September 10th, 2013

Effective Enterprise Risk Management

Posted at 1:00 AM ET

mango_don_bioDonald Mango, Head of Global Advisory

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With Solvency II and similar regimes in place and still on the horizon in some countries, and the continuing evolution of rating agency requirements, the last decade has seen the (re)insurance industry fully embrace the practice of enterprise risk management (ERM). As a trusted advisor to (re)insurers globally, Guy Carpenter has observed firsthand what it takes to implement ERM successfully. An ERM program’s effectiveness may be enhanced with the benefit of adherence to a set of simple tenets. 

1. Make it simple. The success of an ERM program comes down to basic execution, organizational discipline and controls and the alignment of proper incentives. While it is true that undertaking ERM changes can be difficult and disruptive, complex plans that are difficult to implement are not necessary. Keep it as simple as possible.

2. Don’t overlook risks that are hard to quantify. In ERM, companies may focus too much on more easily quantifiable risks, while neglecting those that are harder to quantify - for example, strategic, reputational, brand or operational risks. Companies should ensure the inclusion of these components in their models in order to capture the full spectrum of risk and identify areas that require a deeper focus on risk mitigation. 

3. Allocated capital doesn’t solve everything. Capital allocation is a highly visible part of ERM for insurers, as it is used to maximize return on risk-adjusted capital or “RAROC.” It represents a “perfect storm” of complexity of calculation and sensitivity to expert judgment. Many practitioners fail to recognize that capital allocation brings the most value when the recipient has the ability to improve RAROC, typically through underwriting actions. Allocating capital to, for example, runoff units or operational risks - areas lacking the ability to effect change to improve RAROC - can undermine the effectiveness of the overall capital allocation effort. 

4. The end result of our efforts will put us back where we started, but we may know the company for the first time - to paraphrase T.S. Eliot. Capital models may end up guiding companies to stay the current course. In this case, the value of the ERM effort may be that it yields a central repository of information or as Goldman Sachs has called it, “the official risk record of the company.”[1] An economic capital model can become the central learning record for the company’s enterprise risks. This information can help companies better understand their overall risk management efforts.

5. The same game with a new name. While the term ERM itself is fairly new, many insurers have been managing risk all along with a number of methods, including triaging claims handling, implementing exposure accumulation controls and utilizing reserve opinions. Companies may not have to completely reinvent the wheel to practice ERM and should recognize how they are already successfully managing risk. 

6.  Think multi-front battle. ERM implementation is about change management. To embed a capital model into the operations of a company, progress must be made along four fronts: (i) the technical development of the model itself, (ii) educating all key stakeholders about the process, (iii) planning the process and modifying timelines to include critical decision processes and (iv) acknowledging and addressing any concerns that may arise from stakeholders.

7. ”Amateurs talk strategy; professionals talk logistics” -  Omar Bradley (General of the U.S. Army). ERM success is less about conceptual frameworks and strategy and more about the timely delivery of useful information to key decision makers so they can make better informed decisions. ERM implementation teams must have the resources and buy-in from colleagues to effectively improve processes and implement new practices. Impactful ERM requires logistical execution. 

8. Better Effectiveness is Achieved When the Company is Managed by Like-Minded Individuals Who Share a Stake in the Company. A leading investment firm partnership was better able to weather the 2008 financial crisis than most of its peers. Many factors contributed to this, chief among them their highly effective ERM framework. A large part of that effectiveness is attributable to their partnership structure itself. Risk management research confirms that people’s opinions about acceptable risk-reward tradeoffs change dramatically when their own money is at stake. ERM best practices call for alignment of incentives, the most important being alignment of ownership stakes. This can translate as employee stock ownership programs or risk-adjusted incentive compensation programs. Whichever route is chosen, when employees have a vested interest in the risk-adjusted performance of the company the outcome can be more effective. 

Note: 

1. Euromoney Books, SBC Warburg Dillon Read, Goldman Sachs: The Practice of Risk Management. Euromoney Institutional Investor, 1998.

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