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Risk Management Imperatives for the Industry
Good risk management creates competitive advantage for those insurers and reinsurers who truly understand what it means, says Andrzej Czernuszewicz of EMB.
 ‘Risk management’ has become one of the big topics of the insurance and reinsurance industries. There are good reasons for this but, as with most frequently-used expressions, it can mean different things to different people and cause confusion.
This article seeks to demystify the concept and consider what its implications are for individual companies.
First, however, why has the subject of risk management come to the fore in recent years? There are many explanations, but above all it is because regulators and ratings agencies are changing the way they measure the financial strength of insurers and reinsurers.
The old formulaic approach to this type of exercise is now widely seen as outdated, though things still vary from country to country.
Nowadays, analysts and officials increasingly expect companies to demonstrate that they have fully assessed the risks inherent in their businesses and have taken adequate measures to cope with them. This, in turn, provides assurance that they will have the resources to meet their obligations even in extreme adverse conditions.
That is not say an insurance company needs to be 100% secure in all conceivable circumstances. Such an entity has never existed; any attempt to achieve this level of perfection would need so much capital that premiums would rise to unacceptable levels. The cost of capital would also be too high for shareholders.
Typically, regulators expect insurers and reinsurers to show instead that there is a low probability of default in any one year. Increasingly, they also seek the same assurance over the duration of any outstanding liabilities. This level of security should also be enough to gain a solid, though not exceptional score from the ratings agencies, at least corresponding to investment grade.
What does risk management mean in practice?
The key point is to regard good risk management as much more than just a way to keep the regulators and security analysts happy. Only by understanding the risks you face can you identify the most effective ways to use your capital and run your business.
To provide a simple example, most insurance companies have historically purchased their reinsurance inefficiently. On closer inspection of their programs, it generally becomes clear that they have bought too much in certain areas and too little in others, leaving themselves both over-exposed and over-protected. They would have done better, however, if they had an accurate picture of their reinsurance needs.
Moving to underwriting, a thorough risk analysis will identify whether you have optimised your use of capital between classes of business. You may find that a small change of priorities would release a lot of risk capital for the most profitable areas.
Despite these advantages, it is important to stress that risk management and the decisions that flow from it are not and will never be a numbers-driven process. The big judgements that senior executives make must ultimately take into account softer issues: relationships; understanding of markets; corporate objectives; employees; and many other factors that can be impossible to measure.
With that important qualification, good risk management will give you the information and understanding you need before you make any of your key strategic decisions. These include capital allocation, reinsurance purchase, product and pricing strategy and mergers and acquisitions.
How to approach risk management
To take this down to its next level, the risks that you need to understand can be divided into the following types: Operational Risk, Group Risk, Insurance Risk, Market Risk, Credit Risk and Liquidity Risk. Within these categories, there are many smaller types of risk to be analysed.
As well as calculating the total capital requirements of all the risks, best practice demands that you demonstrate an understanding of how they interrelate. For example, a big insurance event could trigger a fall in equities (as after 9/11) and so accentuate the strain on your capital.
In practice, most insurers find that the best or only realistic way to conduct this exercise is through the use of stochastic models. These are financial models that enable you to simulate how your business would perform financially in any number of possible scenarios. Once you have identified weaknesses, you can then model the potential solutions to identify the ones that would best suit the company.
Financial modelling need not be as complicated as it may sound, partly because there are software packages available to help. For newcomers to this type of exercise, the best advice is to keep it simple and ensure that your model is flexible. As you become confident with the basic operations, you can become steadily more ambitious in its applications.
The competitive advantages of risk management
In my experience, there is a huge range in the understanding that insurers and reinsurers have of risk management. In general the largest international players take risk management very seriously. This is not primarily because of regulation, but for another, even better reason: it helps them to gain competitive advantage. Middle-ranking insurers are less likely to have addressed these issues, but they will have to do so. The increasingly tough commercial environment makes it a management imperative.
This article appeared in Asia Insurance Review in September 2006
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