ERM Central to Restoring Capital Adequacy
It is easy to blame CROs (Chief Risk Officers) and ERM (Enterprise Risk Management) for the impact of the crisis on companies, but such blame is often unfair and disingenuous. In few companies did CROs have the power to prevent the execution of strategies that, although fraught with risk, were pursued to deliver on investor profit expectations and management incentive targets.
The primary objective of crisis mitigation must be to realign risk exposures with risk bearing capital and to improve capital adequacy. Realigning exposures with capital (and implied “risk capacity”) enhances insurance strength ratings and the confidence of investors and customers. Without such confidence, a company’s business and franchise would erode rapidly.
In response to the present crisis, many companies improved capital adequacy by (a) cutting expenses, (b) decreasing dividend payments, (c) discontinuing share repurchase programs, and (d) selling assets and non-strategic operating subsidiaries, all to preserve or increase capital. There are few buyers during a crisis, however, and so divestitures and asset sales are at lower prices than in normal times (e.g. sale of HSB Group by AIG) and are therefore very expensive sources of capital.
Realignment strategies also involve retrenchment from businesses with substandard returns on capital. Typical outcomes are: (a) sales of blocks of business and renewal rights, (b) cessation of certain coverage types, (c) sales of entire subsidiaries, (d) changes in underwriting limits, terms, and exclusions, (e) reinsurance strategies, etc. ERM risk analysis models provide a basis for assessing the relationship between capital needs and value contributions of various businesses. Without that assessment, it is hard to align risk exposures with available capital.
Estimates of capital requirements based on risk measures over a one-year horizon (typical of solvency regulations) are not credible during a crisis because they assume that fresh “recovery” capital can be raised. Rating agencies, regulators, and investors, however, know that many solvent companies cannot raise fresh capital during a crisis. Capital is only adequate if it can sustain the company’s operations on a “going concern” basis in the absence of access to recovery capital, but with credit for capital generated internally.
Companies need robust insights from ERM to assess their capital needs (on or off balance sheet, including contingent capital) and to develop effective mitigation strategies. Their ERM must:
- Measure capital consumption by activity and risk type
- Identify the relative value creation of individual businesses, with appropriate recognition for differences in risk
- Demonstrate the impact and future value creation of alternative retrenchment strategies
Through such ERM informed views of capital utilization, capital adequacy, and value creation, insurance companies can chart effective strategies to restore their capital adequacy and mitigate the impact of crises.
Berliet Associates, LLC
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