ORSA's Head? International Actuarial Association on ORSA Value

Unknown unknowns
- just say it one more time...

A rather verbose piece from the International Actuarial Association, or AAI if you are inclined comme ça, on Delivering Value From ORSA. Always worth a glance over these at this stage of proceedings, regardless of which side of the Atlantic you are currently rocking (with both Canada and the States keeping noisy on the topic in recent weeks).

As one might expect from a publication from an actuarial representative body (and one which aims to cover all IAIS bases, rather than the specificities of US/Canada/EU ORSA), it struggles for semblance once it needs to cover non-quant, and is therefore heavily flannelized.


The definition used by the IAA is:

ORSA provides a declaration of the company’s assessment of its position in terms of profit, risk and capital, both now and in the future, under different scenarios and relative to the company’s appetite to risk.

The purpose of the paper is to provide Board members with "insight into the value of the ORSA Process", which is a noble aim in itself, and a few nice touches can be found throughout, in particular:

• The word “profit” features on virtually every page, almost unheard of in the EIOPA Guideline world where being able to “enhance the management of the undertaking” is King. Heaven forbid anyone makes a quid or two out of it!
• The coverage of how insurance companies tend to profile risk is clean and rational (p3).
• The concept of mitigation through company policies, overseen by good governance structures, as opposed to either holding capital or purchasing mitigation, is also expressed with clarity.
• “A company’s risk appetite, once determined by management and approved by the board, can be treated as a budget”. Lovely concept, though it needs more flesh to provide the 'insight on ORSA Process value' that the paper is intended to.

A few contradictions emerge in the document;

• ORSA “needs to consider and be consistent with an insurance company’s business strategy” – does the process not need to as good as set it? Indeed, they go on to say on page 2 “The true value of ORSA can only be realized when ORSA becomes integral to management’s strategic decision making”!
• Does ORSA “help build/maintain risk awareness throughout the company” – it would be a struggle to say it could do that any further than the relevant staff which EIOPA ultimately allude to. 
• Concept of “Solvency Risk Profile” is borderline unintelligible (p3)
• Terminologically, the section on risk appetite and risk profile on p3 is heavily quant-based, and feels country miles away from similar materials published by the CRO Forum a few weeks back. Specifically, it talks of “acceptable levels” of solvency risk, “minimum and maximum bands”, and that in aggregate across risk categories “This band of acceptable risk is referred to as the risk appetite”. Given it doesn't appear to veer to far away from the FSB's take on Risk Appetite, perhaps this is more of a step forward than EIOPA's 2013 back pass to the AMSB on the matter (p59-60)
• That models used should be “subject to independent validation” – is it that important if you are not using your model for regulatory capital purposes (i.e. just for ORSA)?
• The residue of Rumsfeld, which I had hoped had been resigned to the Noughties dustbin, reappears on pages 7 & 8, specifically “A complete ORSA would include the assessment of unknown unknowns”. Pacino said it best in Godfather III…

PRA on General Insurer Technical Provisions under Solvency II - Taking the "TPs"?

Allow me to take a quantum leap outside of my comfort zone while I pick my way through the PRA's latest Insurance Industry aide memoire, via a consultation paper on the calculation of technical provisions in General Insurers.

This looks specifically at TP calculations with Solvency II in mind, and is aimed specifically at GI firms currently in IMAP. That said, the tone and technical matter covered is an excellent heads-up to Actuarial, Risk and model validation personnel currently active in this space about how the PRA approach to assessing Solvency II compliance is developing.

The document itself reads very much like their last consultation paper release on Deferred Tax Assets, insofar as it is a laundry list of "what not to do" - look at how many times the expression "should not" appears! They have leaned on their findings from both thematic reviews of TP calculations (Life and GI-specific Questionnaires were sent out a year ago) as well as from IMAP and ICAS, so their finding will be well supported by most recent practices in the UK.

The consultation window is pretty short as well, with a mid-April shut-down scheduled, so if you don't like the cut of their jib, you'd better speak soon.

Stand-out points for me included;

Generic


ENID - TP accommodation required

• Expectations of Delegated Acts content are cited throughout, but in terms of the exact date of their public provision, they can only go with "Q3 2014". From what I have seen, there is nothing cited which isn't in the November 2011 draft.
• The abandonment of the term "binary events", replacing it with "Events not in data" or "ENID" - the fait accompli of "binary" (that events which are not in a data set must therefore be extreme and/or rare) is confirmed as unacceptable.  The PRA don't appear to be wedded to the old term in any case, and while the actuarial profession used it liberally in the past (here and here for example), they began a transition away from it late last year (p45 of this).
• "Any data that can have an impact on the outputs of the internal model should be considered to be 'used for the internal model'" (3.19) - important IMAP message across sectors I think!
• There is evidently some concern that firms are thinking of relying on the work of external model providers to meet Solvency II standards, with the PRA confirming that firms may not rely on "...generic validation performed by the model vendor" (3.25). This means that the model validation relationship between IMAP candidates and their third-party providers needs to be much more invasive and aggressive, and needs to start pretty soon!

Technical Provision-Specific

• A large number of points made in the paper relate to over-simplifications, which should help anyone who is struggling with the concepts of materiality and proportionality. These include methods relating to ENID, Risk Margin calculations, Approximations and  the emergence of risk over one year
• Similarly a few tricks of the trade appear to have been scuppered, such as using optimistic business plans for setting provisions, "actuary in a box" methods and assuming improved underwriting performance
• Some substantial focus around the quality and quantity of challenge applied to External Models (focused on third party Catastrophe models in this instance), in particular the challenge of  assumptions used by the provider (3.16-17 and 3.26-28)
• The concept of "cumulative materiality" is introduced in the context of multiple approximations, a concept which I suspect many firms are still struggling with in the context of Internal Model change (2.9)
• An interesting take on the justification of assumptions, with the PRA taking umbridge with firms using "industry standard" or "established good practice" as a supporting argument, rather than using their own risk profile as the basis for support (3.15)
• A section which seems to advocate conservatism, if not prudency, in the setting of sensitive parameters (3.10), as well as advocating the use of stress and scenario testing to make up for ENID when setting parameters (3.2)

Certainly lessons for both Life and GI internal model applicants in here, and the PRA should be congratulated for getting this paper out in good time. I'm not necessarily convinced though that third-party providers of internal model inputs will happily acquiesce with the demands which the industry are being asked to make of them here.

System of Governance - EIOPA's FINAL preparatory guidance for national supervisors

Based on feedback received since their initial consultation paper was released, EIOPA make the following generic clarifications/statements in the preamble of their guidance doc for System of Governance preparations;

• That proportionality will not be defined or presented as examples in the guideline text (p5-6)
• That NCAs are "expected to...review and evaluate the quality of the information provided to them" - bad news for the PRA, who were clinically uninterested in reviewing Solvency II reporting attempts according to one blogger (p6)
• The emergence of a new ORSA acronym, "FLAOR", which looks more like something an amused teenager would write on Facebook (p6)
• The expectation that 2015 will see submissions of (2014) ORSAs to NCAs (p7)
• While there is no generic take on what enforcement action should take place in this interim period, firms are expected to (a) Discuss any negative findings from their ORSA/Governance systems with their supervisor, and (b) To produce SCRs using information of appropriate quality. Enforcement action in the absence of this WILL NOT consist of capital add-ons, apparently (p7)
• That the submission date calendar for all of the information expected will be reviewed at the end of this year, so that EIOPA can take Omnibus II progress into account (p8)
• That the explanatory text in each set of guidance is NOT part of "Comply or Explain" (p9)
• That the reasons behind a negative "Comply or Explain" decision from any country will be kept secret as standard (p10, and disgraceful, frankly).

They then go on to focus on some of the larger bones of contention within the 52 guidelines provided. The following generic points stand out for me as a practitioner;

1. There is almost no discernible movement in EIOPA's position, even after a volumous lobbying effort;
2. That explanations for the inclusion of contentious content are generally forthcoming, though on a number of occasions, flimsy;
3. That planning for 2014 full-year mothballing of Solvency II programmes is not an option, particularly for ICAS+ candidates - some may get away with a few months of inertia, depending on the quality of their paperwork (strategies, policies, process guides/maps, terms of reference, charters etc).

The following supporting arguments for EIOPA's final view were, in my mind at least, poorly formulated, regardless of whether the end result is still agreeable;

3.48 (Guideline 6)

- Refused to add more definition around what constitutes a "significant decision", which is poor form.

3.58 (All of Chapter III)

- That the expectations of Risk Management in insurers  "...comprise risk management standards which are considered to be matter-of-course and wide spread activities" - extraordinarily loose, considering the lack of a majority-accepted global, or indeed pan-European standard on the subject (IRM/ISO/COSO/FERMA/FSB's efforts notwithstanding)

3.65 (Guideline 19)

- That, while it is "not an easy task", Operational Risks should be quantifiable, and therefore subject to tolerance limits - I don't think it would have hurt to suggest (or even compel the use of) a method if it is that difficult.

3.68 (Guideline 25)

- That firms should maintain Investment Risk-related KRIs outside of what might be provided by normal parties (for example, ratings agencies), which would help "...increase overall risk management" - not entirely convinced that a generic "increase" is any kind of worthy ambition. 

3.74 (Guideline 31)

- That a capital management policy and capital management plan is both necessary (though for not entirely convincing reasons when tying back to the Directive)

3.78 (Chapter VI [Internal Control])

- That there is already plenty of clarification on what the Compliance function is charged with. I would agree in principle, but have heard evidence to the contrary in practice.

3.81 (Chapter VII [Internal Audit])

- That they neither wish to mandate or discourage rotation of Internal Audit staff or whistleblowing direct to NCAs - in which case, why mention it!

3.110
- A bizarre comment in response to a suggestion that a public statement should be released by the AMSB annually regarding the discharge of responsibilities around the system of governance that the Directive "...only deals with internal governance, not corporate governance" - think I know what they are fishing at, but terribly worded.

3.144
- Justify their decision not to define risk appetite and risk tolerance in the context of these guidelines

They have however provided some more defendable clarifications, for example;

3.51 (Guideline 11)

- Clarified that the gold-plated "Fit and Proper" requirements apply to AMSB/Control Function staff only, as well as specify what is expected from Outsourcers.

3.57 (Chapter III [Risk Management])

- That in the context of separating the duties of the Risk and Actuarial functions, the Directive is abundantly clear and that undertakings "...cannot deviate from [the Directive's] distribution of tasks"

3.62 (All "Policy"-related guidelines)

- That efforts should be targeted towards drafting the required documents during the preparatory phase. I would imagine this would be "re-working" in the UK, where such activity is most probably long done.

3.67 (Guideline 19)

- That there is no compulsion for firms to operate an electronic database to store operational risk events

3.85 (Chapter VIII [Actuarial])

- That, regardless of the absence of a valuation framework for TPs, the processes behind their co-ordination and calculation justify early activity, rather than "wait and see" on Pillar 1.

3.124
- Regarding Op Risk, activity will have to include "...identifying all operational risks that have crystallised and their near misses" (my emphasis)

Relatively easy in summary then - if it was a gap/issue in your system of governance in March, it probably still is, so go and fix it!

Financial Reporting Council - documenting 'principal risks' in Strategic Reports

I had recently spotted that the UK's Financial Reporting Council had issued draft guidance on the compilation of the Strategic Report for listed entities. This segment of a company's Annual Report and Accounts (currently called the 'Business Review') has been a rather ubiquitous and clunky affair regardless of industry, delivering little information to prospective and existing shareholders about how the company's risk profile, appetite, preferences etc. are catered for when executing its strategy.

Strategic reporting for UK companies 
- elimination of flannel?

Insurers have been prominent in efforts to improve this, though driven more by the need to pacify the FSA/PRA than by Parliament - see "risk appetite" break out from its box in  Aviva's AR&A between 2007 and 2012 for example - but the fact that a substantial piece of statutory reporting generally in the hands of executive management can potentially stray from the lexicon and structure of their increasingly professionalised Control Functions (and for banks and insurers, potentially their Internal Models), is clearly one that warrants some focus.

The Strategic Report will be compulsory content for Annual Reports and Accounts from October (Companies Act 2006 414C). The FRC's (non-mandatory) guidance regarding the incorporation of risk-related material into this section is to address the requirement on p2 that the Strategic Report;

...should include a description of the principal risks and uncertainties facing the company

The FRC's specific definition of Principal Risk is found on p35 of the draft guidance as;

A risk or combination of risks that can seriously affect the performance, future prospects or reputation of the entity. These should include those risks that affect the viability of an entity.

The draft guidance (p23) aims to tack on a few definitional aspects of how "risks and uncertainties" are reported in the context of strategy, most pointedly;

• [The risks] should be limited to those considered by the entity’s management to be the most important to the future development, performance or position of the entity. They will generally be matters that the directors regularly monitor and discuss because of their likelihood, the magnitude of their potential effect on the entity, or a combination of the two
• Principal risks or uncertainties with potential effects of such a magnitude that they may threaten the entity’s viability (ie its solvency and/or liquidity) should be explained fully and given due prominence
• Directors should consider the full range of business risks including commercial, operational and financial risks
• The descriptions...should be 
  sufficiently specific that a shareholder can understand why they are important to the 
  entity. This might include a description of the likelihood of the risk, an indication of when 
  the risk might be most relevant to the entity and its possible effects. Significant changes...

  such as a change in likelihood or possible effect, or the inclusion of new 

  risks, should be highlighted and explained. An explanation of how the principal risks and 
  uncertainties are managed or mitigated should also be included.
• 
  

  Where the risk or uncertainty is more generic, the description should make 

  clear how it might affect the entity specifically.

Prudential provide a good example here (from p72) of how this is currently done by an insurer - the fact that it is buried in 75 pages of 'Business Review' underlines why the streamlining of this work has become of statutory interest!

Interestingly, the FRC note that definition for "principal risks" has been developed/derived from previous FRC work, supplemented by work from the Sharman Inquiry - all of that therefore feels well divorced from anything produced by the IRM/Actuarial Profession/EIOPA around risk categorisation, and leads to the same bridging work I have been involved in previously; namely, reconciling how one manages and monitors risk within the business against what one reports externally. Might we have expected to see some kind of compulsory categorisation of "principal risks" in here that favours the financial services industry who arguably carry the largest set? 

Much of the other compulsory material in the Strategic Report (with exemptions) touches on other topical or sensitive matters such as;

• Inclusion of key performance indicators in the report ("...where possible, they should be accepted and widely used")
• Information on environmental matters, staff and social/community/human rights issues
• Information on gender splits at Board, Senior Management and All-company level

I may throw some feedback in to the FRC on this paper- comments welcome until late November. Externally, the main change for insurers will be trimming down some of the fluff and flannel already produced in the space. Internally, aligning the concept of "principal risks" with existing ERM programme/Internal Model lexicon may be a bigger job for anyone operating on a shoestring.

Actuarial profession and the Risk Function - from 'land grab' to 'colonisation'?

Back in the early days of this Blog I used to post frequently on the Solvency II-sponsored creep towards Risk functions in insurers being 'Chiefed' by members of the actuarial profession as a matter of course rather than choice (here, here and here for a start). It was even a thread in a presentation I delivered to ILAG in late 2012 around areas of control function crossover, in particular that the actuarial profession was acknowledging that there were professional deficiencies in their ability to address the basics of an actuarial function under Solvency II, yet preferred the ambition of conquering a newer (less arduous?) space ahead of remedying them.

Whilst a quant is no doubt a decent fit for such a task, it was an evident snub to the nascent Risk Management 'profession', who took umbridge at the implication of such compulsion from the UK regulator in April 2011, though with seemingly little impact. However, limits to the amount of time and money bodies such as the IRM and FERMA can throw at developing a one-size-fits-all Risk Management qualification package that can appeal to quants and non-quants alike, plus some furious inter-squabbling in the ISO 31000 world, are certainly not lending any credence to "Risk Management" as a profession in its own right as we stand.

Risk and Actuarial professions - 'Poles' apart?

Over in Ireland, the opportunity for the Actuarial profession to secure an additional control function has been pursued so rabidly that the SAI incoming and outgoing presidents were recently able to congratulate themselves on having busted into "the new frontier" of Risk, and are now moving on into "colonisation mode" (p2)! In the UK, the Institute and Faculty of Actuaries already seem to consider that area of influence secured judging by the new president's remarks recently, indicating a desire to influence more mainstream debates than those around risk management systems and corporate governance.

The UK and Ireland don't appear to be the only ones afflicted by the perception of compulsory quants in Risk functions. Munich Re's excellent Knowledge Series delivers a Germanic take that there is "no doubt" that professional mathematicians will be needed for tomorrow's Risk functions.

When considering the history of the Actuarial profession (beautifully summarised here), there should be no reason why Risk Management cannot achieve a similar position given time, regardless of the disparity in existing approaches from representative bodies. A modular qualification which can prepare a 'risk professional' for their favoured activity (insurance buying/continuity management/financial risk/op risk/ERM) is surely an ambition which those bodies can harbour in concert? My concern would naturally be that I probably don't have another 50-100 years to wait for the that convergence to happen and enhance my own career prospects!

Or maybe I do - does anyone know an expert in longevity?

Internal Model Validation - the "desire for certainty"

Some useful snippets on the links here for anyone in the model validation space, whether if be the practical applications of Monte-Carlo simulation outside of the insurance industry, actuarial perspectives on model risks themselves such as parameter uncertainty and goodness of fit testing where "the problem is more often too many candidate distributions" as opposed to restrictions in choice.

This fantastic blog post from one of Willis's finest is about as blunt a critique of actuarial modelling activity and its potential for subsequent misuse as I have read, and I would strongly recommend it on to non-expert risk practitioners who may one day find themselves in the model validation/use test firing line. A few of the pearls of wisdom offered (focused on reinsurance industry, but relevant to all) include;

• How the human "want to believe" and "desire for certainty" can lead to models making rather than guiding decisions
• Reliance of models on "large numbers of heroic assumptions"
• "Data is always limited and flawed"
• That "models take combinations of assumptions and torture them to come to conclusions"
• The revisiting of assumptions only when the answers don't fit expectations ("euphemistically called 'calibration'", hilarious!)
• That using models for setting regulatory capital, rather than just informing decision making, has led to "extremely onerous" IMAP activity i.e. the limitations noted above are so well established that the regulators cannot ignore them at a granular level.

Then there this piece from Deloitte US on model validation, or more specifically, research into the quality of existing actuarial modelling controls, is an eye-opener for anyone working in the validation space. With RMORSA and associated capital modelling firmly on the agenda Stateside, it is interesting to watch how aggressively they approach validation, bearing in mind this work was commissioned by the Society of Actuaries, whose members may ultimately be charged with applying some of these recommendations!

This research in particular assesses current state versus best practice controls over the assumptions, inputs and outputs of actuarial models, and though the sample of respondents to the survey is relatively small (representing "30 unique companies"), the absence of suitable supporting documentation around model governance so evident in the UK's IMAP process appears to be a depressingly constant theme. This report at least includes recommendations as to how the US actuarial profession may bridge some of the gaps Deloitte identify.

In the NAIC's ORSA Manual, they ask that "ORSA Summary Report should provide a general description of the insurer’s process for model validation, including factors considered and model calibration" (p7), which I guess is what one expects to see in the EU (i.e. validation being a sub-process of the ORSA, which can be summarised in the ORSA reports). That said, the breadth of validation work performed over there will surely be driven by S&P expectations communicated in ERM Level III reviews, rather than profession-sponsored consultancy recommendations!


Finally (and slightly off track), an odd piece from Towers Watson on validating ORSAs, pitched to a room full of Internal Auditors. Would be unfair to say there aren't some salient points throughout, but given that there is "no clear requirement" to validate ORSAs (there was something on the matter in the original CEIOPS ORSA pre-consultation, but it was dropped in the public consultation and the final advice), then you would think it could be covered in less than 30+ slides!

As it happens, the TW slide pack for internal model validation appears to have been raided and had the acronym 'ORSA' jemmied into the text for much of the second half of it.

UK's "new" Prudential Regulatory Authority - Approach to Insurance Supervision

So a magical thing happened over the weekend: a venerable institution disappeared on Friday, only to come back reborn on Monday...

...that's right, the FSA is no more, being replaced by two more focused entities in the Prudential Regulatory Authority (PRA) and Financial Conduct Authority (FSA). This is part of the UK-specific fallout from the financial crisis, where a perceived lack of focus from the former tripartite system which housed the FSA allowed for both systemic risk (Northern Rock, RBS) and conduct risks (PPI, Interest Rate swaps) to emerge largely unchecked.

Rather excitingly, this means a new website with some natty logos from the Bank of England (which

PRA - emperor's new clothes
or Solvency II aperatif?

has rehoused the PRA side of the FSA), as well as a statement on the new supervisory approach that the PRA will be taking.

For anyone in the ERM/Solvency II/Corporate Governance space, this gives us a chance to pick up on the kind of regulatory interrogation one might expect when writing/upgrading system of governance-related materials in preparation for both full Solvency II implementation in 20??, as well as how they are accommodating EIOPA's interim measures from 2014.

Remembering that the PRA's two statutory objectives are to promote safety and soundness of the firms it regulates, as well as specifically providing appropriate protection to insurance policyholders, I thought it wise to make some notes on how they have catered for Solvency II and deference (when due) to EIOPA, as well as the general content around expectations of governance systems. I found the following worthy of note;

Control function-specific

Section 82 - "[PRA] wants to be satisfies in particular that designated risk management and control functions carry real weight within insurers"

Section 117 - Should have separate risk management and individual control functions in place (dependent on nature scale and complexity etc)

Section 118 - the PRA "expects these functions to be independent of an insurer's revenue generating functions"

Section 120 - expectation of an "operationally independent Actuarial function", which the PRA consider to be "integral to the effective implementation of a firm's risk management framework"

Section 182 - "Actuaries can play an important part in supporting prudential supervision"

Section 119 - an effective Risk function on the other hand merely "ensures that material risk issues receive sufficient attention from the insurer's senior management and Board" - just because I'm paranoid, doesn't mean the Risk profession isn't being made something of a gooseberry here, particularly as the FSA/Actuarial profession love-in started some time ago!

On Risk Appetite

Section 110 - a firm's risk appetite "[is] to be integral to its strategy, and the foundation of its risk management framework"

Remuneration

Section 84 - "remuneration and incentive schemes should reward careful and prudent management" - just like Prudential's and Standard Life's did this week!

Section 194 - Hint at potentially restricting pay in firms if intervention is warranted

Stress/Reverse Stress Testing

Section 109 - the AMSB must have "...an explicit understanding of the circumstances in which their firm might fail"

Section 145 - with regards to Reverse Stress Testing, "...management should consider the reliability of the output of the internal model compared with the results of these tests"

Section 106 - "competent, and where appropriate, independent control functions" should oversee risk management and internal control frameworks

Internal Models

Section 116 - On Internal Models, the AMSB should understand;

• extent of reliance on models for managing risk;
• limitations of their structure and complexity;
• Data used;
• key underpinning assumptions

Section 140 - "PRA expects internal models to be appropriately prudent"

Section 144 - firms may not choose the lowest capital requirement to determine whether or not to model internally

Regulatory Capital

Section 135 - for capital adequacy, firms "...should not rely on regulatory minima", and also "...should not rely on aggressive interpretations of actuarial or accounting standards"

Proportionality

Sections 212-215 - touches on treatment of "low impact" firms - is this effectively where aggressive approaches to proportionality interpretation should be expected (combined control functions, limited documentation, passive acceptance of Standard Formula etc)?

p43 - table covering the allocation of supervisory staff - 10 staff to 1 firm for the 25 largest insurers, versus approaching 10 firms to 1 supervisor at the small end.

Solvency II-specific references

• In the PRA's view "[Solvency II technical detail should] leave scope for supervisors of individual insurers to make informed judgements around risks posed"
• Confirms that elements of the Directive such as Prudent Person Principle, ORSA, Control Function requirements and Pillar 1 are all aligned with the new Threshold Conditions
• Model approval will be dependent on "adequate" risk identification, measurement, management, monitoring and reporting throughout the modelling process
• Will impose capital add-ons when necessary "to ensure insurers meet the required standards"

EIOPA Preparatory Guidelines - System of Governance

Consultation on System of Governance preparatory guidance (plus explanatory text)

For a topic which has felt like a given for a number of years (certainly in UK and Ireland where we already ask a lot in this area), the System of Governance preparatory guidance is still 40 pages, comprising of 57 guidelines, accompanied by 60 pages of explanatory text.

A couple of things immediately grabbed at me when going through the guidance (again anticipating a conservative approach of the supervisors rolling over and applying all content as is)

• That the Risk Management Policy (regardless of how one structures the component elements) is expected to contain procedure-level information about the management of each major risk category - this sounds hopelessly disproportionate, and almost impossible for supervisors to reasonably get through;
• That it is "expected" that large or complex firms separate their four key control functions, and that others at the small/medium end may ultimately find it easier to do so than consider the range of controls/maintenance of independence required to have combined functions;
• That an expectation that insurers' systems of governance require regular independent review, with the AMSB only retaining the ability to choose the performer;
• That insurers will be expected to formally identify/analyse/report on Operational Risk Events
• That EIOPA bottled out of defining Risk Appetite and Risk Tolerance, leaving national supervisors and insurers to fight it out amongst themselves.

Ultimately, the document reads like a checklist which practitioners or full-timers can run through against the suite of documentation no doubt already in existence which, if based on CEIOPS/EIOPA final advice and/or the Commission's Draft Level 2 measures, won't be miles away as it stands. On that premise, I've only listed elements which jump out for me.

GENERAL GOVERNANCE REQUIREMENTS

Guideline 3

• Evidence should be collected of the AMSB "proactively" seeking information from committees/key functions

Guideline 5

• No more detail than an expectation that the AMSB "appropriately implements" their key functions - in the explanatory text, it goes on to say that larger companies will be "expected" to fully separate Risk/Actuarial/Compliance/IA, with a series of measures expected to preserve functional independence if smaller companies choose to combine some.

Guideline 7

• Expectation that both AMSB decisions, and how information generated from the Risk Management System (RMS) influences them, is "appropriately documented" - compulsion for Board Decision Logs?

Guideline 8

• Regular System of Governance reviews appear to be expected, which are documented and reported back to the AMSB - the AMSB retains the right to choose who performs it 

Guideline 9 - All policies must include:

• Goal of policy
• Tasks to be performed and by whom (person or role, unlike for validation, where person/s was specified)
• Associated processes and reporting procedures
• Obligations of affected operational teams to inform control functions of "relevant facts" at all times

Guideline 10

• Contingency plans are expected for areas which are "especially vulnerable" - this pushes outside of what one would consider a conventional contingency plan for operational emergencies.

FIT AND PROPER

Guideline 11

• Must have a Fit and Proper persons policy
• It must be equally applicable to both hired staff and outsourced functions

RISK MANAGEMENT

Guideline 15 - AMSB is "ultimately responsible" for:

• RMS effectiveness
• Setting Risk Appetite and Risk Tolerance Limits
• Approving Risk Management strategies and policies

Guideline 16 - Risk Management Policy must cover at least

• Risk categories used and measurement methods
• How each category/grouping of risks is managed
• Risk tolerance limits for all categories in line with Risk Appetite
• Linkage of both SCR and ORSA to risk tolerance limits
• Frequency and content of regular stress tests, and circumstances for additional testing

In addition, the associated guidelines touch on the risk categories within one's Risk Management Policy. There is an expectation for pretty much every category that procedure-level information is included in the policy documents themselves, as well as hard limits, which is unlikely to be the case as it stands.

Guideline 18 - Insurance Risk Policy

• Expected to cover types of acceptable insurance risks, how premiums will cover claims/expenses, as well as how product design accounts for investment restrictions and formal risk mitigation techniques

Guideline 19 - Op Risk Policy

• Expectation that Operation Risk Events will be formally identified/analysed/reported in insurers, and that a system for collecting and monitoring them should be in place.
• Operational Risk Scenarios should be developed and used, based on failures of key persons/processes/systems and external events

Guideline 23 - Investment Risk Policy

• Buzzphrase introduced of managing the level of "security, quality, liquidity, profitability and availability" of one's asset portfolio

OWN FUND REQUIREMENTS AND THE SYSTEM OF GOVERNANCE

Guideline 32

• Concept of a "medium term capital management plan" introduced which covers; planned capital issuances, maturities and distribution policies - not sure how that works for mutuals, but I can see what they're fishing for

INTERNAL CONTROLS

Guideline 33

• "All personnel [should be] aware of their role in the Internal Control system
• The Internal Control system should be "commensurate to the risks arising from the activities and processed to be controlled" - this line should hopefully avoid overkill

INTERNAL AUDIT FUNCTION

Guideline 36

• The Internal Audit policy should include the procedure for informing supervisors [of whistleblowing-level wrongdoing I guess]

ACTUARIAL FUNCTION

Guideline 44

• "Material"deviations of Best Estimate Liabilities should be back-tested for by the Actuarial function, reported on, and remedial changes proposed

Guideline 46

• The Actuarial function is expected to "contribute to" specifying the risk coverage in the internal model, as well as the dependency structure - this feels like areas where, even in larger insurers, the function probably already leads, so will they be asked to take a step back?

Munich Re on Solvency II Control Functions - an actuary for all seasons...

Munich Re have continued their infrequent-yet-valuable Solvency Knowledge Series with a piece on Key functions within the system of governance of insurers under Solvency II.

Of course to the grizzled old set of risk practitioners who have done the rounds for the last few years, the fundamentals of the directive's requirements on the four control functions are as basic as the ingredients list for a frozen lasagne. It naturally draws attention to the likelihood that there will be "some overlap" between the activities of Risk, Actuarial, Compliance and Internal Audit, as well as touching on outsourcing as "...an attractive way of meeting the wide range of requirements" for those

However I detected more than a whiff of controversy around the content of this particular publication (which I hasten to add is a smart read nevertheless), were one to take it at face value. In particular;

• Their use of the three lines of defence model in the publication - while perceived to be good practice for segregating operations from risk advisory from risk assurance, it is certainly not cited in any existing materials at Level 1, 2 or 3, and the structure may be disproportionate at the small end of the insurer spectrum. On top of that is the Actuarial function's acknowledged dwelling over a grey area between the first and second lines, in particular if they haven't catered separately for the reporting lines of reserving, pricing and capital management actuaries (p8).
• The comment that "The risk management function will no doubt have to include people with a professional scientific and mathematical background, ideally backed up by appropriate qualifications (eg actuaries)". Whilst, internal model or not, the Actuarial function will clearly have to provide "considerable support" to the Risk function, I don't see any reason at the small-to-medium level for the Risk function to include actuaries unless through choice, using the lever of proportionality.
• That the Risk function "...shares responsibility for the risk strategy" - I think the implication is that it shares responsibility with the Board, but the statement doesn't help identify a) who authors and authorizes it and b) who gets fired for its poor deployment! I am more inclined to think the Risk function owns the risk management system and is responsible for monitoring and reporting on the implementation of the risk strategy which sits within it. The FSA define their requirements on this page in any case.
• That the Risk function "...identify potential risks and recommend appropriate countermeasures to the Board" - as far as emerging risk/top-down risk assessment goes, I certainly expect the function to facilitate the emerging risk/scenario analysis/reverse stress test activities in this regard, but it is most certainly not a solo job.
• That "The compliance function...will have to include staff with a legal background" - appreciating what the wording of Article 46 implies in particular, this is more a proportionality/outsourcing issue for me than anything. Having said that, I'm sure any existing compliance professionals out their who didn't take the Bar might feel slighted by this! 
• That "all four functions have a direct reporting line to the Board" - not certain that this is so in the vast majority of cases. Certainly via Board committees the Risk and Internal Audit functions will be well catered for (and the FSB recommended even better than that for the Risk function last week), but I suspect an executive reporting line is as good as it gets for the other two functions in most firms.

Certainly plenty to engage the grey matt with regardless of your country of origin, even around control function crossover areas (which I presented on at the end of last year), so dig in.

Governance Matters at ILAG - Co-operation between control functions under Solvency II

Been a bit quiet on the Blog front - not because my country and I are licking our wounds after being opened up by HMRC like a Manx kipper, but because I had been asked to chip in with my two cents at an event hosted by the Investments and Life Assurance Group in London. It was an exceptionally well run event, with some interesting takes on the participation of Risk, Actuarial and Internal Audit functions in meeting not only the Directive requirements, but also the expectations of wider stakeholders and indeed policyholders.

My particular focus was on Control Function interaction, the inevitable areas of crossover and emerging skill gaps, and I also touched on some benchmarking papers as well.

My transcript is below and, conveniently enough, reads like a Blog Post. If you would like the slides with the script/hyperlinks embedded, either register with ILAG or drop me a line at allan@governance-matters.co.uk and I will send them on for the bargain price of...free!

________________________________________________________________________________

So back in my former life of BAU busy-ness, my interests in Control Function optimisation were generally led by budget (or lack of it), in particular;

•     Professional standards – were there enough bodies, and were they sufficiently skilled or motivated, to perform the fundamentals required (bearing in mind corporate governance code reforms both in the UK (2010 changes BTW, not 2012’s!) and Ireland meant that some system of governance work had to jump the Solvency II queue regardless)

•     Proportionality – would the lack of definition around the proportionality principle (Lloyds take a stab on p2) lead to companies being woefully underprepared once the national regulators inevitably bared their teeth post-2009. The impact of misinterpreting Article 41.2 genuinely put the fear in me!

•     Multiple roles per person/outsourcing – Whilst some common sense calls were made at the smaller end by merging Risk and Compliance functions, the more operationally substantial calls around merging risk and actuarial functions, outsourcing internal audit/compliance advisory services and recently the march towards outsourcing independent model validation and data quality assessments all posed questions.

Of course, having now worked with one of the biggest, my natural curiosities are not piqued by the unavailability of resource and budget, more by the complexity of wading through the reams of opinion and material that large budgets generate! In particular, I have been monitoring;

•     The ability to get bang for buck out of programme spend, with most Tier 1 firms having comfortable broken 3 figures despite, from a Pillar 2 perspective at least, having something akin to “textbook” governance systems at outset

•     Whether the “Consultant writes/BAU implements” will be proven to be a successful method of preparing for Solvency II, or whether the plethora of Pillar 2 material outputs will, once unsupported by its transient authors, die a little death

•     Control functions in Groups, and perceptions of which countries’ governance is considered superior/inferior in the world of supervisory colleges

But you lucky guys in the UK already have a decent amount of written word around what your control functions are up to, with GENPRU, INSPRU, SYSC, SUP and the Corporate Governance Code all building cases for functional remits and appropriate governance structures

•     So we know our friendly actuarial function will be knocking out the sums which end up in our pricing and reserving worlds, produce the EV and capital calcs that (hopefully) keep the wolf from the door, thus quantifying any risks which lend themselves to being quantified, and all the while self-policing the suite of models, methodologies and assumptions that aid them in doing so…

•     We know our compliance function will be focused on monitoring and assessing the effectiveness of an entity to comply with prevailing laws and regulations, at a micro and macro level…

•     We know our beloved IA function will be assessing the effectiveness of risk management, internal controls and governance processes…

However, the one rather raggedy looking function out of the existing set up is my one, the humble Risk function! While SYSC21 has beefed up the significance of Risk in the prevailing regs, the other SYSC tasks attributed make it feel a bit powder puff functionally by comparison.

In fact, both Risk and Compliance don’t especially feel enormously catered for in the prevailing set up as opposed to Actuarial and IA – not sure whether this is due to the consistency of their development as professions dwelling in the more certain lines either side of the second or not, but it’s certainly my feel as an outsider looking in…

…but thanks to Sol II (or at least the veiled threat of its implementation before I retire), we are now looking at control functions in reasonably neat packages complete with instructions!

One of the biggest problems that I’m sure all present have easily surmounted over the last couple of years is the ambiguities in the language of the Directive and Implementing Measures.

As a man who is married to a wonderful French woman, I am used to following instructions, but of course we are frequently confronted with flowery language such as “covers”, “advises”, “provides an opinion”, “liaises”, which is a consultant’s dream come true, but doesn’t help BAU demarcate and co-operate with any great certainty.

That said, the long and short of it ends with;

Risk

Risk come out with a pretty wide-ranging remit which mostly sits in the FSA’s Dream Function world of advisory, co-ordination, challenge and monitoring, though its ability to monitor “the general risk profile” is clearly reliant on the Actuarial function. Not assuming all present are part of IMAP, but the big ownership piece comes of course with the Risk function taking on responsibility for compliance with the internal model requirements on its design, implementation, testing, validation, documentation and weakness and limitation reporting. Clearly a massive undertaking and, certainly at the small/medium end, not one that can be naturally chalked off with an existing compliment of staff.

Actuarial

Actuarial function requirements include requiring knowledge of actuarial and financial maths but leaving an “other standards” clause in to help out the less well-policed countries! They do also however get some wriggle room on responsibility where it would otherwise be assumed (at least by me!), and so ”co-ordinate” TP calcs, “express opinions” on reinsurance arrangements and the underwriting policy, or “contribute to” implementation of the risk management system.

Compliance

Compliance are not burdened with a laundry list of tasks as such, however to advise the AMSB on compliance with Solvency II is a pretty unenviable one (particularly now!). Perhaps the biggest challenge looking at the remit impartially is the depth and breadth of coverage that the function will need to provide, not just on Level 1, 2 and 3 and SOLPRU, but also be able to challenge the adequacy of the vastly expanded internal policy suite

Internal Audit

IA get the unimaginable luxury of having a relatively unchanged remit, particularly in this neck of the woods where risk-based internal auditing and planning is de rigeur.

Outsourcing

The aggression in the wording around the Outsourcing requirements suggests that the days of outsourcing control functions being a “write a cheque, then dusting-of-the-hands” job are at an end!

Now the legislative ambiguities just mentioned leave ample room for control function bun-fighting due to the inevitable crossovers of skillsets for certain tasks and, perhaps most pointedly, who takes precedence in such instances.

ORSA

Probably the biggest area of convergence and potential toe-stepping-on is of course the ORSA space (covered here on the blog) which in the crossover context it is more about who performs which sub-processes, under whose authority, and who “holds the pen” when collating the record of the ORSA performance.

More by process of elimination than by legislative direction, ORSA oversight seems to sit at the door of Risk, a concession even made by the SAI over in Dublin whilst simultaneously illustrating how little they are required in the ORSA Process! Is this therefore real or nominal oversight, or even worse, a PMO-type record collection role.

One other crossover area comes from the removal of the requirement (after pre-consultation) of an independent assessment of the ORSA Process – whilst losing the compulsion should be welcomed on principle, is there a danger that the IA function, through risk-based planning, may under or over-Audit the ORSA space? Just a thought...

Risk IMMMR/Advisory/Challenge

The world of risk identification/measurement/management/monitoring/reporting also becomes one with potential for friction, through the merger of the worlds of the Risk function’s qualitative risk register-type approach and the actuarial function’s established risk quantification methods, into what ultimately comprises the “general risk profile” as per the Directive text – one of the Big 4 suggested that the P&L Attribution is, for actuaries, “the real risk profile” for example, and perhaps some of you concur!

Regardless, the twin horrors of agreeing with Actuarial quantification methodologies for hard-to-quantify risks, while fostering a dependence on them for measurement, monitoring and reporting facilities around financial and insurance risks suggests more of a one-sided dependence rather than “close co-operation” between the functions.

Compliance risk

This works similarly for the world of compliance risk identification/assessment, nominally in the remit of the Compliance function - are they being dragged somewhere nearer the first line if they are producing this work for the Risk function? Just feels a bit blurry…

Emerging Risk

For emerging risks, my main concern is the robustness of the top-down/emerging risk identification process filtering its way into some quantified element within the ORSA and/or internal model – Risk is chalked down for identifying and assessing emerging risks, but their ultimate measurement isn’t catered for.

For internal Modellers

And into the internal model space, the “close co-operation” between the Risk and Actuarial functions, at firms big and small, has the potential to cause all manner of difficulties, in pure process efficiency terms as well as the cost implications of IMAP failure,. One CRO referred to this as having to “solve the risk management team/actuarial team conflict” in a recent presentation on model governance! Clearly though there is quite a gap to bridge between how this governance worked under ICA and the demands of Solvency II.

Establishing an “independent” team for regular validation, regardless of headcount seems to be something of a holy grail, with a growing trend towards “bringing someone in”, if only for the comfort of benchmarking against one’s neighbours. This also helps a company stay in line with Mr Cardoni from the FSA’s call that “individuals performing the validation must possess the necessary skills, knowledge, expertise and experience”, but does little for self-sufficiency, as well as leaving the Risk function with the job of relationship manager during validation exercises.

The approaches available for the Risk function to discharge its other responsibilities around the internal model requirements, in particular around model design and implementation, of course crossover into terra firma for the actuarial function – would be interesting to know how any modelers in the room have approached this, as a cursory sign-off from Risk on a suite of model development and implementation paperwork doesn’t feel in keeping with the spirit of the regs, though an IRM survey from March suggested at least 11 IMAP applicants were doing something along these lines!

So even if Sol II doesn’t directly ask for enhanced skill sets, we in all functions can all see the iceberg coming if we don’t fix up and look sharp. As ever, the most fascinating movements are in the actuarial space as they meander over towards the risk in what is lined up to be the biggest land grab since Enclosure!

There is certainly plenty of encouragement, in a profession which one of its own was happy to recently decry is “trained to deal principally in numbers and statistics”, to branch out into Risk, with the CERA qualification – “the most comprehensive and rigorous demonstration of ERM expertise available” – perhaps leading the way. While the profession is quick enough to highlight the weaknesses and limitations of an Actuarial CRO, does this additional qualification do enough to bridge the gap?

Certainly the GCAE suggest in their work that professional education may need further enhancement “especially in relation to risk management”. Over in Ireland however, the SAI are taking it one step further in their Strategic Plan for the profession, going as far as looking to partner up with a university to develop a risk programme for anyone “who wants to skill up quickly in the area”. Can’t say I’m sure what the rush is, other than opportunity knocking!

On the Risk front, the IRM were very quick to respond to the FSA’s Dream Function presentation back in April 11 with a vigorous defence of the appropriateness of non-Actuarial heads-of-risk, noting that the two professions were “extremely complimentary while different”, whilst mockingly emphasizing that the very concept of CERA highlighted that “Core [actuarial] qualifications do not give sufficiently broad training”.

That said, while the IRM have focused attention on some big ticket items such as Risk Appetite and Risk Culture  over the last 18 months, is it fair to say that training or certification touching on capital measurement and management, modeling, financial and insurance risks and their strategic application would have been a welcome addition to the qualification roster (notwithstanding what is available elsewhere through GARP’s FRM designation)? I rather embarrassingly had to answer a question from a colleague the other day about “how did you get qualified for Solvency II” – I won’t tell you how I answered!

For IA, there is a brave new world for anyone with the chops to upskill or expand their horizons. While the ever-moving implementation date maybe postpones any programme assurance work that IA could have picked up on the run-in to go-live, there is clearly an expectation at the FSA that they will contribute to activity such as internal model validation and data quality assessments, though I’m not seeing anything in the world of training to aid them in doing this (hence the consultancies are doing so well out of it I suspect!).

Deloitte do present a nice picture of some of the additional skills that IA may fall short on, in particular a natural aversion to covering non-Operational risks, despite their relatively higher contribution to the risk profile of insurers. One other thing I had in mind, knowing the IA profession’s predeliction for COSO was changes in the world of Insurer ERM since the last refreshes of COSO’s ERM work, particularly COSO’s latest take on risk assessment – instinctively feels like there may be some catch-up work to do in the IA field, but may be wrong.

For the compliance guys, is it fair to say that you already have your work cut out swallowing Level 1, 2 and 3 paperwork as well as any handbook changes which will emerge at the end of the PRA/FCA divorce. Interested to know if anyone getting roped into other activities!

The last thing I was going to mention was that, in the absence of rapid upskilling, and the wind-down/mothballing of organisation’s Solvency II Programmes, has anyone worked out whose BAU budgets any outsourcing will come out of for the next couple of years?

Moving on to how people are doing on the functional operation and indeed co-operation front, there is a reasonable amount of intel and ideas out there, which you may have clocked on its way through, but maybe makes a bit more sense in aggregate.

Risk function effectiveness

As far as Risk function effectiveness goes, the IRM straw-polled their Solvency II SIG this year, and identified some worrying trends from a Sol II readiness perspective, in particular;

Only half have their CRO communicating directly with the Board on risk matters – breathes some life into the quote from Axa’s Life CRO that “risk management is too important to leave to the risk management department”…

•     Nearly half said risk papers are "noted with a short discussion" at Boards

•     A number of risks were not covered by the respondees' risk functions – ALM and strategic risk in particular

•     Over half felt they had overlap with either Actuarial or Compliance, and a quarter with IA

•     As mentioned before, a decent number of risk functions are not directly delivering documentation, testing and validation of the internal model.

•     Half said the process of implementing Solvency II affects their ability to become relevant to the Board

The IRM also very recently performed a survey (with a reduced quantum due to the subject) on Internal Model Governance trends, which highlighted that;

•     Risk is “responsible” for IM governance (with no exceptions in the survey), but Actuarial are “involved”, but with no further details

•     And many respondents feel “real decisions” continue to be made outside of IM Governance framework, in particular around stress testing, back testing, model change and expert judgement – makes one wonder if an Actuarial CRO could counter that governance leakage?

Risk appetite design and application

There was a paper released by our hosts this year which emphasized the differences in design and implementation of Risk Appetite Frameworks between Risk and Actuarial functions, noting that a quant heavy actuarial approach gets more traction and quicker! This doesn’t augur well for the new ORSA world of “everything must be quantified”, as it is the qualitative risks that need the most attention.

Reporting lines

The world of reporting lines remains a pretty hot topic, with KPMG putting out a decent paper which recommended, amongst other things, that the Actuarial function should consider a formal demarcation between risk taking and risk assessing/measuring actuaries, which would negate the trend of shoehorning capital actuaries through the Head of Risk, keeping them all reporting through the AFH. They also added that at least half of the respondees were not yet at their desired end-state regarding the basic new Actuarial function requirements around underwriting and reinsurance adequacy opinion provision.

IM Validation

In the model validation space, as early as the end of last year we saw KPMG reporting that half of the IM production staff were also involved in the validation process, emphasizing the practical difficulties in functional separation whilst in Programme mode – would love to see how those numbers have moved since. 

Having seen the FSA’s feedback in May on what had been observed at that point in time (in particular that independence from model development and being “sufficiently competent” went hand in hand), one can imagine that IA’s role in the activity will be marginalized in future at the ongoing expense of bringing in the Big Guns every year.

Things a Risk function could be doing

And finally, while I have touched repeatedly on activities which a Risk function may find cannibalized by their ravenous Actuarial counterparts, as well as responsibilities bestowed upon it that it may not be equipped to discharge, I have seen a few pieces around activities that the Risk function would probably love to be doing more of, given half a chance.

A recent piece by Accenture got my engine running, around the future of data analytics – I definitely feel that, with the appropriate informational power at their hands, the risk function can provide a massively enhanced IMMMR and advisory services at little additional cost (the main cost of course already being sunk into data  quality and data warehousing projects independent of the function)

One lovely piece, pitched in the context of why Equitable failed, reads like a list of things a CRO should be focused on, such as NED ambivalence and underperformance, or executive hubris, while a Towers Watson presentation on prepping for the future draws out the most practical big ticket activities such as superior understanding of model weaknesses and limitations and tail risk, rather than a more general clutch at the full bag of responsibilities bestowed on the function by Sol II.

A research piece from the CII (sadly no longer free!) compliments that, suggesting that a “balance between modeling and judgement” must be struck by Risk departments in order to breath relevance into a function that the author was outspokenly critical of in his research.