The Future of Enterprise Risk Management continued
■■ As insurers look back at their recent performance, it will
also be critical to determine how embedded and effective risk
management actually was in decision-making and performance
Reassuring the Rating agencies
The industry is now in a period of reassessment and, at many
companies, self-assessment. There is much to examine, both
about the recent bullish appetite for and the underestima-tion of market risk. There also must be a review of established
ERM practices and specific aspects of risk governance, analysis,
transparency, and disclosure.
Both life and property/casualty insurers today are tuning
in more intently than ever to rating agency views about the
recent past and short- to mid-term future. The two sectors have
felt different impacts from the financial crisis. Life company
balance sheets have been affected more substantially, and to
ensure their survival, life companies are alert to rating agency
expectations about capital positions and the risk levels of various product and investment portfolios. Because their investment portfolios tend to be shorter term and more conservative,
property/casualty companies were generally not as exposed to
the crisis, but they are nevertheless concerned about rating
agency assessments and performance forecasts.
The rating agencies are taking a particularly tough stance.
They are emphatic about wanting to look hard and deep at the
assumptions and models companies were working with and
at the models they plan to work with in the future. They are
placing greater emphasis on scenarios, stress-testing, and using
multiple views of risk to triangulate on necessary capital levels,
and are focusing, along with state regulators, on reserve levels
and liquidity testing. There’s a particularly strong interest in
how companies will manage future market volatility, including
market dislocations or Black Swan events. Insurers are now
expected to update the agencies on how their assumptions and
models have changed and the impact those changes will have
on running their businesses.
Regulators are also looking at risk management practices in
the context of capital adequacy standards and companies’ ability to remain solvent under extreme circumstances. Even after
the initial, much-publicized phase of capital adequacy stress-testing for banks and other financial institutions is complete,
higher capital requirements, greater transparency, and disclosure of risk-related issues will be de rigueur.
The market is not only experiencing the raising of the rating
bar; the views of rating agencies will also carry more weight
than ever, particularly as they look at potential performance
under extreme conditions. In turn, ratings will weigh more
heavily in companies’ access to and cost of capital as well as
their investor appeal.
In the wake of inevitable calls for reforms and more disciplined
risk governance and management practices, it will be important
to be alert to the potential impacts of procyclicality. There’s the
44 CONTINGENCIES JUL/AUG.09
temptation to set much higher, more stringent standards in reaction to the bottom of the economic cycle rather than to look across
the entire cycle. This creates the potential for exacerbating the
global credit squeeze and systemic dysfunctionality. While new
capital requirements will inevitably be influenced by the behaviors
of the recent past, these requirements could perpetuate continued
volatility, poor financial performance, and further downgrades.
All stakeholders have an understandable interest in insisting
that financial services firms build a stronger capital base. The entire system and individual companies must have greater insulation
from future financial shocks and imbalances. There are certainly
risks in both excessively procyclical and countercyclical strategies,
but no one is arguing for maintaining the status quo. Now’s the time
for dialogue and consensus about the appropriate type and severity
of changes in regulation, public policy, and ratings criteria.
One immediate, obvious outcome of the credit crisis and equity-market volatility is heightened public awareness of and emphasis on risk management.
As the rating agencies update their views of specific companies and reset their ratings (these days, more often lower than
higher), there are concerns about the effectiveness of future
risk management. Insurers will call upon their actuarial departments to play a larger role in formulating the response to the
call for better risk management, answering questions such as:
■■ Does the company have a credible handle on its approach
to protecting its capital adequacy? How much can it lose? How
much will it take to recover? Will its business strategies allow
it to recover?
■■ Is the company applying rigorous stress-based financial testing and forecasting, particularly for trigger events that could
quickly affect liquidity and capital?
■■ Are a company’s compensation structures now designed for
credible risk-adjusted performance measurement and compensation? Do evaluation criteria stress rewarding desired behavior
rather than punishing undesirable behavior? Is performance
looked at and measured holistically?
■■ Is there alignment of communications across the company’s
management levels—from actuarial staff to the board of directors—and within business units so that the insurer’s risks are
both understood and incorporated into business decisions?
These are hard questions. But hard questions are good questions if they stimulate discussion and recommitment to building
on what went right and correcting what went wrong with risk
management during the recent crisis. It’s worth noting that thus
far in the industry’s retrospection, there’s little evidence that risk
management policies, procedures, and models were fundamentally flawed. Rather, most questions concern the degree and efficacy
of risk management’s integration into business decision-making,
performance criteria, and the company’s mind-set and culture.
Insurers need to look at five specific areas of their risk
management programs and risk leadership approaches to help