In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Risk Steering.
If you ask most actuaries who are involved in ERM, they would tell you that Risk Steering IS Enterprise Risk Management.
Standard & Poor’s calls this Strategic Risk Management:
SRM is the Standard & Poor’s term for the part of ERM that focuses on both the risks and returns of the entire firm. Although other aspects of ERM mainly focus on limiting downside, SRM is the process that will produce the upside, which is where the real value added of ERM lies. The insurer who is practicing SRM will use their risk insights and take a portfolio management approach to strategic decision making based on analysis that applies the same measure for each of their risks and merges that with their chosen measure of income or value. The insurer will look at the possible combinations of risks that it can take and the earnings that it can achieve from the different combinations of risks taken, reinsured, offset, and retained. They will undertake to optimize their risk-reward result from a very quantitative approach.
For life insurers, that will mean making strategic trade-offs between products with credit, interest rate, equity and insurance risks based on a long-term view of risk-adjusted returns of their products, choosing which to write, how much to retain and which to offset. They will set limits that will form the boundaries for their day-to-day decision-making. These limits will allow them to adjust the exact amount of these risks based on short-term fluctuations in the insurance and financial markets.
For non-life insurers, SRM involves making strategic trade-offs between insurance, credit (on reinsurance ceded) and all aspects of investment risk based on a long-term view of risk-adjusted return for all of their choices. Non-life SRM practitioners recognize the significance of investment risk to their total risk profile, the degree or lack of correlation between investment and insurance risks, and the fact that they have choices between using their capacity to increase insurance retention or to take investment risks.
Risk Steering is very similar to Risk Trading, but at the Total Firm level. At that macro level, management will leverage the risk and reward information that comes from the ERM systems to optimize the risk reward mix of the entire portfolio of insurance and investment risks that they hold. Proposals to grow or shrink parts of the business and choices to offset or transfer different major portions of the total risk positions can be viewed in terms of risk adjusted return. This can be done as part of a capital budgeting / strategic resource allocation exercize and can be incorporated into regular decision making. Some firms bring this approach into consideration only for major ad hoc decisions on acquisitions or divestitures and some use it all of the time.
There are several common activities that may support the macro level risk exploitation:
- Economic Capital. Realistic risk capital for the actual risks of the company is calculated for all risks and adjustments are made for the imperfect correlation of the risks. Identification of the highest concentration of risk as well as the risks with lower correlation to those higher concentration risks is the risk information that can be exploited. Insurers will find that they have a competitive advantage in adding risks to those areas with lower correlation to their largest risks. Insurers should be careful to charge something above their “average” risk margin for risks that are highly correlated to their largest risks. In fact, at the macro level as with the micro level, much of the exploitation results from moving away from averages to specific values for sub classes.
- Capital Budgeting. The capital needed to fulfill proposed business plans is projected based on the economic capital associated with the plans. Acceptance of strategic plans includes consideration of these capital needs and the returns associated with the capital that will be used. Risk exploitation as described above is one of the ways to optimize the use of capital over the planning period.
- Risk Adjusted Performance Measurement (RAPM). Financial results of business plans are measured on a risk-adjusted basis. This includes recognition of the economic capital that is necessary to support each business as well as the risk premiums and loss reserves for multi-period risks such as credit losses or casualty coverages.
- Risk Adjusted Compensation. An incentive system that is tied to the risk exploitation principles is usually needed to focus attention away from other non-risk adjusted performance targets such as sales or profits. In some cases, the strategic choice with the best risk adjusted value might have lower expected profits with lower volatility. That will be opposed strongly by managers with purely profit related incentives. Those with purely sales based incentives might find that it is much easier to sell the products with the worst risk adjusted returns. A risk adjusted compensation situation creates the incentives to sell the products with the best risk adjusted returns.
A fully operational risk steering program will position a firm in a broad sense similarly to an auto insurance provider with respect to competitors. There, the history of the business for the past 10 years has been an arms race to create finer and finer pricing/underwriting classes. As an example, think of the underwriting/pricing class of drivers with brown eyes. In a commodity situation where everyone uses brown eyes to define the same pricing/underwriting class, the claims cost will be seen by all to be the same at $200. However, if the Izquierdo Insurance Company notices that the claims costs for left-handed, brown-eyed drivers are 25% lower than for left handed drivers, and then they can divide the pricing/underwriting into two groups. They can charge a lower rate for that class and a higher rate for the right handed drivers. Their competitors will generally lose all of their left handed customers to Izquierdo, and keep the right handed customers. Izquierdo will had a group of insureds with adequate rates, while their competitors might end up with inadequate rates because they expected some of the left-handed people in their group and got few. Their average claims costs go up and their rates may be inadequate. So Izquierdo has exploited their knowledge of risk to bifurcate the class, get good business and put their competitors in a tough spot.
Risk Steering can be seen as a process for finding and choosing the businesses with the better risk adjusted returns to emphasize in firm strategic plans. Their competitors will find that their path of least resistance will be the businesses with lower returns or higher risks.
JP Morgan in the current environment is showing the extreme advantage of macro risk exploitation. In the subprime driven severe market situation, JP Morgan has experienced lower losses than other institutions and in fact has emerged so strong on a relative basis that they have been able to purchase several other major financial institutions when their value was severely distressed. And by the way, JP Morgan was the firm that first popularized VaR in the early 1990’s, leading the way to the development of modern ERM. However, very few banks have taken this approach. Most banks have chosen to keep their risk information and risk management local within their risk silos.
This is very much an emerging field for non-financial firms and may prove to be of lower value to them because of the very real possibility that risk and capital is not the almost sole constraint on their operations that it is within financial firms as discussed above.
This post is a part of the Plural Rationalities and ERM project.