September 2nd, 2009

ERM Did Not Fail in 2008, Part III: Managing Constrained Capital

Posted at 1:00 AM ET

mango_smallDonald Mango, Chief Actuary

Going forward, the insurance industry will have to change its thinking. The crutch of excess capital has been kicked from beneath the industry’s arm. Despite some recent successes in capital-raising, the largesse of 2007 and 2008 is unlikely to return in the near future. The insurance industry began 2009 with sufficient capital to bear risk and operate without fear of insolvency, but the coffers were lighter than the year before. The industry is bruised, and may not be able to absorb a reprise of the realized risks of 2008. A new approach to managing and measuring risk is necessary, one that addresses the full spectrum of threats that carriers face.

This implies a profound shift in how carriers understand, price and monitor risk. No exposure exists in a vacuum, as a single event could affect many lines of business or insureds. Companies need to develop their scenario modeling capabilities. This will require a degree of structured imagination among the management team and key opinion leaders. Last year, few accounted for the fact that a devastating hurricane would strike Galveston, Texas as a financial catastrophe shook New York, London, Hong Kong, and other money centers. Firms must start by conceiving of the scenarios that could impair balance sheets, but they must follow that with an assessment of the impact of those scenarios, as well as the projected effects of any mitigation steps. Most insurers have found the best way to do this is an internal risk and capital model.

Guy Carpenter’s MetaRisk® model, for example, enables risk managers to evaluate all major risk sources: underwriting, reserving, catastrophe, credit, market, and operational. The model supports a holistic approach to risk by capturing the risk characteristics and interaction effects in one master file — thereby becoming the official risk record of the company. Once the range of impacts has been quantified, corporate risk tolerance levels can be matched with reinsurance coverage and other hedging strategies to demonstrate to stakeholders how, under a host of possible scenarios, the company’s risk and capital management plan preserves the franchise.

It is important to stress that even the most advanced risk technology cannot replace the human element in risk decision processes. In fact, one could argue that over-reliance on automated logic materially contributed to the financial catastrophe in which the market is currently mired. Instead, think of this technology as facilitating the development of a risk management competency in these organizations — the emergence of a new breed of risk professional able to use these tools along with knowledge of the business dynamics and drivers to provide a company’s leadership with expert navigational guidance.

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Read Part I: A Year of Significant Loss >>

Read Part II: Expectations and ERM >>

Originally published in MMC’s Viewpoint magazine >>

Download the latest issue of Viewpoint (PDF) >>

Order Guy Carpenter’s ERM book, Enterprise Risk Analysis >>

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