Tillinghast Study: Insurers Welcome ERM Globally, but it Remains a Work in Progress

February 8, 2005

Insurers around the globe are making progress – quickly in some areas – with using an integrated risk and capital management approach to drive business decisions, according to the third biennial survey of risk and capital management practices among insurers worldwide by the Tillinghast business of Towers Perrin.

An overwhelming number of study respondents (86%) say that enterprise level risk management (ERM) is more of a priority today than it was a year ago. However, insurers’ blossoming success with so-called “ERM” strategies depends on companies’ adoption of economic capital (EC) concepts.

The survey identified a major shift in the positioning of the risk management function within insurance organizations, with 39% noting that Chief Risk Officers (CROs) have primary responsibility for risk management, up from just 19% in 2002. Additionally, 40% of CROs now report to the CEO, a significant increase from 26% in 2002.

“Senior management has become more involved in the risk management process in recent years due to corporate governance regulations, questions from rating agencies and demands for more financial transparency,” said Prakash Shimpi, practice leader with global responsibility for ERM. “While some executives view these regulations as a costly expense, many see the upside. Better measurement and management of risk can improve the organization’s return to shareholders and create significant value in the long term.”

“Integrating risk is not new to the insurance industry – it’s been done for a long period of time at a product level,” said Ian Farr, principal and study co-author. “More companies have chosen to move away from this ‘risk silo’ approach in order to improve understanding and communication on risk management throughout their organizations.” This trend is particularly relevant in Asia, Canada and Europe, where 70% or more of respondents have set up such committees, while slightly less than half of U.S. respondents have done so.

Other key study findings:

— Gaps Between ERM Objectives and Current Efforts: Insurers want to use ERM to build shareholder value, but current efforts still focus on the fundamentals, such as improving internal risk reporting procedures (67%), improving the measurement and quantification of risks (66%) and improving risk identification and prioritization processes (63%). Only about 40% are incorporating economic capital considerations and risk management into regular decision-making, and less than 10% are incorporating risk considerations into incentive compensation.

— ERM Is Already Making a Difference: Insurers report that improved risk and capital management considerations have caused them to change business decisions in many areas, including asset/investment strategy (64%), product pricing (61%), annual business planning (53%), reinsurance purchasing (51%) and strategic planning (50%). “Executives are recognizing how to extract real value from the ERM process,” said Linda Chase-Jenkins, principal and study co-author. “For instance, one of our clients recently decided to exit certain lines of business that were previously thought to have an acceptable return based on other measurements.”

— Low Confidence About Operational Risk: Respondents expressed low satisfaction with the tools and techniques to manage operational risks, as well as their overall capability to measure them. Only 30% report clear roles and responsibilities for modeling and measuring these risks (compared to 89% for insurance risk and 73% for market risk). “All of these risks are important to insurers, but companies are prioritizing their focus on areas where they can more easily quantify risks and take immediate action,” said Shimpi.


Economic capital is crucial to ERM

An overwhelming majority of respondents say they use (53%), or plan to use (28%), EC concepts to improve risk-based decision making. However, regional differences surface in the way that EC is put into action.

North American respondents tend to have a more regulatory view of EC. For instance, 41% of all respondents define the liabilities they include in EC calculations as regulatory or statutory liabilities. Of those respondents, 55% were from North America and 28% were from Europe.

“The economics of the insurance industry are not always easy to understand because it is essentially based on long-term promises, whereas an industry like banking focuses more on short-term conditions,” said Shimpi. “Further complicating matters are differing accounting standards and rules. As such, we’re strong advocates for insurers using economic capital concepts, which reveal more about the real profitability of a business over its lifetime, rather than managing the timing of profit as required by statutory accounting rules.”

Nearly all (87%) respondents intend to improve their EC calculations and methodology by improving their modeling or measurement capabilities (89%), improving the applications of EC (71%) and extending the risks covered (61%).

Companies are confronting significant barriers as they seek to improve their use of EC, including resource issues (61%), modeling/measurement issues (47%), data or information systems (28%) and complexity of economic capital (21%).

“Although the insurance industry is making progress with ERM practices, it’s an evolving process and there is still more work to be done,” added Hubert Mueller, principal and senior ERM practitioner. “There are many parties keeping a close eye on what companies are doing in this area. Companies that have good ERM practices in place will have a real competitive advantage. They can increase their market share by offering more competitive products, and they are able to create value from ERM by avoiding downside risks and reducing earnings volatility.”

The report details findings from the Web-based survey, conducted in the summer of 2004, of Chief Risk Officers, Chief Financial Officers and Chief Actuaries in large insurance companies around the world. The survey had 150 respondents, including 47% from North American-headquartered companies, 39% from Europe, 10% from Asia-Pacific and 4% from South America. Companies represented multiple business lines: 72% property/casualty, 69% life/health companies, 39% reinsurance and 26% from other financial services areas.

The report is available at www.towersperrin.com/tillinghast.

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