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Home > Asset Management Best Practice > ERM, Best’s Ratings, and the Financial Crisis

Asset Management Best Practice

ERM, Best’s Ratings, and the Financial Crisis

by Gene C. Lai

Executive Summary

  • The objective of ERM should be to maximize the wealth of all stakeholders, including stockholders, policy-holders, creditors, and employees.

  • To have a successful ERM process, a company needs to have an effective risk culture, and have the support of the CEO and other executive officers, such as the CRO or CFO.

  • The ERM process should include capital modeling tools, and hold high-quality and sufficient capital.

  • An effective ERM will have a positive impact, not only on the best capital adequacy ratio (BCAR) but also on Best’s overall ratings.

  • In addition to the traditional ERM, and recent improvements such as dynamic hedging models, an effective ERM needs to consider the systemic risks that made some insurance companies insolvent in the recent financial crisis.

Introduction

The recent financial crisis has raised some questions, such as why enterprise risk management (ERM) was not able to prevent some large insurance companies from either becoming insolvent (for example, AIG) or from suffering large losses of their market value (for example, Lincoln National), and whether rating agencies properly perform their jobs.1 It is critical that insurance companies have effective ERM programs, and that rating agencies provide adequate ratings to protect insurance companies from bankruptcy. Initially, many insurance companies adopt ERM because rating agencies consider ERM as part of their rating. Adopting ERM for the sole purpose of fulfilling the requirements of a rating agency may not be the best practice. A recent survey conducted by Towers Perrin showed that 32% of companies name identifying and quantifying risk as their main purpose. We believe these companies are moving in the right direction, but more improvements to the current ERM process are needed.

Effective ERM

To have an effective ERM, a company needs to have an effective risk culture. To achieve an effective risk culture, a company needs to start from the chief executive officer (CEO) and other senior executive officers (including the chief financial officer (CFO) and/or the chief risk officer (CRO)).

ERM usually involves a process that identifies and assess risks, determines a response strategy and techniques, and implements and monitors the risk-management program for the enterprise. The objective of an ERM program is to maximize the wealth of the stakeholders – including stockholders, policy-holders, creditors, and employees—sustainably over the long term. It should be noted that wealth maximization is not equivalent to risk minimization. Risk and return are trade-offs. Insurance companies need first to establish their risk tolerance level and minimize unnecessary risk.

Some major categories of risk are credit risk, market risk, underwriting risk, operational risk, and strategic risk. Detailed items for each category of risk can be found in one of Best’s articles.2 In terms of credit risk, insurance companies should pay special attention to counterparty risk if they hold credit default swaps (CDSs). The recent collapse of AIG provides a good lesson for insurance companies that do not know the counterparty risk.

As a result of recent events such as September 11, 2001, the financial crisis which started in 2008, and major hurricanes in 2004 and 2005 (including Katrina, Rita, and Wilma), longevity issues have increased the risk profile of insurance companies. Insurance companies have to take action to deal with the increased uncertainty and volatility that they face. In addition, the regulatory changes regarding EU Solvency II and principles-based requirements have also resulted in improvements to the traditional risk management programs. Recent developments in ERM include catastrophe modeling, dynamic hedging modeling, and an enterprise-wide view of risk for insurance companies. Catastrophe modeling aims to deal with the rapid escalation of natural disasters caused by global warming, because it has been more difficult to predict catastrophic events. While the retirement of the baby-boomer generation presents opportunities for insurance companies to manage retirement savings, it also creates capital market-based risk. Insurance companies have developed some products that guarantee certain returns on the invested assets. The guarantees create additional risks related to capital market performance. To reduce the risk of the guarantees, insurance companies have developed and implemented sophisticated hedging models to protect both the policy holders and these companies against adverse movements in the capital markets. The recent financial crisis has shown that the hedging programs are far from perfect. Many insurance companies have suffered from rating downgrades and potential bankruptcy. The new emphasis on ERM today is a heuristic approach, rather than a silo approach. Not only the risk of an individual unit, but also the risk correlations among the units, are critical to the success of ERM. More importantly, ERM today should pay more attention to systemic risk, which can be defined as the risk of collapse of an entire financial system or capital market. One reason for the recent failure of the financial systems is that ERM does not consider the systemic risk.

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Further reading

Book:

  • Moeller, Robert. COSO Enterprise Risk Management: Understanding the New Integrated ERM Framework. Hoboken, NJ: Wiley, 2007.

Articles:

  • Kenealy, Bill. “Sifting through the ashes to assess ERM’s value.” Insurance Networking News (January 7, 2009). Online at: tinyurl.com/5ukt6zu
  • Mueller, Hubert, Eric Simpson, and Edward Easop. “The best of ERM.” Emphasis 2008/3: 6–9. Online at: tinyurl.com/6b9m989

Reports:

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