Conclusion

Extreme event management

The rating agency wants insurers to demonstrate various forms of environmental scanning and scenario planning to anticipate low-frequency events and to test their financial impact.

However, the rating agency’s framework recognizes that merely holding capital to fund the financial consequences of extreme events is not the most effective way to manage those sorts of risks. Instead, companies need to place greater emphasis on establishing processes that help to prepare a response to these events. Contingency planning and crisis response, particularly with respect to financial liquidity, are critical risk- management actions that companies can and should adopt well in advance of actual events.

Risk models and capital models

The rating agency’s focus is to ensure that companies are measuring risk in their business so that they can use the information to guide the decisions that are being made. This focus on using the models to guide decisions explains why the rating agency’s model review emphasizes the efficiency of the models, how quickly assumptions can be altered, how data are updated, and how appropriate the models and assumptions are for critical business decisions.

Nonetheless, one potentially challenging aspect of the rating agency’s intended model review is its apparent emphasis on risk capital as a “vital” component of strategic risk management. As used in this context, risk capital reflects a specific type of risk measurement. Under this approach, an insurer determines the total capital needed to ensure a specific probability of satisfying current policyholder obligations. It then allocates this capital to specific businesses, activities or products in relation to their relative contribution to the total risk of the firm.

References to this type of risk model have led many firms to prioritize the creation of a risk-capital model. However, it remains unclear whether this is an appropriate reaction, for several reasons. One reason is that despite the language used in its public pronouncements on the subject, rating agencies do not intend to suggest any particular method of incorporating risk into insurers’ management decisions.

A second reason risk-capital models should perhaps not be a top priority is that these models, as currently used by many companies and as intended to be used by regulatory purposes, tend to focus on risk from a policyholder’s and not a shareholder’s perspective. It is unclear whether these models actually produce the information insurers need to make “better” or more value-enhancing decisions for their shareholders. These policyholder- or “solvency” -focused models often ignore the risk events that could more immediately harm the shareholders, such as ratings downgrade or a need to raise external capital that is dilutive to the current shareholders. Finally, numerous theoretical and practical issues limit insurers’ ability to allocate risk capital to the fine level at which actual risk-based decisions need to be made.  

Strategic risk management

ERM’s ultimate goal is to see insurers make risk considerations a critical factor in their tactical and strategic decisions. For insurers, product pricing is the primary risk-management activity. This is where the greatest opportunity exists to manage the risk explicitly assumed through policy issuance and to seek an appropriate risk-reward balance. It is clear that insurers need a risk-based pricing methodology and that this methodology will be subject to the rating agency’s review, regardless of whether risk capital plays a vital role in this process.

In other areas such as portfolio management, capital budgeting and risk-adjusted performance assessment, insurers are likely to explore numerous methods to reflect risk and to better inform the decision-making process. It is not yet clear whether one particular approach will emerge as being the most useful for these purposes. But failing to adequately consider risks in decision-making is clearly no longer an option for insurers.

As insurers begin to move down this path, they will need to recognize that this is an uncharted journey for which no clear guidelines have yet been established. The rating agency’s framework reflects one view on how the goal of ERM can be achieved. But since the agency’s approach is not driven by concern for shareholders, it remains unclear whether the rating agency’s suggested priorities or methods, particularly those related to the use of risk capital to guide strategic risk management will enhance shareholder value.

Regardless of the specific steps that individual companies will take as they move to adopt ERM, the rating agency’s new focus on ERM reinforces its status as a vital discipline that deserves the attention of all insurance companies.

Gracia S. Ugut, Ph.D is professor and associate dean at the Asian Institute of Management. She teaches financial engineering and risk management.