The Solvency II guidelines finally came into effect on January 1, 2016. Since then there have been quite a few articles and discussions regarding the ORSA process, its implementation and the success of Solvency II so far. So I thought that I will share my two cents about what I have been able to decipher from my research on the ORSA. Here it goes.
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What is Solvency II?
Before diving into the ORSA process, it is imperative to know about the Solvency II directive. As the II in the name suggests, Solvency II was preceded by Solvency I directive, which was introduced in 1973. While Solvency I was all about a prudential valuation of liabilities and use of quantitative restrictions to manage the company's assets, Solvency II is more vast and covers a lot of bases including a highly risk-based approach and a well-defined risk review framework. In brief, the main motive of the Solvency II guidelines is to harmonise the risk management and reporting processes across the EU countries and later on across the globe. This is intended to bring about a unification of reporting standards across all the (re)insurance firms in the EU. Solvency II mandates (re)insurance firms to maintain a minimum specified level of admissible assets or risk-weighted assets, known as the Solvency Capital Requirement (SCR), so that they are able to meet their obligations under insurance contracts even during black swan events. To ensure that firms maintain a high quality of capital, Solvency II rewards well-diversified insurers with lower capital requirements and discourages those with high-risk accumulation, especially in a single geography or line of business.
Solvency II Pillars
The Solvency II directive consists of three pillars:
- Pillar 1 consists of quantitative requirements
- Pillar 2 lays down the requirements for the governance, risk management and effective supervision of insurers
- Pillar 3 focuses on the disclosure and transparency requirements
What is ORSA?
Out of the 3 pillars mentioned above, the ORSA comes under the purview of the second pillar. Every (re)insurance firm must conduct its own solvency and risk assessment as a part of its risk management process. This involves defining the firm's risk profile, setting the limits for risk tolerance and deciding its business strategy. Using these constraints, the firm can then extrapolate its prospective solvency positions as per various potential scenarios and stress conditions. The ultimate objective of this exercise is to ensure that firms have a healthy level of solvency at all times while having considered all kinds of potential risk scenarios.
The Solvency II directive explains that the ORSA must include, at least, consideration of:
- The undertaking’s overall solvency needs, taking into account the specific risk profile, approved risk tolerance limits and business strategy.
- Continuous compliance with the Solvency II requirements for technical provisions and solvency capital.
- The degree to which the undertaking’s risk profile deviates from the assumptions underlying the SCR, calculated with the standard formula or with its partial or full internal model.
Being at the heart of the Solvency II directives, the ORSA requires a concerted effort by various departments such as the risk management, underwriting, actuarial, internal audit, finance, investments, compliance, internal audit and IT.
In a nutshell, the ORSA is a set of processes constituting the tools for decision making and strategic analysis designed to help the board members of insurance and reinsurance firms make sound strategic decisions, to define the value created and to embed risk awareness throughout the organisation.
Another clear and precise definition can be found in the ORSA Issues Paper (May 2008) by CEIOPS:
“the ORSA can be defined as the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the short and long term risks a (re)insurance undertaking faces or may face and to determine the own funds necessary to ensure that the undertaking’s overall solvency needs are met at all times.”
An important thing to note here is that the ORSA is not a one-time exercise but a continuous and evolving process through which a firm monitors and manages its risk. The responsibility of ORSA lies with the undertaking's administrative or management body. In its report, the ORSA should consider all material risks which can impact the undertaking's ability to meet its obligations under insurance contracts. The ORSA should also form an integral part of the management process and decision-making framework. In case an internal model is used, the ORSA report must include an analysis of the differences in the assumptions and outputs between the Model SCR and the Standard SCR. Finally, the ORSA process should be appropriately evidenced, internally documented and independently assessed.
Looking Ahead
Although the Solvency II came into effect from the beginning of 2016, it is still in a transitional phase as most of the firms are facing teething problems in successfully implementing the directive. The deadline for full compliance for all firms still stands far away at January 1, 2032. In my opinion, although the implementation of ORSA and Solvency II greatly varies in degree from country to country, if we look at the overall progress in the EU, especially in the larger firms, the implementation has been quite successful. Some wrinkles in the implementation, such as the ultimate forward rate and the use of transitional measures in the solvency models, still need to be ironed out. However, looking at the benefit that the firms can derive from this directive, I would say that it has been well worth the effort!
