Reconciling Risk Concerns

From Jean-Pierre Berliet

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 were shown to reconcile the risk concerns of policyholders and shareholders.

Creditors, including policyholders, and rating agencies or regulators whose mission it is to protect creditors, and shareholders are all interested in the financial health of an insurer, but in different ways. Creditors want to be assured that an insurance company will be able to honor its obligations fully and in a timely manner. For creditors, the main risk question is: what is the risk of the business? This is another way to ask whether the company will remain solvent.

Shareholders, however, are interested in the value of the business as a going concern, in how much this value might increase and by how much it might decline. For shareholders, the main risk question is: what is the risk to the business? Shareholders are interested in what ERM can do to increase and protect the value of their investment in a company. While both creditors and shareholders are interested in the tail of the distribution of financial results, as an indicator of solvency risk, shareholders are also very interested in the mean of these financial results and their volatility, which could have an adverse impact on the value of their investment.

Policyholders and shareholders’ views are different but not incompatible: a company could not stay in business if it were not able to persuade regulators that it will remain solvent and should be allowed to keep its license, or obtain from rating agencies a rating suitable for the business it writes.  Its value to investors would be significantly impaired..

Insurers recognize that the main drivers of their risk profile are financial risks, including insurance risk accumulations and concentrations, and the related market risk associated with their investment activities. They understand that resulting risks are best controlled at the point of origination through appropriate controls on underwriting and pricing and through reinsurance and asset allocation strategies that limit the volatility of financial outcomes. Stochastic modeling is being used more broadly by companies to understand how such risks accumulate, interact and develop over time and to evaluate strategies that enhance the stability of outcomes. Capital adequacy is the ultimate defense against severe risk “surprises” from insurance and investment activities. It is of interest to policyholders who want to be certain to collect on their claims, but also to shareholders who want assurance that a company can be viewed as a going concern that will write profitable business in the future.

Methodologies used by rating agencies on behalf of creditors describe in detail how the rating process deals with the three main drivers of a company’s financial position and of the volatility (risk) of this position. In response to rating agency concerns, insurance companies focus on determining how much “economic capital” they need to remain solvent, as a first step toward demonstrating the adequacy of their capital. Analyses they perform involve calculation of the losses they can suffer under scenarios that combine the impact of all the risks to which they are exposed. This “total risk” approach and the related focus on extreme loss scenarios (“high severity/low frequency” scenarios) are central to addressing creditors’ concerns.

To address the solvency concerns of creditors, rating agencies and regulators and the value risk of shareholders, insurance companies need to know their complete risk profile and to develop separate risk metrics for each group of constituents. Knowledge of this risk profile enables them to identify the distinct risk management strategies that they need to maintain high ratings while also protecting the value of their shareholders’ investment. Leading ERM companies have become well aware of this requirement and no longer focus solely on tail scenarios to develop their risk management strategies.

ERM frameworks must also recognize that tools and processes required to address value risk concerns of shareholders are different from those required to address solvency risk concerns of policyholders. Measuring and managing shareholders’ value risks requires tools and processes capable of addressing risk issues on a “going concern” basis, including explicit consideration of i) the compounding of risks across successive periods of activity and ii) operational risk, with special focus on its strategic component.

To reflect these critical considerations, companies need to:

  • Create a risk measurement capability (e.g. a stochastic risk analysis model) for their business, at an appropriate level of granularity, to analyze the combined effects of underwriting and investment strategies on i) the company’s ability to withstand plausible stress scenarios, and ii) the volatility of its earnings.
  • Seek agreement on the level of earnings volatility acceptable to investors, relative to the volatility of results evinced by companies of similar capitalization
  • Assess the impact of alternative underwriting, investment, reinsurance strategies on i) the volatility of their financial results and capital positions and ii) their  ability to carry out their strategy on a going concern basis (e.g. over the next three or five years)
  • Integrate insights from risk modeling and analysis into strategic and tactical decisions, including capacity and capital deployment across business lines or segments, underwriting/pricing, risk retention and risk transfer, and asset allocation.
  • Seek formal approval from the Board of Directors on proposed strategies, expected returns and the related confidence level.
  • Establish processes to identify and manage exposures to material operational risks, including recovery programs and appropriate oversight and compliance mechanisms, and strategic risks that can inflict severe value losses to shareholders.

This road map will lead insurance companies to tighter integration of risk management and business strategy. It calls for insurance companies to establish management decision processes that connect the business and risk insights of underwriters, investment officers, claim administrators and actuaries.

©Jean-Pierre Berliet

Berliet Associates, LLP

(203) 247 6448

jpberliet@att.net

May 22, 2010

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