Integrating ERM and Value Based Management
from Jean-Pierre Berliet
The global financial crisis has reduced the market capitalization and price to book ratios of property/casualty insurance companies dramatically. According to a study published by Bank of America Merrill Lynch in August 2009, the S&P P/C index was trading at a 1.0 price/book ratio at that time, sharply down from a 1.4 average over the last three years and a 1.6 over the last 20 years. The updated historical valuations report published in August 2010 indicates that the S&P P/C index was trading at a 1.1 price/book ratio at that time. Excluding Progressive, companies in the Merrill Lynch index were trading then at an average price/book ratio of .89. This data suggests that the industry lost credibility with investors in 2008-2009 and has failed so far to persuade them that it is positioned to resume growing profitably in an uncertain rate environment.
Ironically, the crisis started just a few years after rating agencies began to include an assessment of the effectiveness of enterprise risk management (ERM) in their rating decisions and after they had given most insurers passing grades or above. It is clear now that ERM did not prevent a number of insurance companies from overextending themselves. Investors have concluded that risk management failed broadly and is disconnected from business strategy. They are justified in wondering whether risk management frameworks and processes of insurance companies will be more effective in the present lower volume and lower rate environment. Under such expected market conditions, investors are concerned that companies might lack discipline and write business at inadequate rates in order to achieve their premium volume objectives.
More generally, investors are concerned that strategic planning frameworks of many insurance companies are “expected value” focused, and are thus myopic about risk. In addition, investors are also aware that design weaknesses of ERM frameworks cause many executives i) to distrust “ex-post” decision signals provided by risk adjusted management performance metrics and ii) often to ignore resulting decision signals to redeploy capital or optimize asset allocation and reinsurance strategies. The existence of significant weaknesses in strategic planning and ERM frameworks and management processes explains why establishing tight and credible linkages between ERM and business strategy decisions is problematic and why ex-post measurement of risk adjusted performance is not viewed by investors as helpful. Just like the cleaning up of risks that manifested themselves, such as catastrophes and investment losses, ex-post risk management accomplishes only little, too late, and at great cost.
To respond to concerns of investors, insurance companies need to make their strategic planning and ERM frameworks capable of addressing credibly, and in a mutually consistent manner, the risk management issues raised and business strategy decisions impacted by the asymmetrical distribution of the financial results of insurance businesses. Investors believe, in particular, that risk management would create more value if i) risk insights guided the management and deployment of a company’s risk capacity “ex-ante”, that is before insurance policies were bound or investment decisions were made, and ii) strategy decisions about risk assumption and accumulations always took into consideration the adequacy of insurance rates and changes in market volume
These considerations call for the integration of value and risk governance frameworks and management processes in insurance companies. In the absence of such integration, there will be an enduring disconnect between strategy and risk management, and neither value based management (VBM) nor ERM will be credible or effective.
To be effective, the integration framework must recognize that, in insurance businesses, the cost of risk is known only after contracts have expired and related liabilities have run off. This unique peculiarity of loss costs, the raw material of insurance businesses, makes ex-post risk management a contradiction in terms. It places risk issues at the core of strategy development and execution. To achieve the needed integration of ERM and VBM, insurance companies must be careful to develop and establish distinct but tightly aligned:
- Governance frameworks for VBM and ERM, that specify the respective roles and responsibilities of the Board of Directors, external advisers, and Senior Management with regard to the development and approval of a company’s business mission and strategic plan, including i) the evaluation of risk return trade-offs, ii) the setting of financial objectives, iii) the oversight of strategy execution, and iv) accountability for results
- Managerial frameworks and processes capable of ensuring alignment of business strategy and risk management decisions across risk types, operational activities and products or markets.
Risk management must not be an afterthought in insurance businesses. An insurance company needs to establish “ex-ante” risk management as an essential foundation for the effective integration of its VBM and ERM frameworks. Ex-ante risk management is based on the observation that, together, risk assumption and accumulation functions in insurance companies are analogous to production in industrial companies. A properly designed risk management framework that supports “ex-ante” management of risk exposure accumulations should help an insurance company:
- Achieve loss costs and earnings volatility advantages
- Reduce both the amount and the cost of the capital they require
- Support effective development and execution of its business strategy
Such possibilities make “ex-ante” risk management concepts and tools and risk capacity management as important to business strategies of insurance companies as scale, equipment and machinery specialization, flexible automation and outsourcing, i.e. production strategy elements, are to business strategies of industrial companies. Notably, ex-ante risk management requires insurance companies to develop and use insights about risks that can provide a competitive advantage. Unlike cost reduction, product or service enhancements or pricing initiatives, risk insights and the underlying ability to compete on analytics, cannot be easily or rapidly duplicated by competitors. They can thus enable insurance companies to achieve more enduring margin improvements and escape for a while the strategic stalemate conditions under which they operate in many businesses.
To restore their credibility, insurance companies need to persuade investors that “ex-ante” risk management will support effective strategy implementation and drive risk capacity deployment, thereby improving financial performance. To accomplish the required alignment of risk capacity management, risk taking and business strategy management, companies need to establish the following three distinct but tightly integrated frameworks for:
- Measuring and assessing risk capacity utilization
- Addressing financial risk concerns of external stakeholders
- Deploying and leveraging risk capacity.
Integration of these frameworks would be effected through development of risk limits by line of business and business segment. Such risk limits would provide an insurance company a means to i) drive and control the deployment of its risk capacity toward uses that are projected to meet the return expectations and risk tolerances of its external stakeholders, ii) develop performance metrics needed to assess risk and return trade-offs of alternative strategies and align risk capacity management and business strategies and iii) improve risk capacity utilization and enhance financial performance.
To establish and use these frameworks, insurance companies need to integrate risk insights that emerge at the intersection of actuarial analysis, underwriting expertise, strategy analysis and financial simulation.
February 14, 2011
Note: This article is abstracted from the “Risk Management and Business Strategy in P/C Insurance Companies” briefing paper published by Advisen (www.advisen.com) and available at the Corner Store.