November 19th, 2012

Implications of Emerging Market Growth: ERM

Posted at 1:00 AM ET

David Flandro, Global Head of Business Intelligence, Julian Alovisi, Assistant Vice President and Lucy Dalimonte, Senior Vice President
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Although improvements in ERM practices meant (re)insurers were better prepared for the major catastrophes of 2010 and 2011 than those in 2005, the global nature of these losses has prompted some companies to review their perception of risk. This international loss trend, along with insurance growth in emerging market regions, is driving the need for better and more comprehensive tools for modeling risk. It also reinforces the need for (re)insurers to carefully consider how and where they diversify their business geographically and the adequacy of pricing in these territories.

As companies target new opportunities in emerging markets, they must continue to improve their risk management capabilities in order to closely monitor their risk exposures. Although the sophistication of insurers’ ERM frameworks in each developing economy differs, practices have generally lagged those in the more developed world. The majority of local insurance companies in emerging Asia and Latin America markets, which are mostly small to midsized local companies, are still formalizing their risk management governance structures. However, the increasingly heavy payouts that follow natural catastrophes in developing countries are likely to prompt (re)insurers in these regions to improve their ERM practices and dedicate the necessary resources to tools such as capital and catastrophe models.

In addition, companies operating in emerging market regions are increasingly focusing on ERM practices because of regulatory activity. Indeed, Solvency II and equivalent regimes will encourage insurers to better understand their risk profiles. This, in turn, will force primary companies to look at risk differently, particularly in emerging markets.

The emphasis that regulators and rating agencies have placed on the importance of risk management has resulted in insurers conducting business in emerging market regions to strengthen their ERM capabilities. Moreover, ERM is likely to play an increasingly important role as international companies with stringent risk management practices enter these developing regions.

Diversification

It is important that (re)insurers refine their ERM frameworks as best practices evolve. Risk diversification is a time-tested risk management practice. Within property catastrophe lines specifically, several (re)insurers have looked to diversify their book of business geographically by writing business outside U.S. peak zones. Yet following the heavy global losses of 2011, (re)insurers with a geographically diversified book of business suffered bigger losses than companies mainly writing business in the peak zones of the United States and Western Europe. Furthermore, geographic regions previously thought to be uncorrelated suddenly became correlated due to supply chain disruption and the increasingly interconnected global economy.

Rating agencies have historically rewarded companies, both implicitly and explicitly, for underwriting diversification both by line of business and by geography. The last two years have nevertheless shown that aggressive geographic diversification within property catastrophe lines can be problematic when placing business in emerging market regions. In particular, the lack of data and tools to price business in these regions means that simple geographic diversification strategies run the risk of merely adding under-priced catastrophe business to a company’s portfolio. Indeed, the lack of catastrophe models and quality data in many emerging markets was recently cited by A.M. Best as an issue that needs to be resolved if (re)insurers are to better understand their exposures and loss aggregations in these regions. (1)

Note:

1. A.M. Best Special Report - Reinsurers Resilient Against Waves of Catastrophes, Economic Uncertainty.

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