G20 Risk Management Directive 2008
RISKVIEWS sometimes remarks that ERM is the only management system that has been endorsed by the heads of state of the 20 largest economies (G20). The following is an excerpt from the G20 directive from the fall of 2008.
Immediate Actions by March 31, 2009
• Regulators should develop enhanced guidance to strengthen banks’ risk management practices, in line with international best practices, and should encourage financial firms to reexamine their internal controls and implement strengthened policies for sound risk management.
• Regulators should develop and implement procedures to ensure that financial firms implement policies to better manage liquidity risk, including by creating strong liquidity cushions.
• Supervisors should ensure that financial firms develop processes that provide for timely and comprehensive measurement of risk concentrations and large counterparty risk positions across products and geographies.
• Firms should reassess their risk management models to guard against stress and report to supervisors on their efforts.
• The Basel Committee should study the need for and help develop firms’ new stress testing models, as appropriate.
• Financial institutions should have clear internal incentives to promote stability, and action needs to be taken, through voluntary effort or regulatory action, to avoid compensation schemes which reward excessive short-term returns or risk taking.
• Banks should exercise effective risk management and due diligence over structured products and securitization.
Looking at this list several years on and from outside of banking, we can ask if other financial institutions can get anything from these points. So we rephrase these points as questions (and provide preliminary answers for the insurance sector):
- Are firms aware of risk management best practices? Most of the larger firms are aware. Quite a number of small to medium sized firms are not aware of best practices.
- Are firms managing liquidity risk? Most insurers have provided for a very large range of liquidity needs.
- Are firms managing concentration risks? Cat modeling provides information to most insurers about their property concentrations. Other concentrations may not be as well attended to.
- Do firms assess their risk models? Insurers that had risk models before the crisis are much more wary of those models now. The insurance sector in the US has been slow in general to adopt a full company modeling approach. Insurers in Europe and in much of the rest of the world have adopted full company models for Solvency II compliance purposes. With the delay of Solvency II implementation, it remains to be seen whether those models will be used or shelved until required. Actions taken purely to satisfy regulation tend to be less effective.
- Are firms using stress tests? Most firms are using stress tests. AM Best is urging all those who do not to develop the capability.
- Do compensation programs incent decreasing or increasing stability? Most incentive programs do not reflect risk and therefore may incent increasing instability.
- Do firms apply special diligence to more complicated risk structures? Most non-life insurers do not tend to participate in complicated risk structures. Many life insurers do manufacture and sell products with complicated embedded options and took large losses from those products in both 2001 and 2008 because they either did not try to hedge the risks (2001) or had hedging programs that did not perform as needed (2008). All who offer these products have made serious adjustments to their offering, their hedging or both, but it remains to be seen whether that situation will hold until the next financial crisis disrupts things in an unanticipated manner.
So five years later, the insurance sector seems to have acted on the six points made by the G20 in 2008. But there are many other elements to a fully effective ERM program. The ongoing theme of the G20 follow through on risk management through the Financial Stability Board is extremely bank centric. Insurers who rely upon this source of motivation for ERM will have the elements of ERM for their risks that line up with banks and little ERM for the insurance risks that predominate their operations.
In addition, banks and their supervisors do not seem to be even thinking about a true enterprise wide view of risk. Insurers that have taken up ERM are adamant about such a view being central to their ERM program.