A Review of Solvency II Principles (Forward Looking Risk Assessment)
The Solvency II (Directive 2009/138/EC) regulatory compliance framework has put in place a robust ‘Three Pillar’ approach for the regulation of insurance and reinsurance undertakings (Undertakings) operating throughout the European Union (EU). Pillar 1 deals with quantitative requirements (e.g. assessment of own funds, Solvency Capital Requirement (SCR)), Pillar 3 deals with disclosure requirements (e.g. transparency, reporting to the public and to national supervisors), and Pillar 2 deals with qualitative requirements (e.g. Supervisory Review Process (SRP), Governance System). This four part blog series will deal with different Solvency II Principles, namely ‘Systems of Governance’ (PART 1), ‘Forward Looking Risk Assessment’ (PART 2), ‘Internal Models’ (PART 3), and ‘Supervisory Reporting’ (PART 4).
Solvency II Forward Looking Risk Assessment
Under Article 45 of Solvency every Undertaking must conduct its own risk and solvency assessment (ORSA). This assessment consists of a review of:
(1) the overall solvency needs taking into account the specific risk profile, approve risk tolerance limits, and the undertaking’s business strategy;
(2) the undertaking’s compliance on a continuous basis with Solvency II capital requirements and Solvency II technical provisions;
(3) the significance with which the risk profile of the undertaking deviates from the assumptions underlying the Solvency Capital Requirement (SCR) calculated with the Standard Formula or Partial or Full Model.
EIOPA previously published Guidelines on Forward Looking assessment of own risks (based on the ORSA principles (2013) during the preparatory phase, which have now been updated with new Guidelines on ORSA (2015) which provide seventeen Guidelines for Undertakings. These Guidelines cover areas such as documentation, ORSA policies and record-keeping, assessment of overall solvency needs, forward-looking perspective of the overall solvency needs assessment, and continuous compliance with regulatory capital requirements.
There are a number of key challenges that Undertakings face when implementing an effective ORSA reporting framework. Key challenges relate to areas such as process documentation, demonstrating continuing compliance, and forward projection of balance sheet and capital requirements. Process documentation is time intensive as it requires overall ORSA policies to be drafted and implemented, records of each forward looking assessment undertaken with attendant internal report, as well as supervisory reports on each ORSA assessment.
Undertakings must demonstrate ongoing compliance with ORSA requirements, and this will require Undertakings to effectively integrate Solvency II capital requirements and technical provisions into existing operational risk frameworks, e.g. identifying and developing sensitivities, proxy models, and Key Risk Indicators (KRIs). The forward looking assessment will prove to be particularly challenging for Undertakings, as it requires them to develop highly comprehensive and accurate asset, liability, and SCR projections which requires highly complex and difficult balance sheet calculations (e.g. sourcing sufficiently granular data regarding holdings of assets and undertaking accurate nested stochastic projections for future liabilities).
Indeed, the Bank of England in a Solvency II ORSA Report issued on 15th June 2015, noted that there were two specific areas in submitted ORSA reports that were noticeably weaker. These were:
(1) many of the ORSAs that were reviewed were much weaker on the forward-looking assessment;
(2) stress testing forms an important part of the Bank of England’s current expectations of Undertakings but it was found that this was an area of significant weakness across the majority of ORSAs reviewed.
The Bank of England noted that a number of reports did not list the key risks to the business or how these linked to the stated risk appetite and individual risk tolerances. Some ORSA reports did not detail the mitigating actions, or were not well explained, plausible, and/or lacked assigned owners. Other firms did not identify emerging risks, or did not consider potential management actions to mitigate these. It was also noted that none of the reports that were reviewed contained sufficient evidence of appropriate stress and scenario testing. Clearly, Undertakings need to significantly improve ORSA reports in a number of key areas.
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 The undertaking must have in place processes which are proportionate to the nature, scale and complexity of the risks inherent in the business and which enable it to property identify and assess the risks it faces in the short term and long term and to which it is, or could be, exposed.
 In accordance with Chapter VI, Section 4, Subsection 2.
 In accordance with Chapter VI, Section 4, Subsection 3.