22 December 2009

Published in: Capital - models, Risk governance, Insurance risk, Investment risk, ALM, Market risks

How ERM evolved over the past year

Fourteen experts pick the key lessons learned for risk professionals in 2009. Their views on what to expect in 2010 will be posted after the holidays.

Chris Waterman, managing director, insurance, Fitch Ratings

Risks were more correlated in an extreme tail event than risk managers and other industry professionals had previously considered. It was seen that in the extreme, investment markets operate in a dysfunctional way where perfectly good assets may not be able to attract a willing buyer. The unusual functioning of investment markets would generally not be considered a major problem for investors that intend to hold their investments to maturity, but in reality, few insurers have that luxury. Investment risk carried in insurance company balance sheets, in hindsight, was much higher than previously perceived.

Justin Elks, associate director, risk, Just Retirement

The insurance sector has learned that having risk management processes and capital models is not enough for effective risk management. Effective risk management requires organizations to have a culture which puts risk management thinking at the centre of its decision making. We have also seen that the size of an organization is not a guide to the effectiveness of its risk management!

Neil Cantle, principal and consulting actuary, life practice, Milliman

Risks are a lot more interconnected than many people realized. The financial crisis highlighted the fact that people are not good at thinking in terms of conditional likelihood: as situations change, the likelihood of risks occurring can change dramatically.

An equally important lesson is that even when risk systems or risk professionals identify new risks, it is hard to convince others that the threat is serious enough to warrant action. The outputs from risk systems therefore need to be more compelling in terms of providing evidence which businesses will buy into, even if the results are unpalatable. And that is very hard to do.

Margarita von Tautphoeus, head of solvency consulting, Munich Re

If Solvency II had not already been designed, it would have to be now. Strict risk- and principle-based rules are needed more than ever to provide for the proper economic evaluation of risks on both sides of the balance sheet. Risk management is not only based on quantitative methods, but also relies to a large extent on experience and plain old common sense. The lesson to be learned is simply: know and manage your risks professionally!

 

George Stylianides, risk and capital partner, PricewaterhouseCoopers

Models are informative and useful under "business as usual" conditions. However, the financial crisis has highlighted that these models can be unreliable under extreme stress conditions. It is therefore important for businesses to monitor any potentially harmful outcomes under a number of different scenarios, including those which may appear to be implausible. It is vital that management considers mitigation options under each of these scenarios.

The lesson to be learned by considering these implausible scenarios is less about assessing whether the events could occur and more about provoking a discussion and uncovering the firm's exposure. Management need to be thinking through what options are available to them when the company's financial condition is impaired.

Risk management is only as effective as management intends it to be. The greatest tools, processes and frameworks do not always result in good risk management. This is only achievable through the leadership, influence and insight of the senior risk management team.

Ed Easop, vice president, rating criteria and rating relations, A.M. Best

The unexpected consequences of the global financial crisis that continued to unfold in 2009 clearly illustrated that ERM is still a "work-in-progress", and that tail events are not just scenarios to be modelled and statistically analysed -- they actually happen!

The single most important lesson learned is very simple - fundamentals matter:

• Risk management at its rudimentary level requires good governance and a strong risk-aware culture, emanating from the board to senior management to every employee.
• Management should not rely solely on models and corporate dashboard reports to the exclusion of fundamental financial analysis and other historical measures.
• Traditional risk management tool practices are the key building blocks of a prudent risk management system. This includes credit analysis, underwriting, cash management, liquidity analysis, sound internal controls and financial management, integrated product development and asset/liability management.

Martin Sher, managing director, SolveXia

The first lesson learned is about how quickly individuals and companies need to be able to react to rapidly changing external events. In the past, many actuaries and managers of insurance companies questioned the need to run models more often than monthly or quarterly and most felt that obtaining the answers within less than a few days was unnecessary. However, most now understand the need to be able to have answers "by first thing tomorrow morning."

A second key lesson learned is that there is a greater need to be able to adjust models and assumptions and perform more -- and a wider variety of -- financial modelling runs in a controlled and automated manner in order to be able to respond to "what if" questions. This has become more important than the previous focus on model "accuracy" with complex and, in many cases, over-engineered actuarial models. For the most part, these modelling exercises are still typically relatively manual (as opposed to automated) and run by actuaries or actuarial associates rather than incorporated into the company's mainstream, enterprise-level IT processes.

Graham Fulcher, principal actuary, Watson Wyatt UK

An important lesson that insurers have learned the hard way in 2009 is that regulators are not fully convinced that the implications of the risk management failures of the recent credit crisis apply solely to banks. A number of regulators believe that the implications apply to insurers as well. This particularly applies to the regulators' belief that financial institutions overstate the benefits of diversification for their tail risk and that the way to deal with that is to hold higher capital levels.

Elliot Varnell, principal advisor, financial services, KPMG

The main lesson being learned is that a simple model whose benefits and limitations are well understood by decision makers is better that a complex model which is poorly understood.

Part of this comes from the realization that the use test requires senior management buy-in for key decision making. Another part comes from the observation that senior managers in the banking sector lacked an understanding of models which appeared to be creating shareholder value but ended up destroying it. The difficulties in amending complex models to test "what if" decisions on a timely basis undermines their ability to meet management's needs, as well as the more complex validation that is required.

Andrew Harley, director, EMB

The main lesson is that people within an organization need to be able to challenge management analysis and assumptions on risk. The parameters that companies use to measure their risks need to be validated regularly and must be able to stand up to the "common sense" test.

Charl Cronje, partner, Lane Clark & Peacock

General insurers have not suffered in the same way as banks. However, the events in the banking world are a reminder that severe risks frequently arise from unanticipated sources. We have also seen how difficult it is to highlight and manage risks when times are good. If anyone had attempted three years ago to warn banks and governments of the disaster awaiting them, they would most likely have been regarded as doom-mongers and opponents of globalization and free trade.

Gregor Pozniak, secretary general and Silvia Herms, senior advisor, Association of Mutual Insurers and Insurance Cooperatives in Europe (AMICE)

There is one main lesson to be learnt from the financial crisis: risk management has to be a complex system embedded into every business activity, allowing the undertaking and its management to better understand the risks borne, both from a qualitative and a quantitative perspective.

A more holistic approach to risk management is needed. Whereas highly sophisticated quantitative methods/models have improved risk management significantly, we should not forget the importance of qualitative methods and processes or more simplistic quantitative methods (e.g. scenario analysis/stress testing) in risk management.

Vicky Kubitscheck, partner, Independent Audit

The most important lesson is that regulation cannot prevent bad things from happening but people can. People can make good or bad decisions by taking risks on an informed or uninformed basis.

Regulators and governments have a significant role to play in encouraging a better quality of governance and risk management; but the wrong incentives or approach can influence the wrong sort of corporate behaviour causing companies to focus on doing things right (compliance) rather than doing the right things (performance).
The "human factor" in risk management must be a lesson we should all seek to understand better if we want to improve the way businesses are run.

Peter McGloughlin, director, insurance solutions, financial markets, Lloyds Banking Group

The biggest lesson is that the markets change very quickly and continue to remain volatile. 2009 has seen a huge turnaround in the performance of most investment portfolios and because the wind didn't blow hard most insurers have gone from capital shortage in 2008 to capital excess in 2009! Nonetheless, in many ways the insurance industry had a lucky escape: had the wind blown harder, many insurers could have taken losses on both sides of the balance sheet. Risk management must be about the total balance sheet and economic modelling must capture the investment risk and underwriting risk in tandem.

On the life side, 2009 brought debate about the liquidity premium for corporate bonds and what rate holders of longer-term liabilities should discount at. At least most market participants now agree that a liquidity premium does exist and insurers with long-tail risks like annuity writers should be able to reap the benefit. The debate with CEIOPS around discounting still continues but highlights the need to understand the components that drive discount rates. The financial crisis has shown us that government bonds are not risk-free and early 2009 long-dated gilts yielded more than long-dated swaps.

Many insurers with ALM swap hedges in place were able to take advantage of the breakdown between swaps and gilts and were able to lock in excess capital gains. The value of swap hedges increased while liabilities decreased due to higher gilt yields and negative swap spreads. This anomaly also brought exceptional investment opportunities for longer-term investors and at one stage you could buy an index-linked gilt and swap it to Libor plus 100bps or more via a cash-collateralized swap. Investors were getting paid to own UK government debt.

In the UK with-profits insurers had to deal with collapsing equity markets in the early part of 2009. It seems so long ago but the FTSE did nearly go through the 3,500 mark in March. The high equity-backing ratio of many of these policies meant that insurers had to be very active in their risk management approach to falling equity prices. Many who have been active with replicating portfolios and modelling their economic capital already had hedging programmes in place throughout 2008 which proved effective. However the dramatic recovery in equity markets should not lull insurers into any complacency for 2010 and insurers yet to put hedging programmes in place should treat the recovery as an opportunity. It is always better to hedge when markets are high and the panic has gone rather than be forced into it when markets are crashing through the floor.

Back to top