ORSA ==> AC – ST > RCS
The Own Risk and Solvency Assessment (or Forward Looking Assessment of Own Risks based on ORSA principles) initially seems daunting. But the simple formula in the title of this post provides a guide to what is really going on.
- To preform an ORSA, an insurer must first decide upon its own Risk Capital Standard.
- The insurer needs to develop the capacity to project the financial and risk exposure statistics forward for several years under a range of specified conditions.
- Included in the projection capacity is the ability to determine (a) the amount of capital required under their own risk capital standard and (b) the projected amount of capital available.
- The insurer needs to select a range of Stress Tests that will be used for the projections.
- If, under a projection based upon a Stress Test, the available capital exceeds the Risk Capital Standard, then that Stress Test is a pass. AC – ST >RCS
- If, under a projection based upon a Stress Test, the available capital is less than the Risk Capital Standard, then that Stress Test is a fail and requires an explanation of intended management actions. AC – ST < RCS ==> MA
RISKVIEWS suggests that Stress Tests should be chosen so that the company can demonstrate that they can pass (AC – ST >RCS) the tests under a wide range of scenarios AND in addition, that one or several of the Stress Tests are severe enough to produce a fail (AC – ST < RCS ==> MA) condition so that they can demonstrate that management has conceptualized the actions that would be needed in extreme loss situations.
RISKVIEWS also guesses that an insurer that picks a low Risk Capital Standard and Normal Volatility Stress Tests will get push back from the regulators reviewing the ORSA.
RISKVIEWS also guesses that an insurer that picks a high Risk Capital Standard will fail some or all of the more severe Stress Tests.
Furthermore, RISKVIEWS predicts that many insurers will fail the real Future Worst Case Stress Tests. Only firms that hold themselves to a Robust Risk Capital Standard are likely to have sufficient capital to potentially maintain solvency. In RISKVIEWS opinion, these Future Worst Case Stress Tests are useful mainly as the starting point for a Reverse Stress Test process. In financial markets, we have experienced a real life worst case stress with the 2008 Financial Crisis and the following events. Imaging insurance worst case scenarios that are as adverse as those events seems useful to promoting insurer survival. Imagining events that are much worse than those – which is what is meant by the Future Worst Case Scenario idea – seems to be overkill. But, in fact, the history of adverse events in the recent past seems to indicate that each new major loss is at least twice the previous record.
A Reverse Stress Test is a process under which an insurer would determine the adverse scenario that drives the insurer to insolvency. Under the NAIC ORSA, Reverse Stress Tests are required, but it is not specified whether those tests should be based upon a condition of failing to meet the insurer’s own Risk Capital Standard or the regulators solvency standard. RISKVIEWS would recommend both types of tests be performed.
This discussion is the heart of the ORSA. The full ORSA requires many other elements. See the recent post INSTRUCTIONS FOR A 17 STEP ORSA PROCESS for the full discussion.