The Right Way to Test for Solvency

We can know, looking back at last year, how much risk an insurer was exposed to. And we can simply look at the balance sheet to see how much capital they held. So that is the way we have tended to look at solvency. Backwards. Was the insurer solvent at the end of last year? Not really useful information. Unless… Unless you make an assumption about the future. Not an unusual assumption. Just the common assumption that the future will be like the past. That assumption is usually okay. Let’s see. In the past 15 years, it has been correct four or five times. But is that record good enough for solvency work -- a system that might give the right answer a third of the time?! There is a solution. Regulators have led us right up to that solution but haven’t yet dared to say what it is. Perhaps they do not know, or even are not thinking that the backward looking problem has two aspects. We are making two heroic assumptions:

1. We are assuming that the environment will be the same in the near future as it was in the recent past.
2. We are assuming that the company activity will be the same in the near future as it was in the recent past.

The regulatory solution based on these two shaky assumptions is:

1. Stress scenarios
2. A look forward using company plans

Solution 1 can help, but solution 2 can be significantly improved by using the enterprise risk management (ERM) program and risk appetite. You may have noticed that regulators have all said that ERM is very important. And that risk appetite is a very, very important part of ERM. But regulators have never, ever, explained why understanding risk appetite is important. Well, the true answer is that it can be important. It can be the solution to one part of the backward-looking problem. The idea of looking forward with company plans is a step in the right direction.  But only a half step. The full solution is the Full Limits Stress Test. That test looks forward to see how the company will operate based on the risk appetite and limits that management has set. ERM and risk appetite provide a specific vision of how much risk is allowed by management and the board. The plan represents a target, but the risk appetite represents the most risk that the company is willing to take. So the Full Limits Stress Test would involve looking at the company with the assumption that it chooses to take the full amount of risk that the ERM program allows. That can then be combined with the stress scenarios regarding the external environment. Now, the Full Limits Stress Test will only actually use the risk appetite for firms that have a risk appetite and an ERM program that clearly functions to maintain the risk of the firm within the risk appetite. For firms that do not have such a system in place, the Full Limits Stress Test needs to substitute some large amount of growth of risk, because that is what industry experience tells us can happen to a firm that has gone partially or fully out of control with regard to its risk taking. The connection between ERM and solvency becomes very substantial and realistic:

• A firm with a good risk management program and tight limits and overall risk appetite will need the amount of capital that would support the planned functioning of the ERM program. The overall risk appetite will place a limit on the degree to which all individual risk limits can be reached at the same time.
• An otherwise similar firm with a risk management program and loose risk appetite will need to hold more capital.
• A similar firm with individual risk limits but no overall risk appetite will need to hold capital to support activity at the limit for every single risk.
• A firm without a risk management program will need to hold capital to support the risks that history tells us that a firm with uncontrolled growth of risk might take on in a year. A track record of informal control of risk growth cannot be used as a predictor of the range of future performance. (It may be valuable to ask all firms to look at an uncontrolled growth scenario, as well, but firms with a good risk control process will be considered to have prepared for that scenario with their ERM program.)
• A firm without any real discipline of its risk management system will be treated similarly to a firm without an ERM program.

With this Full Limits Stress Test, ERM programs will then be fully and directly connected to solvency in an appropriate manner.