By CAROL M. BEAUMIER, managing director, and MICHAEL PISANO, associate director, at Protiviti Inc.
For an industry that is in the business of managing risk and has prided itself as being at the forefront of risk management, the current financial crisis is almost inexplicable. Yet the financial service industry experts who made up the Senior Supervisors Group did come up with explanations.
In March 2008, senior supervisors of major financial agencies from France, Germany, Switzerland, the United Kingdom and the United States--collectively called the Senior Supervisors Group--in an exercise likely to be repeated again and again by various interested parties, evaluated the risk management practices of a group of large financial services companies.
While the Senior Supervisors Group focused primarily on the risk management practices of commercial and investment banks, its findings are instructive for the insurance industry as well, especially for those insurance companies that were active in the credit default swap and financial guarantee markets.
The supervisors concluded that companies that had fared better through year-end 2007, when the financial crisis had yet to reach the proportions witnessed in 2008, shared certain firmwide risk management practices. They were:
--Effective risk identification and analysis
--Consistent application of independent and rigorous valuation practices
--Effective management of funding liquidity, capital and balance sheets
--Informative and responsive risk measurement and management reporting and practices
In contrast, the Senior Supervisors Group concluded that the companies that experienced more significant problems exhibited the following common characteristics:
--Failure to discuss changing market conditions in a timely manner, leaving business areas to make decisions in isolation without creating appropriate incentives for these business areas to manage risk
--Reliance on ratings agency valuations despite observable market changes
--Lack of alignment between their risk management and treasury functions
--Use of outdated assumptions that were unchallenged by management and failure to effectively integrate market and counterparty risk to identify the size of their concentration risk
--Lack of understanding and appropriate challenging by senior management
--Frequent and tolerated limit exceptions
--Hierarchal structures that filtered or delayed information flows and/or organizational silos that tended to compartmentalize information
WHAT DOES THIS MEAN FOR RISK MANAGEMENT?
Some experts simply attribute the problems experienced by many large financial services companies to a failure in leadership. Others say that, in the companies that have been affected most profoundly, risk management failed to identify, aggregate across the organization and adequately support the increasingly complex and risky nature of the business.
Bottom line, the real distinction may be between those companies that truly embraced risk management as a tool for running their business and those with risk management departments that were never fully integrated into the day-to-day operations of the company.
Any discussion of risk management in the insurance industry, however, needs to consider the distinction between those companies that were major players in the subprime market and the vast majority of "traditional" insurance companies that may have made some subprime investments (though not to the degree that threatens the company viability) and are nonetheless seeing their margins and fee income eroding today because of generally deteriorating economic conditions and a broad lack of market confidence in the financial services industry.
So-called traditional carriers remained focused on the basic business of underwriting insurance coverage--with products that they understood well, products where long experience existed to support their decision-making. Even when the traditional companies decided to offer broader services, they tended to stick with the basics: e.g., consumer banking, mutual funds and brokerage.
They did not venture in a significant way into riskier product offerings, such as credit default swaps and subprime mortgage lending, which were far more removed from their core insurance offerings.
As a result, these companies did not undertake the same degree of risk as some of their more innovative competitors, and their existing risk management frameworks, which were designed for managing insurance risk, served them relatively well.
THE ROAD AHEAD
As is often the case in a regulated industry, however, the "fix" for the problems that have occurred is likely to affect insurance companies of all types and sizes.
Insurance companies, as other sectors of the financial services industry, are likely facing a period of significant regulatory reform, which may include changes to the way the industry is regulated and the implementation of more prescriptive and restrictive regulatory requirements.
Central to the regulators' and the market's expectations will be that the financial and insurance industries take steps to enhance risk management practices, including:
--Identifying and managing risks effectively across the enterprise and eliminating silos that undermine success
--Better alignment of financial incentives with risk management objectives
--Proper balancing of quantitative and qualitative assessments of risk
Lastly, ensuring that risk management activities actually drive business decisions
January 20, 2009
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