August 31st, 2009

ERM Did Not Fail in 2008, Part I: A Year of Significant Loss

Posted at 1:00 AM ET

mango_smallDonald Mango, Chief Actuary

The profound financial damage that began last year has left the insurance industry looking for answers. Diligent underwriting and conservative investment strategies were not enough to prevent natural and financial catastrophes from bleeding balance sheets. Both firm leadership teams and key stakeholders have questioned the value of Enterprise Risk Management (ERM) frameworks, yet the conclusion that ERM failed may be hasty. After all, the insurance industry actually survived the events of 2008 reasonably well, with at least some of the credit going to their ERM efforts. Where risk management did fail, the underlying causes were deeper.

Models and ERM frameworks alone cannot protect capital from the myriad threats that carriers face. They will never replace the judgment, insights, and decisions of risk management professionals. As we look forward to the balance of 2009 — and well into 2010 — the insurance industry should reflect on the lessons of last year and plan their ongoing ERM investments accordingly.

A Year of Significant Losses

The insurance industry faced both natural and financial catastrophes in 2008, causing a spike in insured losses and depleting carrier investment assets. Both sides of the balance sheet were subjected to incredible pressure. The insurance industry spent six months revising estimates from Hurricanes Gustav and Ike upward, while the ultimate tally of investment losses from the financial crisis continued to climb. Insured losses were much higher than anticipated, and carriers have struggled to replace even a portion of the capital consumed by these events.

The net effect was an 18 percent drop in reinsurers’ shareholders’ equity, as measured by the Guy Carpenter Global Reinsurance Composite. While a handful of carriers were able to protect (and even increase) their capital, most were down, with a few losing 40 percent or more. Of course, the situation was much worse for the broader financial services industry, particularly the banking sector. In addition to losing shareholders’ equity of more than 30 percent on average (which includes the effects of the Troubled Assets Relief Program), several global banks with robust balance sheets, long operating histories, and unassailable reputations disappeared.

In contrast to the banking sector, the non-life insurance industry fared relatively well. There were a few high-profile casualties in the life insurance sector, but the losses were attributable to asset-linked insurance and annuity products. Conservative accounting and risk management practices contributed to this relative success, but another key factor was the sizeable capital cushion with which carriers entered 2008. In fact, the most common conversation among insurance industry leaders at the start of 2008 involved how to make excess capital productive. Dividends were routine, and share buybacks abounded. Even with the aggressive return of capital to investors, carriers still generally had robust balance sheets, which helped them absorb the effects of a perilous September.

Nonetheless, it’s difficult to keep this perspective when staring at a much leaner balance sheet. Whether it is pessimistically called blame or perceived as an opportunity to improve, carriers have fervently sought answers. For many, the buck stops at ERM.

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Originally published in MMC’s Viewpoint magazine >>

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