Insurers and reinsurers that embed enterprise risk management into their culture will have the competitive edge, says Raj Ahuja.

Enterprise Risk Management (ERM) has taken centre stage in the insurance and reinsurance industry. After years of being a specialised discipline, little understood even by many board members, it is increasingly seen as pivotal to any successful corporate strategy. Indeed, one could argue that the successful insurance or reinsurance company of the future will be one that embraces ERM and makes it central to its corporate culture.

Why should this be? There is no one single answer; it is more a case of a lot of streams converging to become a powerful river. Three forces in particular have come together to create unstoppable momentum: shareholders, regulators and ratings agencies.

In the past these three interest groups have tended to pull in opposite directions. A strategy that advanced the interests of shareholders would cut little ice with the regulators, whilst the requirements of rating agencies might lead a company to allocate capital inefficiently, and so on. Now, by contrast, they increasingly point in broadly the same direction. The result will be to make it easier to run an insurance or reinsurance company.

In the 1990s, shareholders demanding the best possible return on their capital consistent with risk appetite were among the earliest drivers of ERM. Boards - at least those with the necessary understanding and access to expertise - came to the view that ERM was the best solution. The principle is a very simple one. If you have a precise understanding of the risks inherent in your business, you can address them accurately, allocating resources in a targeted way without wasting capital.

In any modern insurance or reinsurance company this involves the creation of financial models that make it possible to simulate any number of possible scenarios and assess their financial consequences. Apart from supporting efforts to make companies more financially secure, this type of exercise assists with a range of core strategic functions. These include, among others:

- Reinsurance/retrocession purchase;

- Capital allocation;

- Product and pricing strategy;

- Business expansion;

- Mergers and acquisitions;

- Investment strategy;

- Rating agencies; and

- Alternative risk transfer mechanisms.

ERM and Solvency II

Until about five years ago, insurance regulators paid little attention to ERM, preferring a rules-based approach to prudential supervision. In many countries that is still the case, but the tide has now undoubtedly turned. The European push towards Solvency II has been the most publicised and is undoubtedly the most important development, but it is by no means isolated. Regulators in many other jurisdictions are making or have already made the switch to risk-based regulation, including the UK, Australia, South Africa and Singapore.

With this level of critical mass for risk-based regulation it is hard to see how any international insurance or reinsurance company can avoid the trend. Even those that are based in countries not regulated in this way will be involved, because it will affect their customers and also their subsidiaries and branches in Europe and elsewhere.

Although the details of Solvency II are not due to be unveiled until next year, ERM lies at the heart of any system of risk-based regulation, with financial modelling again likely to be required, except in the case of smaller companies. It will also have a considerable impact on reinsurance-buying practices. Over time, buyers who model their reinsurance needs will become more knowledgeable, negotiating from a position of strength, because they will know exactly what cover they need and how much it is worth to them. Reinsurers will likely find that their products have become more commoditised in their customers' eyes as a result and less relationship-driven.

The rating agencies were initially hesitant about ERM. Until very recently they based their calculations on a series of risk charges applied to various different risk types based on market average data. This is a fast and cheap methodology in terms of man-hours, but does not provide a complete or thorough assessment of the entity being investigated. It is general by its very nature and does not apply to the particular characteristics of each company. As a result the capital requirement was usually set with an inadequate view of the true risk involved.

Things came to a head about three years ago when some high profile reinsurers complained bitterly about their downgrades, arguing that the agencies' methods were flawed and out of date. At the time, Dr Andrzej Czernuszewicz, partner at EMB, urged the agencies to modernise by adopting ERM methodologies. "Those reinsurers who dare to question the rating analysts may be acting out of self-interest, but they have a strong case," he wrote. "The capital adequacy methodology currently employed by the rating agencies is reducing their credibility."

That argument has now been won. The rating agencies have swung into line with all the fervour of converts. Anyone who attended their news briefings at this year's Monte Carlo Rendez-Vous will have seen them competing with each other to emphasise their total commitment to the new ERM faith.

Closing the knowledge gap

As outlined above, the three interest groups most important to the way insurance and reinsurance companies are governed all increasingly demand the use of ERM. This unity of view has given the process an irresistible strength, but there remains a fourth key part of the jigsaw: the ability to understand the methodology and its application.

At the start of this decade, dynamic financial analysis, stochastic modelling and many of the other central elements of ERM were barely understood even at very senior levels within the industry. While there is still some way to go, these concepts have moved beyond the realm of specialised actuaries and have become central board issues in most large insurance and reinsurance companies.

ERM could turn out to be a good illustration of how the industry normally takes time to assimilate new ideas. Eventually, they become mainstream and even routine. The way ERM is applied has become a lot more user-friendly. People have learnt from the shortcomings of the initial attempts to create financial models; they were typically too complex, too prescriptive, insufficiently flexible and disconnected from the rest of management. They now know what mistakes to avoid. New software products, meanwhile, have made the process technically quite straightforward and enabled companies to create models that fit the company rather than the other way around.

ERM is not just or even mainly about process; it is about culture and communication and it should be enterprise-wide. To be truly successful, risk management has to be embedded in the organisation's thought processes and in the way it interacts with clients. This has implications for the entire organisation: for human resources, IT and even the marketing function.

A key plank of implementation should be an integrated approach to business strategy and planning, risk management and capital modelling. By investing time right from the start for effective planning, a risk management framework can be developed that is consistent with, and provides strong input into, the modelling approach.

Getting the right risk management framework should be relatively straightforward once there is a clear approach leading from risk policy and risk appetite. It should then be fairly easy to develop good risk management, effective processes for identifying, measuring, monitoring and mitigating risk and a consistent, robust approach to getting the right data into your capital models.

Embedding ERM

The insurance and reinsurance industry is rapidly entering a new commercial environment with ERM at its heart. Successful companies will be those that embed enterprise risk management into their entire corporate culture rather than restricting it to one part of the organisation. These companies will employ their capital more effectively, take better informed strategic decisions and have an all-round competitive advantage. Many have already made the transition. But those that fail to adapt will be left behind.