31 December 2009
Published in: Capital - models, Risk governance, Regulation - supervision, Accounting - tax
Understanding risk tolerance is key ERM challenge
"What was learned from the events of 2008 should bode well for improved ERM response going forward," notes Aon Benfield in its latest research report, Reinsurance Market Outlook - Remarkable Recovery. However, the challenge that remains for most in enhancing ERM is to understand risk tolerance.
The report observes that "there were some suggestions that enterprise risk management (ERM) did not meet expectations in 2008, while others suggested that things would have been worse without ERM," adding that "most would agree to the following:
- ERM, as with any management process, is imperfect;
- sophisticated risk modeling and risk metrics by themselves are not a sufficient ERM process; and
- ERM helps to establish more informed boundaries with which to operate. Indeed, ERM has provided many managers additional insight into their organization and should serve as a competitive advantage over time when done appropriately."
However, continues the report, "even the most effective risk controls and risk capacity allocation process will be undermined if the barometer that ERM is being used to manage is not clearly defined within the organization or not understood by its stakeholders. A trend that we have seen across the industry is an increased documentation of risk appetite for certain risk silos or product lines. Often, however, this does not translate into a group-level risk tolerance established for the organization as a whole."
The key to ultimate ERM success will be to minimize the damage from the mistakes that will be made, and to effectively incorporate a risk-analysis mindset throughout the organization.
Other key points in the report (see also other news item today):
Solvency II complexity might be dwarfed by IFRS phase 2
Aon Benfield expects that Solvency II will increase the regulatory capital requirement of composite insurers by 20-40% on average based on the standard formula. The report notes that quantitative impact study 4 (QIS 4) indicated an average increase of 8% for composites, versus 94% for non-life companies and no change for life companies.
"Recent consultation papers by the Committee of European Insurance and Occupational Pensions Supervisors show a more conservative view post-financial crisis, and capital requirements have increased substantially since QIS 4, especially on the asset side of the balance sheet."
Based on an Aon Benfield analysis of various global regulatory and rating agency capital models, both A M Best and S&P capital requirements will be greater than the proposed Solvency II SCR requirements under QIS 4. A M Best would require 16% more capital than Solvency II and S&P would require 29% more capital.
"We understand that QIS 5 should be more straightforward to complete than QIS 4, and the general consensus is that the capital requirements will increase. Moreover, we believe that Pillar 2, regulatory risk assessment, and Pillar 3, public disclosure, will be more important challenges than Pillar 1, which focused solely on capital requirements. Indeed, calculating the capital requirement seems rather simple compared to explaining to regulators and investors how risks are managed and how these are adequately reflected in the available capital."
But, the Aon Benfield report, argues: "Perhaps the most significant challenge of all is bridging the gap between the insurance industry, the regulators and investors. The industry is looking for the correct amount of economic capital, the regulators for a safe amount of capital (the higher the better from their perspective) and investors want capital to maximize long-term value - a perspective that can change over time."
The report observes: "Investors wanted insurers to hold less capital 18 months ago, more capital 12 months ago and today they prefer more capital as long as returns are similar to 18 months ago."
These inconsistencies have become quite challenging for most companies, the report continues. In addition, due to current IFRS accounting where assets are recorded at fair value while liabilities are not, insurers' financial statements experience regular volatility, and the interaction with Solvency II will highlight this disparity.
"Proposed changes to IFRS phase 2 should correct this inconsistency, but timing is still unclear
as the FASB and IASB are still debating the most appropriate way to calculate the insurance liabilities," notes Aon Benfield. "No meaningful changes to IFRS phase 2 are expected in the near-term, so insurers are still uncertain as to what the ultimate accounting will be, and how this might impact assets, liabilities and capital. The potential complexity of IFRS phase 2 could dwarf the Solvency II effort."
Reinsurance purchasing and Solvency II
The new Solvency II regime will also increase the need for insurers to understand solvency capital relief when valuing reinsurance. It will become more important and more challenging than has been the case historically to purchase the optimal reinsurance structure in line with Solvency II's balance-sheet risk management approach.
The CROs of insurers will have an important role managing risks according to the company's risk appetite and risk tolerance, and ensuring an adequate risk transfer policy.
"Across Europe there is a trend of more risk managers appearing, but the formal CRO role is still non-existent within many European insurers," the report states. Aon Benfield says companies will be able to use their own exposures and reinsurance programmes in their Solvency II capital requirements, but in its current form they would be at a disadvantage compared with companies using the standard model for calculating their catastrophe risk exposure. "We expect this to be resolved under QIS 5 (April 2010) and thus companies should be able to manage their catastrophe risk exposure in line with their overall risk appetite," the report predicts.
Rating agency vs Solvency II requirements
The report notes that the rating agencies have repeatedly stated that they do not intend to increase their capital requirements above current levels for most securely rated companies simply because Solvency II is resulting in increased levels of regulatory required capital. "However," the report argues, "greater disclosures and analysis could lead to an increased focus on certain risks, thus resulting in a different perspective of those risks going forward, which could impact future rating agency capital requirements."