Design weaknesses are an important source of resistance to ERM implementation. Some are subtle and thus often remain unrecognized. Seasoned business executives recognize readily, however, that decision signals from ERM can be misleading in particular situations in which these design weaknesses can have a significant impact. This generates much organizational heat and can create a highly dysfunctional decision environment.
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 produce credible and useful risk adjusted performance measures
Risk adjusted performance measures (RAPM) such as RAROC (Risk Adjusted Return On Capital), first developed in banking institutions, or Risk Adjusted Economic Value Added (RAEVA) have been heralded as significant breakthroughs in performance measurement for insurance companies. They were seen as offering a way for risk bearing enterprises to relate financial performance to capital consumption in relation to risks assumed and thus to value creation.
Many insurance companies have attempted to establish RAROC/RAEVA performance measurement frameworks to assess their economic performance and develop value enhancing business and risk management strategies. A number of leading companies, mostly in Europe where regulators are demanding it, have continued to invest in refining and using these frameworks. Even those that have persevered, however, understand that framework weaknesses create management challenges that cannot be ignored.
Experienced executives recognize that the attribution of capital to business units or lines provides a necessary foundation for aligning the perspectives of policyholders and shareholders.
Many company executives recognize, however, that i) risk adjusted performance measures can be highly sensitive to methodologies that determine the attribution of income and capital and ii) earnings reported for a period do not adequately represent changes in the value of insurance businesses. As a result, these senior executives believe that decision signals provided by risk adjusted performance measures need to be evaluated with great caution, lest they might mislead. Except for Return on Embedded Value measures that are comparatively more challenging to develop and validate than RAROC/RAEVA measures, risk adjusted performance measures are not typically capable of relating financial performance to return on value considerations that are of critical importance to shareholders.
To provide information that is credible and useful to management and shareholders, insurance companies need to establish risk adjusted performance measures based on:
- A ( paid up or economic) capital attribution method, with explicit allowance for deviations in special situations, that is approved by Directors
- Period income measures aligned with pricing and expense decisions, with explicit separation of in-force/run-off, renewals, and new business
- Supplemental statements relating period or projected economic performance/ changes in value to the value of the underlying business.
- Reconciliation of risk adjusted performance metrics to reported financial results under accounting principles used in their jurisdictions (GAAP, IFRS, etc.)
- Establishment and maintenance of appropriate controls, formally certified by management, reviewed and approved by the Audit Committee of the Board of Directors.
In many instances, limitations and weaknesses in performance measures create serious differences of view between a company’s central ERM staff and business executives.