Increasing the usefulness of ERM
By Jean-Pierre Bertiet
Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM frameworks were shown to:
- Align performance metrics with management’s performance measurement philosophy
- Integrate ERM into daily management activities
The following two sections discuss these issues and suggest action steps that insurance companies should take to establish ERM as a more robust and valuable management process.
1. Aligning performance metrics with management’s performance measurement philosophy
To provide useful guideposts for business decisions, the risk adjusted performance measurement framework supporting ERM needs to reflect senior management’s views regarding alignment of responsibilities and performance metrics. Alignment is ensured by i) matching of the structure of the financial management reports to the boundaries of business segment, ii) accurate attribution of capital, premium revenues, investment income and expenses to business segments and iii) segregation in financial reports of the results associated with the current period from the impact of business written in prior years.
This alignment ensures appropriate distinctions between results of current and past decisions and a sharp focus on differences in drivers of performance.
In practice, leading companies are making explicit decisions about the design and features of the financial performance measures they develop by developing customized answers to questions such as the following:
- Are business segments to be evaluated on a stand alone basis or in a portfolio context (i.e. after attribution of a capital credit for diversification)?
- Are business segments to be evaluated as if assets they earned risk free, duration matched investment income? Or the average rate of return on the investment portfolio?
- Are business segments to be evaluated in relation to their ‘consumption” of economic capital? Regulatory capital? Rating agency capital?
- Should individual business segments bear the cost of “excess” or “stranded” capital?
- Should performance benchmarks vary across business segments, in line with differences in the volatility of their total risk? Or differences in exposure/premium leverage across lines? Or differences in contribution to corporate debt capacity?
- How granular does such reporting need to be?
- Should performance metrics be developed in a policy/underwriting year framework? Would such metrics need to be reconciled with metrics based on fiscal year GAAP reported numbers?
- How should the period performance of the in-force (or liabilities run off) be measured and separated from the performance of the “new business”? To what extent and how should the performance of “renewal” policies be separated from that of policies written for new customers in property, casualty companies?
- Should the performance reporting framework provide only period measures of performance or should it be extended to capture the longer term economic value of insurance contracts, such as the change in the embedded value of the business?
- Should the performance reporting framework be extended to incorporate stochastic performance metrics such as Earnings@Risk or Embedded Value@Risk?
Leading ERM practitioners, especially in Europe, have found that the usefulness, but also the complexity and cost of risk adjusted performance metrics are determined by the desired level of granularity in reporting, and design decisions in i) risk measurement,
ii) capital measurement and, iii) financial reporting. The availability and quality of risk and financial data determine to a significant degree the level of granularity that can be built to support ERM.
In my experience, success in establishing ERM is highly dependent on the level of effort that companies devote to designing a reporting framework that the organization can understand and embrace intuitively, without having to be trained in advanced financial or risk topics. Setting out to develop the most rigorous and actuarially correct framework is likely to result in poor acceptance by operating managers.
2. Integrating ERM into daily management activities
Many senior executives recognize that establishing an ERM process is an obligation that cannot be avoided in today’s environment. They also have a strong intuitive sense that the science of risk measurement and analysis offered by the actuarial profession and other specialists in risk does not yet provide robust answers to many important questions that are asked by people who manage the operations of insurance companies day by day. Differences in perspectives between executives in the corporate center and the managers of business units hamper the effectiveness of ERM. Bridging these differences is a major challenge to the establishment of ERM. This challenge is rooted in fundamental differences in the roles and responsibilities of these actors.
Corporate center executives who operate under oversight of the Board of Directors are highly sensitive to risk concerns of shareholders. It is natural for these executives to take an aggregate view of risk, across the business portfolio. They contribute to corporate performance by making i) strategic risk management decisions in connection with capacity deployment, reinsurance and asset allocation, ii) operational risk management decisions principally in connection with the management of shared services. Their most important risk decisions, related to capital allocation, involve significant strategic risks.
By contrast, business unit managers have a different outlook. They are typically more focused on meeting the needs of policyholders. They are more likely to view risk as stemming from products and customers. From their point of view risk management starts with product design, underwriting and pricing decisions, control of risk accumulations and concentrations, product mix and customer mix. With regards to operational risk, their activity places them on the front line to control the “execution risks” elements of operational risk. Business unit managers tend to view requests for support of ERM as distractions from serving policyholders and accomplishing their goals. They believe that they help protect shareholders from value loss by focusing on establishing and maintaining a competitive advantage.
The CFO of a very large insurance group confided to me recently that aligning the perspectives of executives at the corporate center with that of business managers was a challenge of great importance. He expressed the view that results from risk models cannot be used simplistically and that experience and business judgment are needed to guide decisions. Caution and prudence are especially important in interpreting decision signals when model results appear unstable or when complexity makes it difficult to recognize possible biases. He had become interested in using a combination of approaches to develop reliable insights into strategy and risk dynamics in his company. He was particularly focused on finding ways to bring these insights to bear on the daily activities of employees who manage risk accumulation, risk mitigation and risk transfer activities, on both sides of the balance sheet. In his judgment, borne out by other discussions and my experience with clients, ERM comes to life and creates value best when a top down framework initiated by senior management is embraced bottom up throughout the organization.
Consistent with these considerations, ERM appears to work best in companies in which operating managers have “bought in” ERM and embraced the perspective it provides. In many of these companies, one observes that:
- Risk management responsibility is owned by operating managers
- Product definitions and investment boundaries are clear and matched to explicit risk limits
- Policies and procedures have been co-developed with operating personnel
- Product approval and risk accumulation are subject to oversight by the central ERM unit
- Risk and value governance are integrated through a committee with authority to adjudicate decisions about trade-offs between risks and returns
- Compliance and exceptions are subject to review by senior management
It is important to observe that none of the considerations discussed in the two sections of this note are about the technical components of risk management. Rather, they define a context for accountability, empowerment and appropriate limitations on the activities of people who run day to day operation in insurance companies.
Berliet Associates, LLP
(203) 247 6448
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