October 29th, 2008

ERM Finishes What Diversification Starts

Posted at 9:01 AM ET

Donald Mango, Chief Actuary

The financial catastrophe currently tearing through financial markets has changed the face of risk. Diversification, once the standard for reducing exposure, has been weakened by a convergence of threats on both sides of the balance sheet. (Re)insurer capital is under assault, and a more robust risk management technique is needed. Enterprise Risk Management (ERM) may help the situation, offering an integrated view of portfolio perils and the tools necessary to develop an effective risk transfer strategy.

Diversification is a time-honored risk management practice. With a formal history that reaches back more than 50 years, it was originally applied to equity assets, with the assumption that a sufficiently varied portfolio of securities would not be correlated perfectly. When this strategy is successful, a few “big winners” can offset many small losses. Unsurprisingly, this principle has been applied to portfolios of all kinds—including underwriting risks.
In a (re)insurance portfolio, underwriting diversification typically entails a reduction in portfolio results variation through an increase in the distinct lines of business covered. As with equity assets, in the original application of this approach, carriers assume that the risks they cover are not perfectly correlated. Instead of looking at the diversification of insured losses, though, the prudent perspective is to focus on the diversification of underwriting profits—as an asset manager would seek to offset several small losses with a few large gains.
Unfortunately, the financial catastrophe currently gripping the market has exposed the limits of simple diversification. Until now, we have never seen a systemic risk so powerful that it could strike both sides of the balance sheet and impede a carrier’s ability to write business on a diversified portfolio of perils. Distributing risk across business lines—and managing the perils separately—no longer affords the protection necessary to protect solvency. Instead, carriers will have to understand the marginal effects of each risk assumed on the financial performance of the entire firm.
ERM is the process by which risk-bearers determine how much capital is needed to support the risks they have assumed (subject to risk tolerance). Carriers can implement ERM frameworks to identify threats, develop action plans, and measure results. The result is an integrated approach to risk and capital management based on the overall impact of each decision rather than the limited evaluation inherent in silo-based hedging.
Among the weak links in traditional diversification is a confluence of unrelated events and the damage it could cause to a carrier’s capital. The accumulation of distinct perils does not account for a simultaneous occurrence, such as the financial catastrophe. The impairment of carrier investment assets has come alongside above-average hurricane activity and the likelihood of professional liability claims related to the financial catastrophe. Instead of seeing several small losses to be covered by a few strong gains, carriers could sustain several large underwriting and investment losses.
While the ERM discipline is uniquely suited to this perilous environment, its use of metrics, models, and frameworks associated with ERM are intended to educate decision-makers. However, they do not replace judgment. An over-reliance on metrics can be just as treacherous as ignoring them. ERM is a tool set…and an important one for coping with this financial catastrophe. It should complement—not be a substitute for—a risk manager’s instinct and expertise.
While diversification has served (re)insurers well for decades, it is no longer enough to support diligent capital management. ERM methods can be particularly effective in identifying the full extent of a carrier’s risk, especially within the context of the financial catastrophe that has taken hold of global financial markets. Risk is pervasive and multifaceted, requiring an enterprise-wide response. A blend of metrics and judgment can lead to a capital advantage.

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