Insurers Want to Know: Does Enterprise Risk Management Add Value?

July 23, 2007

Enterprise risk management will have to meet the expectations of corporate board members and deliver real value to firms if it is to flourish, attendees of the Casualty Actuarial Society meeting in Florida heard.

Bill Panning, executive vice president, Willis Re, noted that up to now, ERM proponents have paid very little attention to demonstrating how it creates value, and that is a problem.

“In three or four years I think many CEOs and CFOs of firms that have put a lot of executive time, effort, and money into ERM will be asking what they are getting in return,” said Panning. “There are going to be some really hard questions asked.”

According to Panning, ERM as currently practiced typically lacks relevance to a firm’s strategic decisions and its value to stakeholders. “ERM won’t survive if we continue to hype it without addressing these questions,” he said.

Panning described a value-oriented model that incorporates the crucial connections between risk, capital, and value and explained its use in maximizing the value of a firm.

“There is an optimal or value-maximizing relationship between the overall amount of risk a firm is taking to get its earnings and the amount of surplus or reinsurance it needs to maximize its value as a firm,” he said.

In the case of reinsurance, Panning argued that ERM’s focus on a firm’s overall risk is especially significant. “The scenarios that typically sink or seriously damage firms are ‘perfect storms’ – a convergence of two or more serious problems – such as a severe hurricane season accompanied by a decline in the stock market,” he explained. “An important but seldom recognized implication is that investment risk is highly relevant to reinsurance decisions. If two firms have identical underwriting profiles, but one has a riskier investment portfolio, then it has a greater need for surplus or reinsurance.”

Ultimately, Panning believes it is crucial for firms to adopt a value-oriented ERM model. “Currently ERM and most risk measures typically focus on current-year losses. They ignore the fact that high near-term losses diminish the capacity of the firm to produce future earnings, which are an important component of a firm’s value.”

The real value at risk, in Panning’s view, is the total potential decrease in the value of the firm. ERM that focuses on value, Panning concluded, “benefits owners and policyholders, because the stronger and more valuable the firm, the better able it is to withstand losses and pay claims.”

Wayne Fisher, executive director, Enterprise Risk Management Institute International, and former chief risk officer for Zurich Financial Services, told the session that while ERM has the potential to create value for all insurers, the risks and opportunities are far greater for international companies.

“These companies have to deal with multiple regulators, diversification and its complexities, linked in with liquidity, foreign exchange, and aggregation risks. Operational risk is a much more significant item when you can’t walk out and touch people. Emerging risks can come from many different venues,” he said.

Fisher noted that in a far-flung operation, correlations between investment portfolios and underwriting risks are critical to identify and think through. “There are also key issues with data. By regulation or statute, some parts of a firm will look at loss adjustment one way and reinsurance recoverables another way,” he added.

International insurers that get it right will have a big advantage while firms that don’t will lose that advantage, Fisher said.

The move towards greater risk-based solvency testing in Europe via Solvency II and the Swiss solvency test is a major issue for international insurers right now.

Boards and regulators are also more attuned to risks, both personal risks and the risks of the enterprise. “We have to be able to demonstrate the data, provide a clear articulation of what assumptions are in there, and how we made those assumptions in order to build a comfort level to build capital and take more risk,” he said.

Fisher noted that a critical area is how a company determines and quantifies new risk areas such as major concentration risk, interdependencies, and accumulation risk, along with its loss potential in extreme stress scenarios across an international enterprise.

The aim is to implement capital requirements that are specific to an insurer’s risk profile. “The better the identification, assessment and quantification of risk, the lower the required capital,” Fisher said.

While ERM benefits customers and shareholders through lower regulatory capital requirements and lower costs of capital, employees also benefit because most people want to work for a company that takes risk seriously.

However, Fisher noted that insurers need to be more proactive to unlock the value in ERM. “Part of realizing the value of ERM is to walk the talk and embed ERM into the corporate DNA,” Fisher said.

Source: The Casualty Actuarial Society
www.casact.org

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