Insurers face a critical choice that can separate those that thrive from those that get by. Enterprise risk management (ERM) can be a mere regulatory compliance exercise that satisfies a minimum requirement, or the starting line to a sprint toward a cross-business, risk-aware culture.
Ironically, a more complex world is making this choice simpler. New technologies such as driverless cars and smart homes; a changing climate; and new data sources for tracking consumer behavior are game changers that are making it perilous to simply go through the motions.
What is practical risk management?
Quite simply, practical risk management covers all organizational risks holistically — both upside and downside risk outcomes. Practical risk management requires these elements:
- Business strategy that promotes a fully incorporated risk/reward continuum and consistent risk taking, and makes organizational decision-making risk aware
- Solid framework that identifies and manages risk and integrates risk considerations directly into a company’s everyday business decision-making process right from the start when action is still possible
- Effective risk culture with top-down, ERM tone and culture with visible support from management.
At a minimum, underwriting, reserving, asset and capital modeling teams should coordinate the models and parameters used so that all key functions are on the same page.
Key components of an effective risk culture
- Positive support from the board – “tone from the top”
- Common risk taxonomy
- Risk support from within the business
- Second-line understanding of the business
- Positive engagement in key meetings
- Interaction with business units and between business units
- Effective use of tools
- Willingness to challenge
- Openness to opinions
- Diversity of views
- Defined timelines for interaction
- Clear and aligned objectives
How this can work
ERM can be applied to product and pricing, reserving, claims, marketing, assets, human resources, finance and management.
Product and pricing
Oftentimes, pricing and capital model approaches differ, or pricing and capital market segments may not line up cleanly. In many cases, risks to product changes or new products are not adequately identified, or their effects aren’t known. Requiring risk assessments for new products and product changes will help identify risks during the development process and necessary monitoring requirements to detect evolving risks before they become problems.
Reserving can present similar challenges. The reserving group may use segmentations that don’t naturally line up with those used in capital or pricing models. Companies often have long-held practices for calculating reserves that don’t naturally translate to simulated results for the capital model.
The reserving group needs to communicate changes in reserve development that may shift an organization’s risk profile. The calculation of the overall reserves needs to align with recent data on claim trends and practices from the claim department. This communication may provide additional insight into the reserve risk profile, its contribution to the company’s overall capital need and, eventually, to its pricing targets and asset needs.
The risk management process often overlooks claims. Pricing and capital modeling will typically use aggregate data to parameterize models, but this may obscure claim trends that can help identify emerging risks, changes in cat exposure or cat events. Changes in claim practices and policies can directly change the overall levels of losses or shift risk profiles. Likewise, other areas in the company can provide claims with information on policy trends to better prepare for changes in customer composition and behaviors.
For many companies, the asset management group is the one most focused on risk (outside of the risk function). Even so, many companies find that asset projections use different economic scenarios than those used in the planning, underwriting and capital modeling processes. A common set of economic assumptions will help identify correlations and diversifications that may benefit the organization or potentially amplify a risk beyond the limits set by an individual business function.
Marketing is often excluded from risk discussions with the ERM or planning areas. Marketing expenses or advertising costs may be included in plans, but a company’s marketing is rarely included in capital modeling or any risk assessment. However, marketing has potentially the most information on current and potential customers and their behaviors, and should be part of an insurer’s future risk profile.
Compliance and safety are traditionally human resources’ only participation in risk management discussions. More sophisticated organizations focus on employee engagement, talent management, performance measurement and remuneration, which can directly impact a company’s risk profile. Human capital risk management can link to some of the largest risks within an insurer, as a key component of operational risk, and also impact all other risk categories.
In most companies, finance works with the ERM group but often simply provides projections for model calibration and uses capital model output for capital planning activities. Finance might provide input or request data on events after the fact, but rarely is the capital model used as input to the company’s financial planning. Given the potential similarities between capital and financial planning models, we would expect more of those processes to overlap, and for risk management to be an integral part of financial planning, capital management, and dividend and M&A decisions. This ensures financial decisions don’t adversely affect the company’s overall risk profile.
At its core, ERM allows management to better assess the potential to meet objectives and goals, provide an adequate return to shareholders and proactively address areas that may hinder performance.
The value of a risk-focused culture
A practical and aligned risk-focused culture supports an active risk assessment and opportunistic risk taking that positions companies to identify and prepare for future changes and deliver greater long-term value for stakeholders.
I cover this in more detail in Practical risk management creates a winning, risk-aware culture.
Matthew Peters specializes in helping property and casualty insurance companies identify, model and manage their risk. He is an industry-leading expert in ERM, economic capital modeling and has implemented and supported models for a number of the top-20 insurers, as well as advising numerous others in the U.S. and Bermuda. Matthew also manages Willis Towers Watson’s P&C ERM and capital modeling practice in the Americas and Bermuda.