October 27th, 2008

ERM: Part of the Answer to the Financial Catastrophes

Posted at 5:00 PM ET

Peter Zaffino, President & CEO
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While hurricanes spun through the Gulf of Mexico last month, a larger catastrophe ripped through New York, London, Shanghai, and every other major financial center in the world. Tropical Storm Credit Crisis (which started as Tropical Depression Subprime) intensified quickly and became a Financial Catastrophe that destroyed vast amounts of shareholder wealth.

 
For the first time in recent memory, an insurance industry financial event upstaged a string of natural disasters, and we experienced the destructive power of a “financial catastrophe.” As the industry sifts through the wreckage, it has become clear that Enterprise Risk Management (ERM) techniques may be able to help protect capital in the future.
 
There is no doubt that we are experiencing a financial catastrophe—a new type of disaster with the power to strike both sides of the balance sheet. Both equity and credit markets have been battered, and carrier investment gains have been eroded. The cost of capital has been pushed higher almost universally. Simultaneously, carriers may have to address an increase in claims and a drop in financial resources. A higher cost of capital could apply further pressure on their abilities to meet obligations, which could exacerbate the current liquidity crisis in financial markets. Profitability, of course, is imperiled.
 
Already well into the current financial catastrophe, carriers have had little choice but to cope with prevailing market conditions. The way we look at risk has to evolve, as the threats we face have grown in complexity. Risk used to be measured as linear, allowing specific perils to be managed individually. This is no longer the case. Threats are intertwined, and one event could send shockwaves through an industry (or many).
 
The conventional approach to risk management—i.e., identifying and hedging risks individually—is becoming less effective. We have seen over the past two months in particular that the total risk in a portfolio is greater than the sum of its constituent perils. Traditional property, casualty, and now financial catastrophes can converge on a portfolio and exploit exposures that may have gone unnoticed.
 
ERM disciplines offer considerable preventive support, requiring a more contemplative approach to the selection of which risks to cover and emphasizing holistic capital management. Through the application of ERM techniques—including the analysis of underwriting risk, market risk, credit risk, and operational risk—carriers can reduce their exposure and improve their use of capital. This method, however, requires a profound organizational transformation. Metrics must become the language of risk, with every decision supported by a clear impact on revenue, profit, or shareholder value. The assumption of a new risk should reflect an evaluation of the enterprise-wide implications, not merely those for a particular portfolio or line of business.
 
For many carriers, ERM components are already in place. The investment has been made; the only item missing is the return. Through deliberate execution, (re)insurers can begin to realize the benefits of integrated risk and capital management. A quick look at the market shows that there are many benefits to be gained. Carriers have fought through the financial catastrophe without using the tools at their disposal. As the crisis continues to unfold, the implementation of ERM practices could limit the drain on balance sheets and accelerate a recovery.
 
The current financial catastrophe underscores the fluid nature of risk. (Re)insurers need to change with the business environment, and integrated financial risk is the latest challenge. With ERM, even if it has been adopted only in part, many of the tools are in place. Merely using what exists could have the twofold result of guiding a carrier through today’s treacherous conditions and positioning the firm for a faster recovery.

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