Enterprise Risk Management

ERM: A paradigm shift

Rating agencies are pushing acceptance by insurers and reinsurers

By Michael J. Moody, MBA, ARM

At the beginning, enterprise risk management (ERM) opened to much fanfare. Many experts believed that ERM would greatly change the way risk management was practiced. In fact, initial projections indicated that it would result in a paradigm shift in risk management. By the mid-1990s, many within the banking sector were routinely talking about the paradigm shift that would occur in banking as a result of adopting an ERM approach to risk management.

But in our haste to label ERM as a paradigm-shifting event, it may be well to consider just what qualifies as a paradigm shift. The term was coined and first used by Thomas Kuhn in his 1962 book titled The Structure of Scientific Revolutions. Kuhn describes a paradigm shift as “a change in the basic assumptions within the ruling theory of science.” Subsequent to the publication of the book, the concept also began to be applied in a non-scientific context. Today, paradigm shift has come to generally mean “an essential shift from one way of thinking to another.”

So, does ERM represent a paradigm shift? Well, clearly it is having an effect on risk management; as the financial service sector is rapidly moving towards adopting ERM. This is particularly true of insurance companies as they become aware of the advantages generally associated with ERM. Insurers and reinsurers, large and small, are working towards embracing an ERM approach for their organizations.

Case in point

Lion Insurance Company (Lion) is a small monoline insurer that writes workers compensation predominantly in the state of Florida. According to Bruce Miller, chief financial officer for Lion’s parent company, “Lion writes a large deductible workers compensation policy for Southeast Personnel Leasing, a PEO that specializes in the construction industry.” Miller notes that Lion was exploring ERM in early 2007 when it hired SIGMA Actuarial Consulting Group (SIGMA) to assist them in looking at an ERM framework as well as a strategy for ERM implementation.

Lion did not pursue ERM at that time, primarily due to a lack of an appropriate framework with which to work. However, when A.M. Best published its new “Risk Management and Rating Process for Insurance Companies” in early 2008, Lion again approached SIGMA about assisting them in developing an ERM program that would utilize Best’s ERM framework. Lloyd Kelley, director of strategic consulting at SIGMA, says, “The Best framework, which incorporated their new rating methodology, ultimately served as a template for Lion’s ERM program.” Miller notes that shortly after starting this ERM project, Lion was also advised by Best in March 2008 that “ERM would be included as an item on our rating meeting agenda.” At this point, the ERM project became a little more urgent, Miller points out, “since I assumed this was a requirement for all insurance companies.”

Michelle Bradley, consulting actuary for SIGMA, also points out that the publishing of the guide was important because Lion wanted to make certain that whatever they did, it was going to be accepted by Best. The new A.M. Best methodology “emphasized the quantitative side of the insurance business.” Kelley notes that “one of the more significant issues is a requirement of a dynamic financial analysis,” which serves as a centerpiece of the Best ERM program. Kelley points out that this type of forecast provides a “moving picture of the financial statement,” and amounts to an effective stress test for an insurance company’s financials. “It’s very important,” he notes, “to determine how the financial statements are going to react to the stress of unanticipated risk.”

He also notes that it’s important for smaller carriers to perform these types of tests because they may be more susceptible to unanticipated losses. Further, he notes, it’s very important for insurers to move beyond traditional underwriting risk. In this regard, he says actuaries should be able to provide detailed information about the confidence level analysis, which will be associated with the stress testing.

With assistance from SIGMA, Lion did develop an ERM program prior to the rating meeting with A.M. Best. But, “despite the fact that Best indicated the importance of the ERM program,” Miller says he was “surprised at the rating meeting.” During the meeting, Lion had requested that SIGMA be allowed to provide the overview of their ERM program. But Miller notes, “The presentation did not generate as many questions as I would’ve thought.” However, following the meeting, Lion was advised that Best had affirmed their rating.

Bradley notes that, in her experience, “Many insurers still have not started down the ERM road yet.” However, she points out, “It’s clear from Lion’s experience, being an early adopter of ERM has its advantages, since A.M. Best did affirm the rating. And,” she adds, “having better information with which to make decisions should allow insurers a method to better gauge the risk and rewards from various courses of actions.”

More work remains

Recently, PricewaterhouseCoopers (PwC) embarked on a study of 53 international insurance carriers to determine how well ERM was being adopted by the insurance industry. The study, which updated an earlier one that was published in 2004, showed significant improvement in how ERM has developed and matured since 2004. Bottom line, PwC was trying to determine how well the industry is equipped to meet the evolving insurance market as well as stakeholder demands.

On the positive side of the ledger, most of the participants had made real progress with regard to ERM implementation. Most had moved past the design and planning stages to begin to implement proactive ERM programs. However, PwC points out that many participants are now at a critical juncture with regard to their ERM programs. Many realize that their boards of directors as well as senior management are beginning to look to ERM for help in striking the right balance between risk and reward. All of this is coming at a time of increasing competition, a more volatile risk climate, and a soft market in non-life rates.

As was the case with Lion Insurance Company, the PwC study was quick to point out the impact that rating agencies are having with ERM implementation. PwC points out, “Rating agencies are increasingly evaluating risk management as part of their overall assessment of financial strength.” And it is not just the rating agencies; study participants noted that there is an increasing stakeholder scrutiny that is also pushing the risk management bar up. Additionally both “analysts and investors are demanding more information about risk management programs and capital positions,” according to PwC.

PwC notes that fewer than half of the participants are confident that ERM has been sufficiently embedded into their strategic planning, resource allocation or even performance management. This is reflected in the limited extend to which ERM has permeated into the strategic direction and risk-taking activities of many of the participants. For example, the articulation and application of risk appetite are critical in defining and enforcing the amount of risk a business is willing to take in the pursuit of value, PwC notes. As such, it is a cornerstone to effectively embed ERM. It was therefore surprising to them that more than three quarters of the participants “did not base their risk tolerances on the broad risk appetite and tolerance levels set by senior management.”

In short, despite numerous improvements noted by PwC, there remains one major problem that has plagued most of the participants. According to PwC, “The extent to which ERM is integrated into the day-to-day decision-making and frontline risk-taking of the business is often limited.” And without this integrated, or enterprise view of risk management, ERM will continue to fail to meet it potential.

Conclusion

Will ERM be a game changer, a true paradigm shift for business management? At this point, the jury is still out on this issue. Most experts agree, however, that if ERM is properly implemented and does, in fact, encompass an integrated, enterprise view, better management decisions should be possible. To date, however, this has rarely occurred. But many insurers, from large carriers like AIG to smaller companies like Lion are already beginning the journey to ERM. While Lion’s Miller admits that “we went down the road primarily because it became a hot button item to A.M. Best,” they nonetheless began the movement necessary to develop an integrated ERM program.

It is clear that rating agencies are a prime driver of the ERM movement within the financial services sector. And while there are significant issues still surrounding the reconciling of the different methodologies used by the various rating agencies, they are forcing the issue within the insurance industry. And as Miller points out, “I think that this was a worthwhile exercise in addressing some of our risk issues.” Further, he notes, “these requirements are not going away anytime soon.” Other insurers would do well to listen to Miller’s message. n

The author
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.