenge them.

Field: Is the materiality and proportionality principle a fairly movable feast? 

Deighton: Yes. I think you would need to do the ORSA to a comparable level to the materiality and proportionality that is in your internal model.

Field: What is the most difficult part of the ORSA to fulfil then?

Deighton: The forward-looking bit is definitely the bit that we have found most difficult so far because our old systems were really not built to do that, and the new system is not online yet.

Field: What system are you talking about, new software?

Deighton: We took a fundamental decision at a very early stage to scrap all of our existing actuarial software and build something new, which we are building on the Mo.net platform.

Field: The technology is quite important to you in getting this process right, then? 

Deighton: I think the technology is clearly important in doing the numbers but it is only a part of it. The ORSA is meant to be, as we said earlier, a coming together of all of the elements of the risk framework.

The other issue between the SCR and the the ORSA is the concept that the ORSA can be your own view of the appropriate capital requirement. In order to get the model approval, in theory you are meant to say, 'I believe in this model and I believe in these assumptions sufficiently well that I use them to make decisions,' and then at the same time you may be presenting the ORSA paper to the board which has a set of numbers on a completely different basis.

Baxter: The SCR is actually moving away from economic reality. Sometimes you are forced to actually look at your own view. For example, contract boundaries: we are getting an uneconomic view of contract boundaries built into the SCR. So the debate is, 'Well, should you be looking at your position from an economic basis?' And, 'How do you rationalise that within the ORSA?'

Deighton: Absolutely. You could also ask if there is an opportunity here because if you have to give up the argument with the regulator on the SCR, then you have another chance to put it in front of them on the ORSA.

ORSA frequency

Field: Is the frequency of the ORSA an issue?

Borrett: How frequent can that exercise be? Legislation clearly provides for an ad hoc rerun of the ORSA in the event of a significant change of certain circumstances, a black swan event, a major organisational change, a merger or a divestment. However, outside of that, I think it is around adequate trend data which allows you to drive revised assumptions.

Field: Is quarterly what is laid down at the moment?

Borrett: No, the legislation is not prescriptive. We have moved this year from a pillar one basis to being a pillar two company largely as a proxy for Solvency II until our internal model comes fully on stream. We are therefore running the model quarterly on a pillar two basis.

Goddin: I think though you can distinguish here between the ORSA report and the ORSA process to a degree. I agree that the ORSA process should be running far more frequently than annually, certainly quarterly, if not more frequently depending on the area of risk you are talking about.

However, a full ORSA report documenting the process can certainly be an annual exercise but the process itself should definitely be ongoing throughout the year to get any sort of value from it.

Diverging from the economic view of capital

Coombes: I think we were all hoping that the internal model approach and Solvency II in general would adopt an economic view of the company's assets, liabilities and capital requirements. However, there have been increasing signs recently that it is moving away from an economic view. As soon as it does that, management teams will inevitably take their own economic view of the circumstances and requirements looking forward. Then there will be a divergence between the ORSA assessment and the SCR, and that is really unfortunate. 

Deighton: The SCR will be seen as a financial constraint on your own planning process driven by your own view of capital. Unfortunately, along the way, we have lost a lot of the original purpose and benefit of Solvency II.

Baxter: However, if we look at Basel, there is a precedent and it should come as no surprise.

Field: Does your ORSA differ very much from your current SCR?

Coombes: We are still continuing to review some of our calculations. But it would not surprise me if, perhaps like other companies, the assessment of the capital requirement under the standard formula was perhaps at the highest level, then at an SCR or internal model level was slightly lower and at an ORSA level was slightly lower still.

However, the regulator would obviously keep us to the SCR amount at least, and then maybe require some buffer. There are areas where we could see that some of the requirements of the internal modelling of the SCR are uneconomic and on an own-risk basis we would consider we need less capital.

Kirby: The FSA [Financial Services Authority] had this perception that the standard formula and the SCR calibration were more or less aligned to the BBB rating from Standard & Poor's (S&P). I always had this view that most insurance companies would want to be better capitalised than BBB.

Is releasing capital likely?

Coombes: I think we are still in a moving feast. We still have things like contract boundaries out there which could be uneconomic; we have the FSA reviewing technical provisions and, where we thought that they were meant to best estimates, there are now murmurings that they actually ought rather to be prudent. If the starting point is prudent and then a risk margin is required on top, it starts ratcheting up.

You cannot help but feel that, if the FSA saw as a result of a whole lot of internal models, a significant amount of capital was going to be released from the industry as a whole, they might feel a little bit uncomfortable about that and start putting in buffer requirements. No-one knows exactly what they might be. 120% - maybe a bit more or less? There is a lot of uncertainty over the final outcome.

The murmurs we have heard recently tend to suggest that we are going to end up with a more cautious regulatory regime. Therefore, the ORSA and an economic basis might well come up with a lower figure of what management think is really required economic capital.

Kirby: Capital add-ons go against an SCR only. I understood that it is meant to be a temporary measure only, and only applied on the basis of an underlying risk factor or risk deficiency, which needs to be addressed.

Borrett: You are absolutely right that add-ons were a feature of the ICA [individual capital assessment]. I think that has been replaced now by a rhetoric of prudence and, on a very practical level in very volatile economic circumstances, it would be a brave regulator who in introducing a new solvency regime chose as one key piece of evidence of that to see firms releasing capital.

Coombes: However much the economy might need that.

Borrett: And however much your own risk profile suggests that is appropriate.

I too would question the calibration of SCR to S&P rating. We in the UK have a standalone S&P rating for Unum and it does not correlate to a BBB against our assessment.

Deighton: As we go through the process of actually building the models and getting them agreed, we are already seeing evidence of the drift that comes from the benchmarking approach. The quantitative tools that the FSA have developed are effectively just benchmarking exercises.

You will get see a continuation of the process whereby companies that are below the average of the benchmark distribution are persuaded to strengthen, which obviously results over time in the average creeping up. If a company does not strengthen, it runs the risk of a capital add-on.

Channels: 

Companies: