The ERM Weathervane

Insurers operate in a world economy full of risk peppered with catastrophic incidents. While this environment offers unprecedented opportunities for growth, it has also substantially increased the chance for big claims. Large claims can stem from regulatory and legal action against clients, various natural and manmade disasters, supply chain failures, product liability and more.

For risk managers in property and casualty insurance, the greatest challenge lies in managing the ever-evolving risks and changes in a global economic and commercial landscape. As developing nations continue to grow and improve their economic status, the need for insurance solutions grows—as does the need for insurers to rethink their approach to risk management.

In today’s global landscape, the P&C industry has exposures in widely diverse locations and can be severely affected by concurrent catastrophic events. Risks are no longer simply geographically based. A port-destroying typhoon in Japan has implications for supply chains half a world away, and a meltdown in the credit market in New York has toxic effects across the entire globe. Companies must, therefore, examine their complete risk portfolios and the consequences associated with paying out claims when concurrent, cross-border catastrophes hit.

Enterprise risk management (ERM) provides risk managers, insurers and reinsurers alike the ability to more accurately measure the potential cost of risks against the profits earned by insuring them. If used properly, ERM can vastly improve claims reserving accuracy.

Enterprise Risk Management in Insurance
ERM is defined by the Casualty Actuarial Society as “the discipline by which an organization in any industry assesses, controls, exploits, finances and monitors risks from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders.” For insurers, ERM is a holistic approach to risk management that not only measures, mitigates and transfers risk across the enterprise, but also offers carriers a key opportunity to improve performance all along the insurance value chain.

For insurers and risk managers, particularly those with a global risk profile, an effective ERM program should be designed to help diversify risk and contain its expansion. In fact, multidimensional ERM can be leveraged to examine the impact that both risks and opportunities will have on current and prospective portfolios.

Using advanced technology and predictive analytics, organizations can better identify a range of uncertainties and enhance the overarching decision-making process—adding significant value throughout the enterprise. For instance, many savvy insurers are employing economic capital models to improve overall returns. Such sophisticated tools can help carriers impose consistent financial restraint, benchmark overall performance against risk-adjusted results, and even integrate underwriting and investment risk.

ERM serves as a dynamic response to changes that take place both inside and outside an organization. Through the implementation of ERM, companies effectively combine the traditionally separate disciplines of financial and operational risk management while creating more positive momentum for growth. Indeed, many companies are using ERM when making crucial business decisions ranging from capital allocation to risk retention and product management.

Using ERM to Improve Claims Reserves
Risk managers want to be sure that claims will be paid. But how does ERM enable a carrier to provide that comfort level?

Insurers that adopt and implement an advanced ERM program can better quantify the uncertainties in their loss reserves—a critical component of a company’s solvency and overall stability. Indeed, carriers that effectively utilize a sound ERM program are generally in a better position to fulfill their obligations to policyholders when disaster strikes. For this reason, most ratings agencies look positively on a strong ERM program, and the European Commission’s Solvency II initiative calls on insurers to adopt economic capital models that quantify all the material risks facing their companies.

Employing economic capital modeling in addition to advanced ERM can reveal where varying levels of capital are needed to support different types of exposure. A robust ERM program also looks at clients’ risk, giving insurers the data they need for better underwriting—offering lower prices to buyers with relatively steady loss experience and applying higher prices and reduced availability to buyers with more volatile loss experience.

Insurer ERM and economic capital modeling have already begun to transform the dynamics of insurance markets. In turn, this allows carriers to more accurately price coverage as it is related to the actual risk. Furthermore, the adoption of a solid ERM program can help the organization augment its decision-making regarding how much risk to retain, which particular risks to retain and which risks to cede, how much capital a captive should hold, and how much to charge operating divisions for coverage provided to them. Proper application of these techniques may substantially reduce claims and lead to the collateral benefit of reducing cost when risk transfer is the chosen strategy.

In the current global economic environment, traditional claims-reserving practices often fall short of providing adequate capital. Carriers large and small are susceptible to the significant, skewing impact of catastrophic events on small data sets used for setting reserves for individual books of business. Moreover, many of these insurers don’t have the historical data necessary to set reserves for new markets and products. An insurer can alleviate those deficiencies by using industry aggregate data tailored to match the profile of a specific book of business.

The point forecasts of traditional reserve analyses are limited to the amount of capital needed to settle all outstanding claims, and more often than not, such forecasts turn out to be wrong. Additionally, these forecasts do not offer a solid basis for managing the inherent uncertainty in claims reserves or for allowing for correlations between losses for different profit centers, lines of business or classes of risks.

As a result, insurers, regulators and rating agencies have gravitated toward the integration of ERM and stochastic reserving practices that generate point forecasts as well as probability distributions describing a range of potential outcomes. Such probability distributions for the different portions of a carrier’s operations can be amalgamated to properly reflect correlations, thereby allowing the insurer to set total reserves in conjunction with the organization’s overall risk appetite.

Implementing a Successful ERM Program
For an ERM program to be effective, senior management must endorse the initiative. In today’s global environment, companies must be able to examine the rapidly increasing potential of risk all across the enterprise, and such a feat cannot be accomplished without the support of top-level executives.

ERM must also be embedded at organizational levels below the C-suite to the point that unit managers assess risk within their operations and, as participants in cross-functional teams, feed timely risk information back to the risk management unit.

The hazards to the organization must be identified, contemplating past and future scenarios. The more complete the corporate risk profile generated by this exercise is, the more it can help an organization anticipate claims activity and potential reserving requirements, thus leading to better risk-adjusted decision making.

Risk is dynamic, and ERM must be as well. Therefore, risk managers and insurers must:

Traditional risk management strategies that identify, evaluate, mitigate, plan and fund for consequences should still be a primary focus of the risk manager. However, by supplementing this approach using tools such as advanced analytics, modeling and scoring, organizations can more consistently adjust costs for risk and provide valuable decision support for management—particularly when it comes to making critical judgments regarding the allocation of capital and claims reserves.

Robert J. Schneider is managing principal of the ISO risk management practice.