At first glance, the Own Risk and Solvency Assessment (ORSA) seems like an unnecessary redundancy. For some firms, they will have looked at the Standard formula for capital adequacy and then looked again at the Internal Model and the Economic Capital. And on all of those views, the firm has sufficient solvency margin.
But the problem that ORSA solves is a problem that is so very fundamental that we have almost completely forgotten that it exists. That problem is that all of the traditional ways of looking at capital adequacy look at the wrong thing. Yes, you heard that right, we have always and will continue to focus on the wrong thing when we assess capital adequacy.
The basis for capital assessment is the wrong view because it looks backwards. We already know that the firm survived the past year. What we really need to know is whether the firm can survive the next year and probably the one after that.
The traditional backwards looking solvency assessment tradition started when there was no viable alternative. It is a good basis for looking at solvency under only a few possible futures. Fortunately, many firms broadly operate within the range of futures.
For the backwards looking approach to solvency to have any validity, the future of the firm needs to be very much like the past of the firm. Firms need capital more for the future than for the past and the balance sheet is more about the past of the firm than the future. So a capital regime that is tied to the balance sheet is useful only to the firms whose future does not materially change their balance sheet.
But wait, the only time when that capital is needed is when the balance sheet DOES change materially.
So ORSA shifts the question of solvency from the past to the future.
The second thing that ORSA does is to shift the burden of determining adequacy of capital from the regulator to the board and management. With the ORSA, the board and management will never again have the excuse that they thought everything was fine because they met the standards of the regulators. The ORSA requires the board and management to assert, IN THEIR OWN OPINION, that the firm has sufficient capital for its own risks AND its own risk management systems. Prior regimes allowed management to pass a test set by the regulator and thereby show adequacy of capital. Even if the test did not pick up on some new risk that management was totally aware of but which was not at all recognized by the regulatory formula.
Now that is a game changer.