One of the fundamental objectives of the upcoming Own Risk and Solvency Assessment (ORSA) is to provide an evaluation of the level of capital an insurance company will need both now and in the future. This assessment should represent an insurer's own view of the amount of capital it needs based on the risk within its business. Capital therefore needs to be calibrated to the level of risk the specific company bears, as well as allow for all relevant and material risks to which the company is exposed. Furthermore, the capital metric will need to be sufficiently risk-sensitive in order to react to management's actions to mitigate risk; in fact, insurers who identify, understand and manage all relevant and material risks can benefit because they will reduce their capital requirements.
We see the ORSA as an opportunity to strengthen existing enterprise risk management (ERM) processes or establish a formal risk-management framework. Because the ORSA will provide insurers a chance to assess the veracity of their ERM programs, it will be much more than just a regulatory-compliance exercise.
As companies begin to think through their intended approach, some may consider whether or not they can use statutory risk-based capital to meet the assessment's requirements. Because the NAIC Risk Based Capital (RBC) measure is an existing metric that takes into account a company's risk exposures to at least a certain degree, management may be tempted to leverage it in order to quantify the required level of capital. And, indeed, there are a number of advantages to adopting this approach. Management often bases its existing targets and objectives on multiples of the minimum level of RBC coverage. Therefore, using RBC as a metric in an ERM framework is useful because it can indicate how management currently thinks about capital and can be a key component of how it makes business decisions.
In addition, using RBC for the ORSA would offer the benefits of not requiring new processes for data, models, assumptions and results, as well as removing the need to introduce new metrics to the business. Moreover, because the results are relatively stable and the drivers for change are easily identifiable, RBC figures generally are relatively easy to produce and understand. If management understands the metric and the potential limitations, then they will know when they can make decisions using RBC and when they need additional information.
However, RBC has limitations, and without significant enhancement, it is unlikely to be a directly appropriate quantification of capital for use in an ORSA. RBC is based on an industry perspective of the significant quantifiable risks and is a point-in-time capital metric. It generally uses a factor-based approach and is calibrated with industry data and averages. This results in a metric that is unlikely to sufficiently focus on the risks that a particular company bears and is difficult to link to stress scenarios (as the base capital requirement doesn't represent a particular scenario outcome).
Furthermore, RBC is relatively insensitive to changes in some of the underlying risks, and the industry average calibration may not capture the risk-mitigation actions management employs. Therefore, the metric will not provide full feedback on the success (or failure) of management's actions to mitigate risk. For example, RBC does not include a risk-sensitive allowance for operational risk, and it won't reflect actions management takes to improve IT or data security.
Crucially, in a risk-management context, an unadjusted RBC metric does not encourage an insurer to fully identify, understand and manage the risks in its portfolio. Not only does this mean the insurer could omit some risks, but this approach limits the company's ability to identify situations in which the reward for taking on risk is likely to outweigh the potential for negative outcomes. Therefore, RBC can miss strategies that provide a favorable return for a given level of risk.
Insurers will need to consider the limitations we describe above and enhance the RBC metric in order to make it suitable for use in the ORSA. However, a considerable amount of the ORSA's value to insurers will come from their going through the production process and focusing management's attention on key business risks. Therefore, for companies that go through the process of identifying, quantifying and managing the risks but do not want to adopt a full economic capital model, RBC could be a base from which to build a capital metric. They could recalibrate parameters that are more appropriate to an individual company, adjust the target coverage multiple and enhance the metric by including additional risks. This is likely to require use of at least some of the individual risk models that underlie the RBC process to perform the risk assessment and calibrate the RBC metric. However, to become sufficiently risk-sensitive, management would strongly benefit from investigating and adjusting these recalibrations and enhancements as the risk profile changes.
While RBC can serve as a starting point or foundation from which to construct the ORSA capital metric, insurers shouldn't short circuit the ORSA process to the point they miss the opportunity to improve risk-management practices.
Brian Paton and James Isherwood contributed to this article.
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