December 14th, 2009

ERM Offers Competitive Compliance for Solvency II, Part I

Posted at 1:00 AM ET

mango_smallDon Mango, Chief Actuary

(Re)insurers face a labyrinth of capital management challenges. Financial markets have proved that they can change the industry’s view of risk swiftly — and with little warning. New risks are emerging, as well, some of which can be difficult to identify, lurking in portfolios for years without detection. The need for Enterprise Risk Management (ERM) is palpable, and risk-bearers are beginning to appreciate that preserving their capital requires metrics-based management and a robust capital modeling discipline. With regulatory requirements such as Solvency II on the horizon, the stakes are even higher, as capital optimization must be accomplished within a compliance framework.

Of course, decisions are only as effective as the quality of the choices available. In order to understand the full range of options that can be pursued, risk managers need to model a variety of scenarios quickly and easily. A robust capital management platform can unveil the opportunities in a (re)insurer’s portfolio, help manage systemic and hidden risks and generally make capital more productive. In the end, this creates a foundation for securing a competitive advantage, even in a world where risks become more vexing every day.

(Re)insurers have been in various stages of ERM adoption for the past several years. A renewed sense of urgency came in September 2008, however, as a financial crisis gripped the entire world. Credit markets virtually ground to a halt, and equity values plummeted. In the (re)insurance industry, as elsewhere, access to capital was constrained. The Guy Carpenter Global Reinsurance Composite posted an aggregate decline of 18 percent for shareholders’ equity in 2008, signaling the extent of the financial damage for (re)insurers. At the same time, Hurricane Ike tore through the Gulf of Mexico, ultimately causing USD13.9 billion in insured losses — at a time when carriers already had a substantial challenge in front of them.

Since then, financial markets have thawed, and the Global Reinsurance Composite’s aggregate shareholders’ equity is up 8.2 percent from the end of last year. Though we still have a long way to go, the strain of the financial crisis has eased. Nonetheless, (re)insurers are left with a new appreciation for what is possible. We saw the inconceivable unfold last year on a single weekend in September: simultaneous property-catastrophe and financial events. The enduring lesson, therefore, is likely to be the importance of understanding the many threats to a carrier’s capital and how to ascertain the implications of a broad array of scenarios.

When it came to risk, most financial institutions were guilty of tunnel-vision, taking a line-item view of risk, with the aggregate appearing to reflect macro-level control because micro-level concerns have been addressed. Yet, this ground-up, tactical view of risk management does not provide protection from systemic, strategic risks. Macro-level risk management must be viewed top-down, with a holistic model of each risk factor and the dependency structure that links them together.

So, how does a (re)insurer protects its capital from the many threats it faces?

Doubtless, the ability to envision the dependency structure that links individual risks is a crucial component of ERM. To fully grasp — and inventory — the risks to capital on both sides of the balance sheet, possible scenarios that could cause damage must be identified. In addition to both the typical and extreme insured loss scenarios that risk managers are accustomed to modeling, the asset side of the balance sheet needs to be considered, not to mention the confluence of insured and asset losses, when the impact claims is magnified in an unexpectedly capital-constrained environment.

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Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide. All such matters should be reviewed with your own qualified advisors in these areas.

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