1 February 2011Re/insurance

ERM: rising to the top

Enterprise risk management (ERM) has emerged as something of a hot topic in the past few years as corporations have looked to stave off the threat posed by financial instabilities that have laid even financial giants low. Fortunately, the reinsurance sector has proven itself markedly resilient in the face of the global economic downturn, and despite the troubles faced by large sections of the financial sector, reinsurers weathered the storm remarkably well and continue to show their resilience in a soft market exacerbated by a sluggish investment environment.

Difficult conditions, diminishing returns and a search for a means to optimise a position characterised by too much capital chasing too little business have led many to re-examine and strengthen their ERM strategies. The industry is evidently looking to ERM as a means to achieve benefits when rewards on the investment and underwriting side are so meagre. And successful ERM strategies should enable industry players to manage their risk in a more holistic manner and realise benefits inherent in being able to regularly measure, mitigate and respond to risk across all aspects of the business.

Regulatory drivers

Regulatory demands from the likes of Solvency II have likewise encouraged companies to examine risk more closely and embed ERM thinking into their business. As James Peacock, associate director at Standard and Poor’s (S&P) made clear: “Historically, the regulatory focus has been on the quantification of risks and the derivation of capital requirements, but new regulation, such as Solvency II, will push companies towards addressing all aspects of their risk managementframework. In Europe, we have noted that there have been widespread improvements in ERM frameworks, which have been driven by Solvency II.” And the impact of Solvency II has been felt well beyond the shores of Europe, with reinsurers in Bermuda, North America and Asia all examining their ERM strategies more closely as European regulatory demands have joined tough market conditions as a further driver for the development of ERM. As Barry Zurbuchen, chief risk officer at Allied World indicated, Solvency II has had a “major impact on internal risk management and reporting”, with one of the directive’s central aims being to “institutionalize [risk management] best practice”. And not only has Solvency II instilled a greater sense of the need for strong ERM strategies, it has also required companies to establish risk management structures that enable “outsiders to make fair comparisons” regarding the ERM capabilities of the various firms. This has helped to encourage best practice in ERM, with those with less robust risk strategies finding themselves compared unfavourably with their more risk-conscious competitors. And such comparisons will be reflected in company ratings, with all the financial implications this entails.

Increasingly significant

Speaking with the ratings agencies, it is clear that a robust ERM strategy is likely to become yet more significant to the industry moving forward. “We view ERM as particularly significant to the reinsurance sector due to the complexity and volatility of the reinsurance business,” Peacock said. Reinsurers are “typically willing to assume larger, more complex risks and, as such, experience more volatile results relative to other sectors, and therefore necessitate a more robust risk managementframework”. Fortunately, when comparing reinsurers with their insurance cousins, Peacock indicated that S&P had “observed that global reinsurers and groups with reinsurance as a key component generally have more advanced ERM capabilities than pure primary insurance writers”. It would seem that robust ERM and necessary attention to risk continue to pay dividends for the sector. Continued progress in the development of ERM is likely to remain an ongoing and positive by-product of ratings scrutiny, further spurred on by the economic crisis, soft market conditions and greater regulatory pressure.

Discussing the issue, Charles Dupplin, chief executive officer of Hiscox, said that ERM “as a science has improved dramatically in recent years”. Dupplin likewise echoed the sentiments of S&P, pointing to regulatory developments as a major spur to ERM. Dupplin said that the world’s regulatory authorities are “well aware that a healthy insurance industry is as important to a developed economy as a healthy banking industry”. However, unlike in the banking sector, ERM strategies in the insurance sector have proven themselves effective to date. “It was the ERM that went wrong in the banking industry because they were all playing in the same highly toxic pits and they all got poisoning at the same time,” Dupplin said. Fortunately, close attention to ERM in the reinsurance sector has enabled it to avoid the toxic concentrations and excessive leveraging that characterised the banking sector in 2008-2009.

Zurbuchen indicated that the credit crisis “caused companies to re-examine the risks inherent in their investment portfolios as well as the contagion risk to other parts of the organisation. It also highlighted the potential liquidity problems that can wreak havoc on a firm regardless of its capitalisation. While the property casualty insuranceindustry was impacted far less than other segments of the financial sector”, the financial crisis did prompt companies to be more vigilant when dealing with risk, he said.

Improvements in ERM brought about by the crisis have been considerable, but it seems there is still more that can be done: “It is incredible to me to see over the last 20 years how far we have come in terms of actually understanding the various risks that our business faces and to manage those risks,” Dupplin said. “I dare say we can travel a lot further, but we’ve come a long way.” Solvency II and soft market conditions might well mean that a distance will be travelled in improving ERM before the next turn in the market.

A more robust approach

Whereas, in the past, ERM formed something of a bolt-on element of the business, reinsurers nowadays are placing risk mitigation strategies centre-stage, with all departments paying close attention to the impact risks in one part of the business will have on the wider portfolio. Today, ERM is “meant to capture all the risks, not solely those insurance risks re/insurance firms face”, Zurbuchen said. And speaking with Tatsuhiko Hoshina, chief executive officer at Tokio Millennium Re about the issue, he made clear that a more robust approach to risk has meant “constantly looking over our portfolio and seeing where it can be optimised”. At Tokio Millennium Re, the company performs “constant analysis on each and every risk. We see how much capital is being allocated for a particular account against the whole portfolio as well as on a stand-alone basis.” By rating the risk “against the whole portfolio, we can ascertain whether what we write will increase the return on risk of the whole portfolio”, Hoshina said. It is this interlinked approach to risk that ERM and the regulatory authorities are trying to instil in the sector. Close, constant risk-monitoring seems to be the order of the day.

Asked how companies can optimise their approach to ERM, Hoshina said that “the question is where to allocate your capital—the object being an optimal portfolio that can best utilise the capital you are deploying. The ERM approach that we take is to ensure that our activities are kept high for both return on risk and return on equity. By balancing these requirements, we then focus on ensuring that we optimise the capital utilised.” Regular portfolio management is a key component of ERM at his company. Hoshina said that “the impact to the enterprise is constantly monitored on an account-by-account basis. At Tokio Millennium Re, we take a proactive approach in ensuring that we have the optimal ROR and ROE at any given time, instead of retrospectively looking back at the portfolio after a prolonged period of time. And that’s what companies should be doing, especially when the market is soft—monitoring their ERM more closely.”

“In a hard market, your portfolio will be stronger than that of the previous year due to the increase in rates. But in a soft market, monitoring the portfolio becomes of utmost importance because you need to be sure of where your capital is being deployed. The importance of carefully choosing the accounts you grow and those you don’t becomes more pronounced in such an environment,” Hoshina said. Others likewise echoed his sentiments, making clear that ERM becomes all the more important in a soft market. But ERM strategies should not only be considered a product of poor market conditions, but rather should be integral throughout the business cycle. “ERM is not only about protecting against the things that can go wrong,” Zurbuchen said. “It is also about [consistently] making sure that the potential reward in undertaking a risky endeavour is commensurate with the amount of risk inherent in the endeavour. By properly understanding and measuring the risk of writing a particular class of business, acquiring a competitor or investing in a particular asset class, as well as the interdependence of that risk with other risks within the organisation, a re/insurer is able to construct a portfolio that provides the optimal risk/reward trade-off commensurate with the organisation’s risk appetite.” It is in striking this balance of risk and reward that effective ERM strategies can be truly realised.

Diversification: risks and rewards

One of the key areas in which reinsurers have sought to mitigate risk has been through diversification. Gone are the days of monoline reinsurers, who may well have fallen foul of some of the ERM requirements set out by the likes of Solvency II, and with excess capital characterising the market, many players are looking to diversify by line and geography. Diversification should play well with companies’ risk mitigation strategies, but speaking with Hoshina, it is evident that such moves aren’t without their complications.

"ERM is not only about protecting against the things that can go wrong. It is also about [consistently] making sure that potential reward in undertaking a risky endeavour is commensurate with the amount of risk inhertied in the endeavour."

“In terms of diversification, it is important to understand the correlation between each product in the portfolio; for example, between a property risk XL and a cat XL programme,” Hoshina said. “If you write the casualty book, how does this correlate with your existing book? The correlation matrix between specific accounts and your portfolio—and among segmented lines of business—is something that needs to be monitored carefully. If you change one correlation, you’ll get completely different answers. So when diversifying an account, you need to completely understand the impact of time spent on determining the correlation.”

Nevertheless, diversification strategies—when carried out effectively—do have the potential to reduce risk and create greater depth in the portfolio. New lines and new geographies, which have been considered and pursued by a number of reinsurers in recent years—from Switzerland, Ireland, Singapore and Australia, to complementary and sometimes specialist lines—have helped in the search for returns in today’s soft market. Until returns improve on investment and the more competitive lines, it seems likely that such an approach will remain a popular option and a component of ERM.

Rating a good strategy

Asked what sets successful strategies apart from less telling ones, S&P’s Peacock made it clear that “one of the factors that differentiates those reinsurers we assess as ‘excellent’ or ‘strong’ from those that we assess only as ‘adequate’ is not only in having strong controls for their main risks, but also the consideration of risk-and-return-orientated targets, and the performance metrics in their strategic decisionmaking processes and management compensation programmes to deal with risk”.

“We would expect that recent decisions by some reinsurers to return excess capital to shareholders have been an application of strategic risk management,” he said. “However, before strategic risk management can be considered strong, a company must have a firm foundation of risk controls.” Part of this is down to “how embedded ERM is into the business. This is achieved, for example, through improvements in the communication of risk management and the education of the business, which in turn raises the profile of ERM. We view it as more favourable when the whole business, starting from the board, buys into, understands and has an active role in designing the ERM framework, and uses it to define strategy and the business profile.” The long-term benefits of a successful strategy are not only an improved rating and the implications that this infers, but will also “ultimately result in capital efficiency”. And with pressures from Solvency II, overcapacity, stagnant investment returns and stalling cessions, maximising capital returns through ERM continues to remain an attractive proposition.

Guarding against the unthinkable

ERM—at its heart—remains a guard against the unthinkable. And following the demise of financial institutions in 2008-2009, it seems that the unthinkable has now become merely unpalatable. Fortunately, ERM strategies are now finding themselves higher up the agenda of all companies, and as Zurbuchen outlined, “by actively identifying, monitoring, measuring and discussing the risks an organisation faces”, the prospects of having to head off the impact of catastrophic failure and risk is “much less likely”. As he made clear, it is “when organisations fail to identify risks, ignore risks or don’t properly understand them, [that] they are more likely to have unhappy surprises”. However, if the current focus on ERM persists, it seems likely that the industry will be well prepared to deal with the next big risk as, and when, it rears its ugly head.