One of the fundamental objectives of the upcoming Own Risk andSolvency Assessment (ORSA) is to provide an evaluation of the levelof capital an insurance company will need both now and in thefuture. This assessment should represent an insurer's own view ofthe amount of capital it needs based on the risk within itsbusiness. Capital therefore needs to be calibrated to the level ofrisk the specific company bears, as well as allow for all relevantand material risks to which the company is exposed. Furthermore,the capital metric will need to be sufficiently risk-sensitive inorder to react to management's actions to mitigate risk; in fact,insurers who identify, understand and manage all relevant andmaterial risks can benefit because they will reduce their capitalrequirements.

We see the ORSA as an opportunity to strengthen existingenterprise risk management (ERM) processes or establish a formalrisk-management framework. Because the ORSA will provide insurers achance to assess the veracity of their ERM programs, it will bemuch 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-basedcapital to meet the assessment's requirements. Because the NAICRisk Based Capital (RBC) measure is an existing metric that takesinto account a company's risk exposures to at least a certaindegree, management may be tempted to leverage it in order toquantify the required level of capital. And, indeed, there are anumber of advantages to adopting this approach. Management oftenbases its existing targets and objectives on multiples of theminimum level of RBC coverage. Therefore, using RBC as a metric inan ERM framework is useful because it can indicate how managementcurrently thinks about capital and can be a key component of how itmakes business decisions.

In addition, using RBC for the ORSA would offer the benefits ofnot requiring new processes for data, models, assumptions andresults, as well as removing the need to introduce new metrics tothe business. Moreover, because the results are relatively stableand the drivers for change are easily identifiable, RBC figuresgenerally are relatively easy to produce and understand. Ifmanagement understands the metric and the potential limitations,then they will know when they can make decisions using RBC and whenthey need additional information.

However, RBC has limitations, and without significantenhancement, it is unlikely to be a directly appropriatequantification of capital for use in an ORSA. RBC is based on anindustry perspective of the significant quantifiable risks and is apoint-in-time capital metric. It generally uses a factor-basedapproach and is calibrated with industry data and averages. Thisresults in a metric that is unlikely to sufficiently focus on therisks that a particular company bears and is difficult to link tostress scenarios (as the base capital requirement doesn't representa particular scenario outcome).

Furthermore, RBC is relatively insensitive to changes in some ofthe underlying risks, and the industry average calibration may notcapture the risk-mitigation actions management employs. Therefore,the metric will not provide full feedback on the success (orfailure) of management's actions to mitigate risk. For example, RBCdoes not include a risk-sensitive allowance for operational risk,and it won't reflect actions management takes to improve IT or datasecurity.

Crucially, in a risk-management context, an unadjusted RBCmetric does not encourage an insurer to fully identify, understandand manage the risks in its portfolio. Not only does this mean theinsurer could omit some risks, but this approach limits thecompany's ability to identify situations in which the reward fortaking on risk is likely to outweigh the potential for negativeoutcomes. Therefore, RBC can miss strategies that provide afavorable return for a given level of risk.

Insurers will need to consider the limitations we describe aboveand enhance the RBC metric in order to make it suitable for use inthe ORSA. However, a considerable amount of the ORSA's value toinsurers will come from their going through the production processand focusing management's attention on key business risks.Therefore, for companies that go through the process ofidentifying, quantifying and managing the risks but do not want toadopt a full economic capital model, RBC could be a base from whichto build a capital metric. They could recalibrate parameters thatare more appropriate to an individual company, adjust the targetcoverage multiple and enhance the metric by including additionalrisks. This is likely to require use of at least some of theindividual risk models that underlie the RBC process to perform therisk assessment and calibrate the RBC metric. However, to becomesufficiently risk-sensitive, management would strongly benefit frominvestigating and adjusting these recalibrations and enhancementsas the risk profile changes.

While RBC can serve as a starting point or foundation from whichto construct the ORSA capital metric, insurers shouldn't shortcircuit the ORSA process to the point they miss the opportunity toimprove risk-management practices.

Brian Paton and James Isherwood contributed to thisarticle.