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Enterprise Risk Management ERM—Time to take it seriously Standard & Poor’s is factoring carriers’ ERM programs into rating By Michael J. Moody, MBA, ARM Over the past four or five years, a number of groups and organizations have been actively promoting the enterprise risk management (ERM) concept, with varying degrees of success. One of the first groups to get actively involved was the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Their contribution to the ERM movement was to publish the first broadly based ERM framework and application guide. This went a long way toward solidifying a common approach to ERM, but it did little to promote the concept. Since that time, groups and interested parties as diverse as the Federal Reserve Board to the head of Lloyd’s have promoted the virtues of ERM. Despite the efforts of these groups and interested parties, ERM was slow to catch on in corporate America. But by early 2005, rating agencies began to call attention to ERM in a big way. As 2005 unfolded, each rating agency began to advance its views on ERM. Their activity was for the most part limited to the financial services industry. This was a logical direction for them to take, since banks and insurance companies had progressed much further with ERM than non-financial service organizations. Formalizing an approach One of the first rating agencies to formalize its views on ERM was Standard & Poor’s (S&P). By the middle of 2005, they had advanced their ERM criteria for the insurance industry and had indicated that they would begin to assess insurers/reinsurers based on their published criteria. While S&P indicated that they had always reviewed various aspects of an insurance company’s risk management program, now there would be a separate ERM evaluation process, and the results of the analysis would be considered when assigning a rating. Currently, S&P uses eight specific factors to develop a rating—one of these factors is an assessment of the ERM program. The question, of course, is: Is all of this having an effect on insurers/reinsurers? According to David Ingram, speaking for the ERM department of Standard & Poor’s, it most certainly is. “Interest in ERM has increased now that rating implications are involved,” he says. What’s more, “we are continually hearing from insurers/reinsurers that have just hired a new chief risk officer, or added staff or even adopted new ERM policies and procedures.” Additionally, Ingram points out, “Every time we meet with companies, they advise us how much their board of directors is involved in the ERM process.” Without question, he says, “it’s on everybody’s mind now.” Where the rubber meets the road But it is not enough just to propagate some standards; obviously they must have teeth. It has been widely believed that several insurers/reinsurers have been able to improve their overall rating due to an excellent ERM program. Ingram confirms that MunichRe did in fact have a higher rating, due in large part to a good ERM program. And he notes that there have been others that have benefited from good ERM programs, which were reflected in rating upgrades. But that is only half of the story. Ingram also confirms that he is aware of at least two separate cases, “where we cited the quality of the ERM program as a factor in a negative outlook.” He goes on to note that ERM is really coming to the forefront. He says that at least once a week, S&P deals with ERM-related issues at their rating committee meetings. Future direction As profound as the effects of the ERM movement are today, it may turn out to be just the tip of the iceberg because, ultimately, ERM may have an effect on the amount of capital an insurer is required to maintain for a given rating. Ingram states, “Where we are headed on this issue is similar to what the banking regulators and European regulators are headed to.” He says that the insurer/reinsurer would set up a process where S&P would give some credit for capital after reviewing the insurance company’s internal models. This procedure could result in the insurer being able to reduce its capital while maintaining its current rating. However, he points out that before S&P would even consider an insurer for this type of review, “they would have to have either a strong or excellent ERM program rating.” S&P had confined its ERM program analysis to banks and insurance companies until recently when it expanded the ERM effort to the energy sector as well. Ingram says that even in the energy sector, “they only review trading risks.” Many people are wondering if S&P will move into other non-financial sectors with regards to the ERM analysis. According to Ingram, they quite possibility will move into other sectors. However, he also notes that, “S&P is still not totally on board with ERM for non-financial institutions.” In many respects, Ingram says this is really a labeling issue, since S&P already considers many of the ERM components in other rating criteria. That said, it would appear that S&P will give strong consideration to expanding the scope of its ERM analysis into other industry segments. Summary It is clear that insurers/reinsurers would be well advised to move their ERM plans to the front burner, if that is not where they currently are. S&P, as well as most of the other rating agencies, are beginning to see the wisdom of ERM. As Ingram points out, “We think that there are a lot of competitive advantages to be gained from ERM.” He indicates that S&P is beginning to put particular emphasis on strategic risk management, or “the process of using ERM to help select what business to do.” He says, “We think in the long run, the companies that are using ERM are the ones that will make the best choices.” Playing this out to its natural conclusion, he says, “ERM’s real value may be to assist an insurer/reinsurer in selecting the best mix of products.” * The author |
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