Strategic ERM:The Key to Engineering High-Performance Insurance Enterprises

By Michael R. Murray

Even a cursory scan of the insurance universe reveals that the advent of Big Data, increases in computing power, plunging data storage costs, and advances in analytics are radically transforming point solutions and business processes at every link in the insurance value creation chain. Perhaps the most well-publicized example is the application of telematics to pricing and underwriting personal auto insurance, a development already changing competitive dynamics in the personal auto insurance business. The problem is that independently optimizing performance at each link will leave insurers woefully unprepared for the rigors of competition against others who understand that their enterprises are systems operating within a larger one — the macro-political economic system.

Strategic ERM

Strategic enterprise risk management entails the strategic application of enterprise risk management, or ERM, with ERM itself being:

“The discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders.” (Overview of Enterprise Risk Management, Casualty Actuarial Society, Enterprise Risk Management Committee, May 2003)

Strategic ERM systematically embeds consideration of risk-return tradeoffs and other essential elements of sound ERM in a broad array of an organization’s planning, decision making, and other business processes, thereby enabling ERM to achieve its full potential as a vehicle for optimizing overall performance.

Lest this point be misunderstood, optimizing individual business processes is essential to insurers’ survival in an increasingly competitive world. And tapping the power of Big Data and advanced analytics to price coverage, underwrite policies, and settle meritorious claims fairly while ferreting out fraud and abuse is an essential element of sophisticated insurers’ strategic plans. But engineering a truly high-performance insurance enterprise capable of surviving and thriving far into the future requires fully integrating and optimizing across all links in the value chain and doing so in a manner that allows for all the uncertainty born of the inherently random nature of insurance loss experience and as yet unknowable economic, financial, political, legal, regulatory, and technological developments.

The key is strategic enterprise risk management, or ERM, an emerging discipline with the power to vastly improve insurers’ overall performance while making them more resilient. Strategic ERM is not about minimizing risk. Rather, it’s about reaching the efficient frontier — the locus that simultaneously traces the maximum rate of return obtainable for bearing a given amount of risk and the minimum amount of risk that must be assumed to achieve a given rate of return (see Figure 1). In other words, strategic ERM is about optimizing an organization’s overall performance.

Implementing strategic ERM requires an insurer to express its overall appetite for risk (or the amount of risk it wants to assume in pursuit of profits), its tolerance for risk (or the amount of risk it is willing to assume), and the underlying limits for individual risks that will enable it to operate within its risk tolerance. Implementing strategic ERM also requires an insurer to identify and quantify all the material risks it faces, taking account of correlations or dependencies between risks. Broadly speaking, the risks insurers face can be classified as strategic, operational, financial market, credit or counterparty, and hazard or underwriting risk. Identifying and quantifying all the material risks within those categories provides a basis for simultaneously managing all the elements of an insurer’s business to maximize its overall rate of return while staying within its appetite for risk.

Tools for Strategic ERM

The tools facilitating strategic ERM include modern economic capital models (ECMs) and economic scenario generators (ESGs). Those tools enable insurers to view the full range of possible results under a virtually unlimited number of scenarios and then chart the course most apt to optimize overall results. But one can get high-quality output from an ECM and an ESG only if the distributions and correlations used to model stochastic loss experience and economic developments are themselves of high quality.

Using economic capital models and economic scenario generators, insurers can achieve a competitive edge by making smarter decisions about:

  • how much and what kinds of business to write
  • which risks to retain and which to transfer
  • where to grow and where to retrench
  • which acquisitions to make and which operations to shutter or divest
  • how much and what kinds of reinsurance to buy
  • how to allocate investments to maximize the combined performance of underwriting and investment operations
  • how much capital the enterprise should hold
  • how to allocate capital (or the cost of capital)
  • how to price insurance products to generate returns commensurate with the capital supporting the business
  • how much to invest in risk mitigation and which investments to make

Figure 1
The Efficient Frontier

An insurer currently assuming the amount of risk and earning the rate of return consistent with Point A can use strategic enterprise risk management to achieve higher returns with less risk, positioning itself anywhere along the arc BC on the efficient frontier. While getting to Point D would be even better, achieving a rate of return that high with such low risk is beyond the realm of the possible, given the insurers’ resources and the environment in which it is operating.

The Efficient Frontier

Developments Driving Strategic ERM

Regulatory developments are spurring strategic ERM and economic capital modeling. In particular, insurers in Europe are preparing for Solvency II, which will enable insurers to use internal economic capital models to calculate regulatory capital and require insurers to submit prospective Own Risk and Solvency Assessments (ORSAs).

Currently scheduled to take effect January 1, 2014, but likely to be postponed due to delays resolving various issues, the effects of Solvency II are already being felt far beyond Europe’s borders as a result of its “equivalency” provisions. Those provisions create impediments to foreign insurers seeking to do business in Europe if they are not domiciled in jurisdictions deemed to have equivalent regulatory standards.

In the United States, the National Association of Insurance Commissioners (NAIC) adopted its Risk Management and Own Risk and Solvency Assessment Model Act last September. Like Solvency II, the NAIC’s model act requires that insurers exceeding specified premium thresholds prepare and submit prospective ORSAs. Moreover, the act stipulates, “The requirements of this Act shall become effective on January 1, 2015. The first filing of the ORSA Summary Report shall be in 2015 pursuant to section 5 of this Act.” But it remains up to the individual states to enact their own enabling legislation.

Select Verisk Strategic ERM Resources

ISO participating insurers interested in enhancing their enterprise risk management programs may wish to consider participating in the ISO Enterprise Risk Management (ERM) Forum. Meeting twice a year since its inception in 2008, the ISO ERM Forum provides a venue where insurer ERM practitioners can exchange knowledge about tools, techniques, and best practices; share ideas; and discuss issues of mutual interest. The agendas and minutes for past ISO ERM Forum meetings are available to all ISO participating insurers through ISO’s insurer ERM portal at ISOnet®. For more information about the ISO ERM Forum, our ERM portal at ISOnet, and related initiatives, contact Michael R. Murray, assistant vice president for financial analysis, at 201-469-2339 or mmurray@iso.com.

Insurers seeking to begin or bolster their scanning for new or emerging risks may wish to consider participating in ISO’s Emerging Issues Panel. The agendas and minutes for past meetings of ISO’s Emerging Issues Panel are available through ISOnet as Line Service Circulars. To learn more about our Emerging Issues Panel, contact Jeff De Turris, assistant vice president for personal lines, at 201-469-2697 or jdeturris@iso.com.

Rating agencies such as A.M. Best and Standard and Poor’s are also spurring strategic ERM and economic capital modeling. Rating agencies are scrutinizing insurers’ ERM like never before, with at least one having added a special section on ERM to its supplemental rating questionnaire and another explicitly rating insurers’ ERM programs and economic capital modeling.

Strategic ERM is not about minimizing risk. It’s about reaching the efficient frontier — namely, optimizing overall performance.

Other Essentials for Strategic ERM

In and of themselves, state-of-the-art ECMs and ESGs are merely tools, and merely having the tools to succeed is far from success itself. Tools must be used, and they must be used skillfully. More specifically, the results of economic capital modeling must be incorporated in decision making rather than left to gather dust on a shelf until it becomes necessary to show a rating agency or regulator that, yes, an enterprise does indeed have an economic capital model. Effective means of accomplishing this include embedding economic capital modeling in strategic planning and budgeting processes. Economic capital modeling can and should also be embedded in tactical decision making pertaining to mergers and acquisitions, reinsurance purchases, and other critical activities ranging from pricing insurance products to managing investment portfolios.

Successfully embedding economic capital modeling into decision making requires top-down support from the highest levels of management. It also requires bottom-up support from a riskaware culture a culture in which frontline risk-takers actively consider the entire distribution of potential outcomes and seek to optimize the risk-return tradeoff rather than simply maximizing growth and profitability under the most likely scenario.

Additional essentials when seeking to harness the full power of strategic ERM include controls that clearly signal when risk tolerances and/or limits have been breached. Ideally, those controls are accompanied by clear, predefined escalation procedures that specify the actions to be taken in the event of a breach and the staff responsible for taking them.

Strategic ERM also requires constant scanning of the environment to detect new or emerging risks, the assessment of such risks, and processes that ensure assessments lead to appropriate actions. The risk landscape is constantly changing, as evidenced by the crisis that roiled the global financial system in 2007 and 2008, the emergence of cyber risk in all of its many forms, and the as yet unknown potential health consequences of nanotechnology and genetically modified crops. Failure to detect, assess, and adjust to new or emerging risks leaves insurers needlessly vulnerable to unanticipated shock losses.

Finally, strategic ERM requires commitment to the process. It is not “once and done,” in part because insurers’ books of business, investments, and capital positions are all in a constant state of flux. So too are the environment in which insurers operate and other factors such as technology.

We’ll stop here with respect to this effort to enumerate the essential elements of strategic ERM, because every insurer is unique. There is no “one size fits all” solution. Rather, each insurer must choose for itself a course well suited to its resources and its needs, with the amount of resources an insurer should devote to strategic ERM and the benefits to be gained being proportionate to the scale and complexity of the insurer’s operations.

Closing Thoughts

While regulators and rating agencies are hastening the adoption of strategic enterprise risk management and economic capital modeling, competitive dynamics will ultimately elevate them to business imperatives — table stakes — for all but relatively small insurers writing only a limited number of lines or classes and making only plain vanilla investments. While this may seem a bold assertion, there is ample historical precedent. Catastrophe modeling was practically unheard of before Hurricane Andrew. Now, catastrophe modeling is de rigueur for those in the property insurance business.

Michael R. Murray is assistant vice president for financial analysis at ISO.