Posted tagged ‘ERM’

Insurers need to adapt COSO/ISO Risk Management to achieve ERM

July 29, 2014

Both the COSO and ISO risk management frameworks describe many excellent practices.  However, in practice, insurers need to make two major changes from the typical COSO/ISO risk management process to achieve real ERM.

  1. RISK MEASUREMENT – Both COSO and ISO emphasize what RISKVIEWS calls the Risk Impressions approach to risk measurement.  That means asking people what their impression is of the frequency and severity of each risk.  Sometimes they get real fancy and also ask for an impression of Risk Velocity.  RISKVIEWS sees two problems with this for insurers.  First, impressions of risk are notoriously inaccurate.  People are just not very good at making subjective judgments about risk.  Second, the frequency/severity pair idea does not actually represent reality.  The idea properly applies to very specific incidents, not to risks, which are broad classes of incidents.  Each possible incident that makes up the class that we call a risk has a different frequency severity pair.   There is no single pair that represents the class.  Insurers risks are in one major way different from the risks of non-financial firms.  Insurers almost always buy and sell the risks that make up 80% or more of their risk profile.  That means that to make those transactions they should be making an estimate of the expected value of ALL of those frequency and severity pairs.  No insurance company that expects to survive for more than a year would consider setting its prices based upon something as lacking in reality testing as a single frequency and severity pair.  So an insurer should apply the same discipline to measuring its risks as it does to setting its prices.  After all, risk is the business that it is in.
  2. HIERARCHICAL RISK FOCUS – Neither COSO nor ISO demand that the risk manager run to their board or senior management and proudly expect them to sit still while the risk manager expounds upon the 200 risks in their risk register.  But a highly depressingly large number of COSO/ISO shops do exactly that.  Then they wonder why they never get a second chance in front of top management and the board.  However, neither COSO nor ISO provide strong enough guidance regarding the Hierarchical principal that is one of the key ideas of real ERM.    COSO and ISO both start with a bottoms up process for identifying risks.  That means that many people at various levels in the company get to make input into the risk identification process.  This is the fundamental way that COSO/ISO risk management ends up with risk registers of 200 risks.  COSO and ISO do not, however, offer much if any guidance regarding how to make that into something that can be used by top management and the board.  In RISKVIEWS experience, the 200 item list needs to be sorted into no more than 25 broad categories.  Then those categories need to be considered the Risks of the firm and the list of 200 items considered the Riskettes.  Top management should have a say in the development of that list.  It should be their chooses of names for the 25 Risks. The 25 Risks then need to be divided into three groups.  The top 5 to 7 Risks are the first rank risks that are the focus of discussions with the Board.    Those should be the Risks that are most likely to cause a financial or other major disruption to the firm.   Besides focusing on those first rank risks, the board should make sure that management is attending to all of the 25 risks.  The remaining 18 to 20 Risks then can be divided into two ranks.  The Top management should then focus on the first and second rank risks.  And they should make sure that the risk owners are attending to the third rank risks.  Top management, usually through a risk committee, needs to regularly look at these risk assignments and promote and demote risks as the company’s exposure and the risk environment changes.  Now, if you are a risk manager who has recently spent a year or more constructing the list of the 200 Riskettes, you are doubtless wondering what use would be made of all that hard work.  Under the Hierarchical principle of ERM, the process described above is repeated down the org chart.  The risk committee will appoint a risk owner for each of the 25 Risks and that risk owner will work with their list of Riskettes.  If their Riskette list is longer than 10, they might want to create a priority structure, ranking the risks as is done for the board and top management.  But if the initial risk register was done properly, then the Riskettes will be separate because there is something about them that requires something different in their monitoring or their risk treatment.  So the risk register and Riskettes will be an valuable and actionable way to organize their responsibilities as risk owner.  Even if it is never again shown to the Top management and the board.

These two ideas do not contradict the main thrust of COSO and ISO but they do represent a major adjustment in approach for insurance company risk managers who have been going to COSO or ISO for guidance.  It would be best if those risk managers knew in advance about these two differences from the COSO/ISO approach that is applied in non-financial firms.

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Key Ideas of ERM

July 24, 2014

For a set of activities to be called ERM, they must satisfy ALL of these Key Ideas…

  1. Transition from Evolved Risk Management to planned ERM
  2. Comprehensive – includes ALL risks
  3. Measurement – on a consistent basis allows ranking and…
  4. Aggregation – adding up the risks to know total
  5. Capital – comparing sum of risks to capital – can apply security standard to judge
  6. Hierarchy – decisions about risks are made at the appropriate level in the organization – which means information must be readily available

Risk management activities that do not satisfy ALL Key Ideas may well be good and useful things that must be done, but they are not, by themselves ERM.

Many activities that seek to be called ERM do not really satisfy ALL Key Ideas.  The most common “fail” is item 2, Comprehensive.  When risks are left out of consideration, that is the same as a measurement of zero.  So no matter how difficult to measure, it is extremely important to really, really be Comprehensive.

But it is quite possible to “fail” on any of the other Key Ideas.

The Transition idea usually “fails” when the longest standing traditional risk management practices are not challenged to come up to ERM standards that are being applied to other risks and risk management activities.

Measurement “fails” when the tails of the risk model are not of the correct “fatness“.  Risks are significantly undervalued.

Aggregation “fails” when too much independence of risks is assumed.  Most often ignored is interdependence caused by common counter parties.

Capital “fails” when the security standard is based upon a very partial risk model and not on a completely comprehensive risk model.

Hierarchy “fails” when top management and/or the board do not personally take responsibility for ERM.  The CRO should not be an independent advocate for risk management, the CRO should be the agent of the power structure of the firm.

In fact Hierarchy Failure is the other most common reason for ERM to fail.

Who should do ERM?

February 25, 2014

Risk Identification – don’t just mail it in

January 9, 2014

ERM programs all start out with a suggestion that you must identify your risks.

Many folks take this as a trivial exercize.  But it is not.  There are two important reasons why not:

  1. Everyone has risks in the same major categories, but the way that those categories are divided into the action level is important.  All insurers have UNDERWRITING RISK.  But almost all insurers should be subdividing their UDERWRITING RISK into major subcategories, usually along the lines that they manage their insurance business.  Even the very smallest single line single state insurers sub divide their insurance business.  Risks should also be subdivided.
  2. Names are important.  Your key risks must have names that are consistent with how everyone in the company talks.

Best practice companies will take the process of updating very seriously.  They treat it as a discovery and validation process.

To read more about Risk identification, see the WillisWire post

(This is the first of a 14 part series about the ERM practices that are needed to support the new ORSA Process)

and the RISKVIEWS post

Identifying Risks

Most Popular Posts of 2013

December 30, 2013

RISKVIEWS made 66 new posts in 2013.  You can visit all 66 using the links at the right of the page for Archives, which link to the new posts for each month.

For total traffic in 2013, posts from 2013, 2012, 2011 and 2010 were the most popular,  led by

  1. Getting Started in a Risk Management Career  from November 2012
  2. Avoiding Risk Management  from February 2012
  3. Five components of resilience – robustness, redundancy, resourcefulness, response and recovery  from January 2013
  4. REDUCING MORAL HAZARD  from July 2010
  5. Frequency vs. Likelihood  from June 2011

And here are ten posts that RISKVIEWS recommends that you may have missed:

Inflationary Expectations
Changing Your Attitude
Skating Away on the Thin Ice of the New Day
Full Spectrum Risk Management
Focusing on the Extreme goes Against the Grain
Maybe it is not as obvious as you think…
Capabilities
The World is not the Same – After
Uncertain Decisions
Murphy was a Risk Manager!

ERM on WillisWire

December 3, 2013

Risk Management: Adaptability is Key to Success

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There is no single approach to risk management that will work for all risks nor, for any one risk, is there any one approach to risk management that will work for all times. Rational adaptability is the strategy of altering … Continue reading →


Resilience for the Long Term

Resilient Sprout in Drought

In 1973, CS Holling, a biologist, argued that the “Equilibrium” idea of natural systems that was then popular with ecologists was wrong.He said that natural systems went through drastic, unpredictable changes – such systems were “profoundly affected by random events”.  … Continue reading →


Management is Needed: Not Incentive Compensation

Bizman in Tie

Many theoreticians and more than a few executives take the position that incentive compensation is a powerful motivator. It therefore follows that careful crafting of the incentive compensation program is all that it takes to get the most out of a … Continue reading →


A Gigantic Risk Management Entertainment System

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As video gaming has become more and more sophisticated, and as the hardware to support those games has become capable of playing movies and other media, video game consoles have now become “Entertainment Systems”.  Continue reading →


Panel at ERM Symposium: ERM for Financial Intermediaries

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Insurance company risk managers need to recognize that traditional activities like underwriting, pricing and reserving are vitally important parts of managing the risks of their firm. Enterprise risk management (ERM) tends to focus upon only two or three of the … Continue reading →


ERM Symposium Panel: Actuarial Professional Risk Management

SS Risk Button - Blank Keys  53606569 April 23

In just a few days, actuaries will be the first group of Enterprise Risk Management (ERM) professionals to make a commitment to specific ERM standards for their work. In 2012, the Actuarial Standards Board passed two new Actuarial Standards of … Continue reading →


Has the Risk Profession Become a Spectator Sport?

The 2013 ERM Symposium goes back to Chicago this year after a side trip to DC for 2012. This is the 11th year for the premier program for financial risk managers. Continue reading →


What to Do About Emerging Risks…

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WillisWire has on several occasions featured opinions from a large number of our contributors about what might be the next emerging risk in various sectors. But what can be done once you have identified an emerging risk? Continue reading →


U.S. Insurers Need to Get Ready for ORSA

paperwork

Slowly, but surely, and without a lot of fanfare, U.S. insurance regulators have been orchestrating a sea change in their interaction with companies over solvency.  Not as dramatic as Solvency II in Europe, but the U.S. changes are actually happening … Continue reading →


Resiliency vs. Fragility

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Is there really a choice?  Who would choose to be Fragile over Resilient? Continue reading →

– See more at: http://blog.willis.com/author/daveingram/#sthash.xxAR1QAP.dpuf

Reviewing Risk Appetite

November 19, 2013

[The material below is the work of an ad hoc IAA working group.  It was produced in 2011 but never completed or published.  RISKVIEWS is sharing so that this good work can be viewed.]

Risk appetite setting and its implication on business strategy. 

Risk appetite is a high-level view of the risks the organization is willing to accept in pursuit of value. When an insurer defines the optimal level of risk, a common view of the ultimate priority is to serve shareholder’s benefits. This will facilitate the decision on the types of risks and magnitudes of the risks to be taken that are consistent with business strategies and market situation. At the same time, the desired risk profile should satisfy the explicit and implicit constraints set by other parties such as regulators, rating agencies, policyholders, debt holders, senior management, and employees. Some external changes have also expedited the process. S&P has required a clear statement of risk appetite as a foundation of “strong” or “excellent” ERM rating. Solvency II also requires insurers to explicitly consider their risk appetite.

Risk appetite framework normally includes three levels.

Enterprise risk tolerance: The aggregate amount of risk the company is willing to take, expressed in terms of

  1. capital adequacy
  2. earnings volatility
  3. credit rating target

It represents the company’s long term target and shall be revised only if there are fundamental changes to the company’s financial profile, market situation and strategic objective. Risk appetite helps prevent default by preserving capital position. This is required by regulators, rating agencies, policyholders, and debtholders. These stakeholders show little or no interest in the upside from risk taking. On the other hand, shareholders are interested in the upside resulted from risk taking and low earnings volatility.

Risk appetite for each risk category: Enterprise risk tolerance needs to be allocated to risk appetite for specific risk categories and business activities. For example, selling life insurance policies or underwriting property and casualty risks. Or taking more market risk versus credit risk. By doing this, the company’s resources, like capital, can be allocated to the areas that the company feels comfortable with, or has competitive advantages.  When determining or updating risk appetite for different risk categories, in addition to considering the constraints set by enterprise risk tolerance, it should aim to maximize the risk-adjusted return of risk-taking activities.

Risk limit: Risk limits are the most granular level which is used for business operation. It translates enterprise risk tolerance and risk appetite for each risk category into risk monitoring measures. The consistency between risk limit and enterprise risk tolerance help the company realize its risk objective and maximize risk adjusted return.

Risk appetite not only protects value, but also creates value for the business. It helps senior management make informed decisions to maximize risk adjusted return for the shareholder. Ensuring the consistency between risk appetite and risk limits is very important. Both rating agencies and investors are concerned about whether risk appetite is properly aligned with the risk limits being set for business operation. A sound risk management practice requires risk appetite being integrated into business strategy and corporate culture.

Desired actions/features of risks management by category:

Ad Hoc

1. Unsystematic description of the company’s willingness to take risk. This could possibly be by an answer to investors, regulators or rating agencies’ inquiry and not fully linked with the company’s ability to take risk.

Basic

  1. The company has a formal statement of enterprise risk tolerance which has been approved by Board of Directors (BOD). The statement should at least include target credit rating, capital adequacy, earnings volatility, and attitude to operational risk such as reputation risk and legal risk.
  2. Risk appetite statement is incorporated in the risk management policy and will be reviewed annually by risk management committee and BOD.
  3. When making a strategic decision, the impact is sometimes checked against enterprise risk tolerances to make sure they are not breached.

Standard

  1. The company has a well established risk appetite framework which includes enterprise risk tolerance, risk appetite for each identified risk category and risk limits. Those are reviewed and approved by BOD and updated at least annually or in market turmoil.
  2. The risk appetite framework considers all the constraints the company faces and reflects key stakeholders’ risk preference. They include regulators both at group level and local level, shareholders, debtors, and management.
  3. There exists a consistent framework to align risk limits with enterprise risk tolerance. This is essential to make sure all the business decision is made within the company’s tolerance of risk.
  4. Integration of risk appetite and strategic planning. Risk appetite framework plays an active role in providing information about risk exposures of business activities and risk reward trade off. Asset allocation and product mix are the two key areas.
  5. The whole company is involved in risk appetite framework to facilitate risk identification and foster a healthy risk culture.

Advanced

  1. Risk appetite framework is integrated with all the business decision, including business operation constrained by risk limits and strategic decision to fit into enterprise risk tolerance. Strategic decisions include, but are not limited to strategic asset allocation, tactic asset allocation, new business planning, capital allocation, and risk management strategies.
  2. Performance measurement of management is linked to risk adjusted return or risk adjusted value.
  3. Effective and company wide education and communication of risk appetite framework are in place and regularly scheduled.
  4. Back testing of risk appetite framework is conducted to identify new risks, key assumption errors, and model errors.
  5. Risk appetite framework is considered more of strategic risk management than risk limit system.
  6. Risk appetite framework puts more efforts on emerging risks or risks hard to identify and quantify. Qualitative analysis becomes critical in corporate strategic decision.

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