As Financial Sector Losses Mount, Embedding ERM into Business Practices Remains a Challenging Mission for Insurers According to Towers Perrin Survey

North America Lags Europe in ERM Implementation; Operational Risk Remains a Weak Spot

Insurers around the globe are finding it challenging to fully implement essential risk and capital management processes that would enable them to realize the full potential of enterprise risk management (ERM), according to Towers Perrin’s 2008 insurance industry ERM survey.

Fully Embedding ERM Will Require Significant Effort

While insurance companies have made progress in integrating ERM into their business processes, more than half (55%) believe that substantial work is needed before they can use economic capital (EC) to guide risk-based decision making, and 60% noted that considerable strides must be made before they can link EC metrics to performance management. More than 40% remain focused on getting the basics right in their EC calculations.

Despite the acknowledged need for improvement, ERM is influencing many important strategic decisions according to the survey, which was conducted during May and June of 2008, prior to the global financial crisis. More than 30% of survey respondents have made changes to their company’s risk strategy or appetite (36%), asset strategies (35%) and product pricing (31%) since the previous survey, conducted in 2006.

“The current crisis in the financial markets, the fragile state of the global economy and a North American hurricane season that has resulted in significant insured losses underscore the importance of having clearly defined risk strategies and tolerances in place,” said Tricia Guinn, managing director of Towers Perrin’s Risk & Financial Services segment. “Taking a holistic approach to risk management, one that connects a company’s risk tolerance to the decisions it makes and the capital it holds, while fostering a culture of prudent risk management and risk taking at every level of its organization, has never been more crucial.”

However, insurers appear reluctant to link compensation to risk taking. Only 30% of respondents indicate that they incorporate risk measures of any kind into incentive compensation arrangements, and only 10% use EC for this purpose. Furthermore, 66% of insurers globally have no future plans to use EC in incentive compensation.

European Insurers Are Leading Progress

European insurers lead their North American counterparts in the implementation of EC and its use in decision making. These capabilities, especially under Solvency II, are expected to lead to both lower capital requirements and a competitive advantage – in the short and long term – as illustrated in the survey findings. European insurers are giving greater short-term priority to the use of EC within their decision making processes (56%), compared to their brethren in North America (40%) and in the Asia/Pacific region (38%).

Additionally, within the next two years, European insurers said they expect to use EC in most major decision processes (80% to 90%), compared to North American firms (60% to 75%) and those companies in the Asia/Pacific region (50% to 65%).

Over half (52%) of European firms have documented their risk appetite, compared with only 40% of insurers in North America. Survey findings indicate that those same companies in Europe are also more apt to set risk limits for such day-to-day management issues as market risk (88%) than their counterparts in North America (61%).

“European insurers are implementing more sophisticated risk analyses that place them in a stronger position to demonstrate lower capital requirements,” said Steve Taylor-Gooby, managing director of Towers Perrin’s insurance consulting business. “Regulatory drivers are also raising awareness around risk mitigation, for example, hedging and reinsurance programs.” Among some of the other key findings from the survey:

– Operational risk management capability remains relatively weak. Only 7% of participants believe they have in place an adequate operational risk management capability, and 37% said that significant work is required, which is in stark contrast to views expressed on insurance, credit and market risks (9%, 11% and 16%, respectively, requiring significant work). Operational risk also lags other risks in terms of setting risk limits and EC calculation methodology.

In addition, operational risk management ranks only seventh among near-term ERM priorities (mentioned by 41% of respondents globally). In calculating EC for operational risk, relatively simplistic factor-based methods are the most commonly used approaches (43%), with only 17% using stress testing and 16% utilizing stochastic methods. Among European insurers, the proportion expected to use an internal model for operational risk (51%) is significantly behind insurance, market and credit risks (86%, 80% and 65%, respectively).

– Size matters. Larger insurers are significantly more advanced in most aspects of ERM implementation. Large companies (those with revenues in excess of $10 billion) demonstrate a superior level of commitment to EC, with 84% already calculating EC, compared to 69% of medium-sized companies (firms with between $1 billion and $10 billion in revenues) and 37% of small organizations (those companies with less than $1 billion in revenues). Larger firms are also already leading the way in utilization of EC, 44% of larger companies use EC in strategic planning and capital allocation compared to 19% of smaller firms; 40% use EC in product design and pricing, as opposed to 17% of small firms.

– Market consolidation seems inevitable. Larger companies, first in line to realize competitive advantage by fully integrating ERM into their decision-making processes, are well positioned to acquire less sophisticated firms unable to keep pace. Since 2006, the expected impact of Solvency II on European insurance markets has swung strongly toward consolidation (up from 40% to 50% of respondents) and away from the need to raise more capital or resort to more innovative financing techniques (down from 55% to 39%).

“Every risk can be viewed as both a threat and an opportunity, and organizations are increasingly recognizing the importance of successfully managing their entire risk landscape, and not just those risks that are either familiar or easy to quantify,” said Ms. Guinn. “Market leaders of the future will be those companies that have developed a strong risk-based culture that is fully aligned and actively engaged in their risk analytics and business processes.”

About the Survey

Participants in the Web-based survey – the largest global survey of the insurance industry on the topic of ERM – included 359 insurance and reinsurance executives. Survey respondents were split between North America (49%) and the rest of the world, with 29% from Europe, 19% from the Asia/Pacific region, 2% from Latin America, and 1% from Africa and the Middle East.

About Towers Perrin

Towers Perrin is a global professional services firm that helps organizations improve performance through effective people, risk and financial management. The firm provides innovative solutions in the areas of human capital strategy, program design and management, and in the areas of risk and capital management, insurance and reinsurance intermediary services, and actuarial consulting. Towers Perrin has offices and alliance partners in the United States, Canada, Europe, Asia, Latin America, South Africa, Australia and New Zealand. More information is available at www.towersperrin.com.
Contacts

Towers Perrin
Michael McNamara, 914-745-4126
michael.mcnamara {at} towersperrin(.)com