William Monelle continued the Mazars Risk and Capital Management Seminar, held on the 21st May 2013, after the break with a session discussing the practical benefits and challenges of Solvency II’s Own Risk and Solvency Assessment (‘ORSA’). An initial show of hands revealed that there was a fairly even mix of actuaries and non-actuaries from life and non-life firms, and standard formula and internal model firms. Attendees were also representing firms at very different stages of ORSA development. A few had defined and run their ORSA process but the vast majority of the audience were still in the design stages.
What do we already know? We also know that, as well as those directly impacted by the requirements of Solvency II, there are a growing number of territories that are adopting the ORSA. This includes the NAIC, the US regulator, which has not always fully embraced the rest of the Solvency II approach. In addition, the delays to Solvency II implementation have led to the current EIOPA consultation on Solvency II ‘Interim Measures’ of which the ‘Forward Looking Assessment of Own Risks’, essentially the ORSA, is a particular area of focus.
Areas that remain uncertain
It’s not what you would normally hear from a consultancy, but Mazars feels that it’s healthy to question commonly used statements such as “ORSA will drive real benefit” and “ORSA will unlock the huge investment firms have made into Solvency II”. Essentially Mazars believes that this will really depend on the culture of the individual firm and how much the senior management embrace the opportunity. Also, different firms are likely to benefit from different aspects of the ORSA depending on the risk management that’s already in place and embedded.
Areas that Mazars has seen working well:
The biggest benefit Mazars is seeing is the continued focus on risk and capital management. The ORSA has helped firms understand which areas of their ERM framework they need to develop. Indeed, it is often not the ORSA itself that is the problem but a process or calculation that feeds into it. For example, if firms haven’t already, the ORSA highlights a need to formalise risk appetite and risk tolerances. ORSA has also started to highlight whether firms can actually achieve their business strategies by staying within their risk appetite!
ORSA is also starting to change firm’s perspective of risk with more time spent considering the upside of risk rather than tending to focus solely on the downside. Firms have also had to think about future strategy in a different way and Mazars has observed a shift towards more pro-active strategic thinking.
ORSA projects have also led to a focus on governance. Documentation in this area has developed considerably over the past few years and has also led, in some cases, to firms making changes ot their governance structures.
In addition firms have spent more time considering, often very material, non-SCR risks and correlations. However, as discussed later, there remain a number of challenges around the quantification of these items.
Areas that Mazars hasn't seen working well:
Few firms, if any, can really argue that their ORSA process is truly embedded. Whilst a number of ORSA related processes are already in place for many firms, most would still consider themselves to be in a development stage rather than an embedding stage.
Mazars is seeing individual business functions working well in isolation but it is taking time for the interactions between areas to develop. For example, to date there has been limited involvement from first line functions such as underwriting. Given that these are the individuals that actually take on risk, it is important for them to understand how these relate to risk appetite and the overall business strategy.
Whilst there are big variations across different firms, in general we are seeing that Boards who have had more training are providing a more active role in the ORSA. This is not surprising given that there are some new concepts to learn and even risk professionals have spent considerable time absorbing and understanding the requirements. Leading firms have had structured Board and senior management training in place for a considerable time now and in some cases we have seen some training being provided to all staff.
As discussed above, firms have been spending more time considering non-SCR risks and diversification but there remain a number of challenges around the quantification of these items. However, this is an area that firms will have to address as requests to EIOPA to limit the risk quantification requirements have not led to relaxation in the requirements.
Even with EIOPA relaxing the rules in relation to quantification of solvency needs for each separate year of the ORSA projection period, firms are still coming to terms with how they will model future years. Mazars is seeing a range of modelling approaches from simple stress and scenario tests to sophisticated economic capital models and these approaches are likely to develop iteratively over time.
ORSA Proverbs
A number of simple ‘ORSA proverbs’ were then used to consider various elements of the Own Risk and Solvency Assessment. Whilst it is not always that easy, ‘keeping it simple’ is often the way to get things working – at least initially!
“If it ain’t broke, don’t fix it!”
The UK’s INSPRU regulatory regime and, more recently, Solvency II has led to an increased focus on risk management and the industry has dedicated significant resource developing risk management knowledge and techniques. However, the core principles are not new. Insurance is, and always has been, fundamentally based around the concept of risk. ORSA, therefore, should be thought of as a way to reaffirm best practice in risk management rather than to reengineer business management.
To make the ORSA work, firms really need to leverage their existing risk management systems. However, from our experience, this has actually highlighted to firms some areas that are not embedded or sometimes not working at all!
The industry should also learn some lessons from the existing INSPRU regime. This was the first time insurers really had to specifically report on risk management and risk-based capital. However, the ICA was often an isolated exercise carried out by the actuarial function and was not always based on a forward looking assessment. The ICA is the closest thing that we’ve currently got to an ORSA but the level of embedding, demonstration of risk management governance and linkage to business strategy are now much more of an explicit regulatory requirement.
Whilst the minimum requirement is for an ORSA to be run at least annually, Mazars feels that firms will benefit from running their ORSA process quarterly (or at least a subset of it depending on the complexity) and firms should look to supplement existing risk management information and reporting with ORSA-type output.
“Too many cooks spoil the broth!”
Governance is again an area with a broad definition but it essentially boils down to roles and responsibilities. What can go wrong if people don't carry out their functions appropriately?
The ‘too many cooks’ message relates to governance but can be a bit counterintuitive. It suggests that lots of people having an input into the ORSA process threatens its success. Actually, the risk is that involving too many people leads to a lack of ownership. Whilst the Board is ultimately responsible for ORSA, it is often driven by the risk management function. Risk managers need to use a broad range of skills to bring together the expertise of other business functions and empower people within the ORSA process. This has been a particular challenge due to Solvency II ‘fatigue’ often leading to a lack of engagement within the firm and key personnel hoping that ‘somebody else will take care of it’.
The ORSA is a great opportunity to link the ‘people on the ground’ with the senior management and Board. Employees at all levels of a firm have different incentives, different opinions and different requirements but they should all have a common understanding of the firm’s objectives and the part they play in achieving effective risk management. The ORSA can, and should, therefore be used to help communicate the core values of the business.
“Knowledge is power!”
The ‘intelligence hierarchy’ slide was used to highlight two very important areas strongly related to the ORSA; data and knowledge transfer.
Data is a long standing issue within the financial services industry. It has a direct influence on analytical effectiveness and firms expend significant effort transforming source system data into usable management information. Risk and capital management requires risk and capital information and if firms are making decisions based on this it is vital that it is complete, accurate, appropriate and timely. The ORSA has highlighted a need to ensure that the data that is feeding into management information is fit for purpose. This is likely to be the reason why Solvency II has driven significant investment in areas such as data warehousing and data validation.
Article 48 of the Solvency II Directive sees a clear role for the Actuarial Function in supporting the ORSA. In the past actuaries have been criticised for being ‘protective’ of knowledge which has often led to a gap between knowledge and the level of understanding of actuaries and the rest of the firm. Sharing ORSA output throughout the firm puts into context the technical actuarial and risk work that is carried out and helps to bridge this gap.
Whilst Solvency II and the ORSA are helping to consolidate risk and capital management knowledge, tools and techniques, Mazars continues to see a wide variation in understanding. For example, Value-at-Risk is now a commonly used technique that is almost accepted without challenge. However, in many firms, particularly smaller firms, there is still a lack of true understanding of the concept. The focus on regulatory capital at the 99.5th percentile has not helped this. Values in the tail of the distribution are conceptually difficult to understand as it is difficult to connect this with your own experiences and mental model of how the business works. Economic capital derived in the 'middle-percentiles' is what people are interested in and where decision making is enhanced.
This also helps another very important element of the ORSA, namely stress and scenario testing. The value for decision makers is to think through the business impact of real life events and think about the management responses in such situations. Stress and scenario testing helps management consider extreme events, essentially quantifying the losses in the tail of the distribution. It also helps to fulfil the important validation requirement of sense checking model output. To fully leverage senior management’s experience and knowledge, the risk and capital models (certainly stochastic models) should be challenged thoroughly and tested for reasonableness. Whilst this seems fairly straightforward and common sense, it is an area that Mazars feels would benefit from further development and documentation.
Therefore, if senior management and the Board are really expected to use risk data, information and knowledge in key decisions it would be foolhardy to use this without truly understanding it. This leads into the area of the Use Test.
“Actions speak louder than words”
Whilst the Use Test is specific to internal model firms, it should really be considered by all firms. In its own way, the standard formula is a risk based capital model and firms should at least be evaluating its appropriateness. Whilst the ORSA does not require an undertaking to develop or apply a full or partial internal model, a firm that already uses an approved model for the calculation of the SCR should use this within the ORSA. The ORSA also needs to capture all material risks. Therefore if management are not using their ORSA to make decisions, are these decisions not material or is the ORSA deficient in some way?
The ORSA process and associated documentation is key when firms are looking to satisfy the requirements of the Use Test. For example, having to reconcile different measures within the ORSA means management are considering what it is that they are actually trying to do. Is the firm objective to maximise IFRS profit? Reduce capital requirements? Improve earnings stability?
Real life practicalities are not built into models and what appears to be the optimal strategy arising from model output may not actually be applicable for a number of reasons. These reasons could include regulation, politics, lack of availability, operational inefficiencies etc. Although often not documented, these are many of the factors that management have been taking into account when making decisions for many years. It is therefore important for the management and financial modellers to work closer together. Both parties need to appreciate that there are inadequacies in both approaches but used collectively can be extremely powerful.
Finally, sometimes doing nothing is the optimal strategy and is therefore the management decision taken. However, there still needs to be sufficient documentation to support and evidence this!
“You can’t judge a book by its cover”
The next ORSA ‘proverb’ relates to documentation. We know that the ORSA should be ‘appropriately evidenced and internally documented’ and that some ORSA information will even be publically disclosed. It is therefore vital that firms ensure that all levels of documentation are consistent whether the intended use is for internal management information, regulatory reporting or public disclosure.
From Mazars’ experience, firms continue to struggle with the level and quality of documentation required in order to satisfy the requirements of all stakeholders. However, there is a tendency to leave documentation to the end of a task and complete it if time permits yet it is common to hear comments such as “the regulator doesn’t understand our business!” ORSA documentation, whilst vital for internal management information and business decision making, is the perfect way for the regulator to assess and understand a firm’s risk profile, level of ERM sophistication and compliance against many areas of the regulatory framework. Given the importance of the ORSA, firms should ensure that they allocate sufficient time and effort to this very important area.
“If at first you don’t succeed, try, try again!”
Finally, the importance of taking active steps towards ORSA development was emphasised. Whilst conceptual guidance is helpful to design the ORSA, the learning only really begins when a firm attempts to actually run their ORSA process. This is when firms very quickly work out which are going to be the most challenging areas that will require more thought and development. In addition, ORSA is not a one-off exercise and so it is important to be flexible with the approach to ensure that the ORSA can evolve as it is embedded into the business. The firm can then also incorporate market good practice as and when it emerges.
To summarise, Mazars acknowledges that it is often easy to get lost in the detail. It is therefore important to remember to go back to basics every now and again and ask yourself “What is it that we are actually trying to do?” and “Are we aligned to the basic principles?” This essentially means considering the following points:
1. The key risks you face/ may face; 2. How they are identified; 3. How they impact/ might impact; 4. How you deal/ will deal with them. 5. How best to report these to all stakeholders.
By William Monelle, Senior Manager at Mazars
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