Recovery and resolution1 plans (RRPs) are becoming increasingly important for insurance and reinsurance companies. A requirement to develop RRPs already applies to global systemically important insurers (G-SIIs) and in some territories we are also seeing requirements coming into force which apply to smaller insurers that have not been classified as G-SIIs. In Europe, for example, the European Insurance and Occupational Pensions Authority (EIOPA) is looking at the area of recovery and resolution planning, with Gabriel Bernardino stating that 'One of the lessons learned from the recent financial crisis is the need to have in place adequate recovery and resolution tools which will enable national authorities to intervene in failing institutions and resolve failures when these materialise in an effective and orderly manner.'2 This speech was followed by the release of an EIOPA discussion paper on the potential harmonisation of recovery and resolution frameworks for insurers.This blog post offers a look at the link between RRPs and the Solvency II Own Risk and Solvency Assessment (ORSA).
ORSA requirements
One of the key aims of the ORSA is for insurers to identify and measure the risks that they face, with a view to either holding capital against these risks, or taking steps to manage or mitigate them. This process is called the insurer's assessment of its overall solvency needs.
Guideline 7 of the Solvency II Level 3 Guidelines on the ORSA covers this assessment. It says that, "The undertaking should provide a quantification of the capital needs and a description of other means needed to address all material risks."
The explanatory text of this guideline expands on the factors to be considered by companies in deciding whether to cover risk with capital or to use risk mitigation techniques. These considerations include the following:
- If the risks are managed with risk mitigation or recovery techniques, the (re)insurer should explain the techniques used to manage each risk.
- The assessment needs to cover whether the company currently has sufficient financial resources and realistic plans for how to raise additional capital if and when required.
- The assessment of the overall solvency needs is expected to at least reflect the (re)insurer's management practices, systems and controls, including the use of risk mitigation techniques.
- When assessing the overall solvency needs, the company should also take into account management actions that may be adopted in adverse circumstances. When relying on such actions, companies should assess the implications of taking these actions, including their financial effect, and take into consideration any preconditions that might affect the efficacy of the management actions as risk mitigators. The assessment also needs to address how any management actions would be enacted in times of financial stress.
Based on some of the ORSA reports that I have seen, companies are generally good at identifying possible risks and projecting their solvency positions allowing for the impact of these risks. Companies are also quite good at using the results of such analyses in determining capital buffers as part of the assessment of their overall solvency needs. Furthermore, as required by Solvency II, companies tend to have capital management plans in place, identifying possible shortfalls in own funds and how they might be addressed. However, some of these plans are often quite vague in terms of companies' prospects of raising capital in the event of financial distress. In such cases, parents might not be willing or able to provide capital and the investment markets might also prove difficult to access.
Furthermore, simply relying on capital to cover risks may not always be appropriate. Firstly, there is an opportunity cost associated with holding capital and that capital may well be put to better use elsewhere. Secondly, there is no guarantee that the amount of capital set aside will be sufficient. It may be that the risks that emerge in reality are different from those considered by a company in its ORSA or it may be that the risk events that occur are more severe than those allowed for in determining the capital buffers required. Therefore, companies may need to consider strengthening their plans for dealing with risk events--supplementing their capital buffers with other plans to recover from the impact of risks should they occur.
Another issue to consider: given the fact that under Solvency II companies have a reasonably short period of time (six months) to restore own funds to a level above the Solvency Capital Requirement (SCR) or to reduce the company's risk profile,3 companies cannot afford to lose time analysing and deciding on what recovery strategies to put in place should capital buffers prove to be inadequate. If the ORSA indicates the potential for a future breach of the Solvency II capital requirements, companies should already be considering developing a clear strategy or plan that can be enacted quickly should such difficulty actually arise.
Even where capital is not set aside because the company is instead relying on risk mitigation or recovery techniques, companies could be doing more to develop concrete, achievable RRPs. Many ORSA reports seem to only contain simple information on risk mitigation plans. High-level statements such as, "we would look to reduce expenses" or "we would look to our parent for capital" are not uncommon. But how meaningful and actionable are these statements? Are companies confident that they can actually achieve the desired goals in a timely and cost-effective manner without having given more considerations to the strategies chosen?
The need for recovery planning
It is in light of the above issues that recovery planning comes to the fore. Recovery planning involves identifying options to restore financial strength and viability when a firm comes under severe stress. This process can be quite detailed with plans being very explicit in terms of what actions companies might take in certain circumstances. The actions are expected to be well thought out, so that in times of stress the company should easily be able to enact them without losing time in the design phase. Therefore, there would appear to be a natural alignment between recovery planning and the ORSA requirement to identify risk mitigation and management actions and address how any management actions would be enacted in times of financial stress. Even where RRPs are not a formal requirement, I feel that best practice would be to develop such plans in order to ensure (and demonstrate) that capital, risk mitigation and management actions identified in the ORSA are achievable.
My colleague Bridget MacDonnell and I, together with support from a number of other Milliman consultants, have written a research paper on the topic of recovery and resolution planning. This paper sets out the governance considerations relating to RRPs and studies various options available to (re)insurers to restore their financial positions using a number of case studies to provide a real world context for the options that we outline. The paper also looks at the more extreme resolution actions that could be undertaken. A copy can be found here.
1Resolution is a more extreme situation than recovery when a firm is no longer viable or is likely to be no longer viable, and has no reasonable prospect of becoming viable. Resolution generally includes involvement from supervisory authorities who may dictate the actions chosen.
2Source: EIOPA chairman, Gabriel Bernardino, speech at EIOPA annual conference in Frankfurt, 18 October 2016.
3In the event of a breach of the Minimum Capital Requirement (MCR), companies only have three months to restore their own funds.