ERM In-Depth Series (Part 2): Learning From ERM's Year of Living Dangerously
By B.G. YOVOVICH, who has written for national trade publications for more than 20 years
Talk about "learning experiences."
Sooner or later, when the aftershocks to the banking and financial services sectors have subsided and the dust has settled sufficiently, enterprise risk management lessons galore will be gleaned from studying the tectonic shifts that rocked the economy in 2008.
In fact, even as the economic topography has continued to move beneath our feet, useful insights about ERM already have begun to emerge.
Consider, for example, what can be learned from a compare-and-contrast look at the 2008 experiences of two sectors that have been ERM pioneers--the banking and insurance sectors.
On the one hand, the widespread, risk-related devastation in the banking industry during the past year has been well-documented.
However, in contrast to the banking sector, "So far, the insurance industry has weathered this storm," said Marsh & McLennan Cos. Inc. President and Chief Executive Officer Brian Duperreault in a speech to an Association of Professional Insurance Women luncheon in New York in January.
"There were outliers of course--there always are--but by and large the insurance industry has so far come through this in far better shape than the banking industry," Duperreault continued. "I think that's proof that we've learned a lot ourselves about risk management."
A study from Zurich Financial Services makes a similar point.
"While the credit crisis is having a deep impact on the financial services industry, most insurers, at least initially, escaped the crisis largely unscathed," reports Zurich's "Dealing with the Unexpected: Lessons for risk managers from the credit crisis" study published last fall.
The Zurich study cites two major reasons. First, "Insurers are prefunded by premiums; they generally do not rely on short-term market funding. While premiums are invested to support future claims, insurers do not employ leverage to enhance expected investment returns."
However, the study also gives an ERM-related reason for the relative lack of financial carnage in the insurance sector.
"One lesson the industry relearned in the 2001-2003 financial market crisis was the role of asset-liability management and the necessity of focusing on a well diversified investment portfolio. This resulted in a reduction of the proportion of equities in the investment portfolio of most insurers and a curtailment of investment in potentially illiquid structured products."
In fact, an instructive exception comes from a look at the travails of the American International Group, which had to be rescued with an investment and loan guarantee from the federal government last fall.
In its analysis, the Zurich report pointed out that AIG's problems were "attributable to its financial services unit, which had engaged heavily in the sales of risky, complex derivatives. In contrast, the core insurance business of AIG was and is considered healthy."
Going even further, the Zurich report points out that "Despite AIG's demise, the credit crisis has not brought into question the insurance business model. While banks are reconsidering the securitization and originate-to-distribute business model, the securitization of general insurance liabilities has not been contested."
THE TRAIL OF THE FAT TAIL
Despite the news about the good performance of ERM in the insurance section, other lessons from the economic crisis are not so encouraging for ERM. This includes the emergence of issues that have created enormous problems in the banking arena and that raise problematic questions for ERM in virtually all sectors.
For instance, one particularly troubling problem that has been spotlighted by the banking disasters is the disturbing proliferation of low-probability, high-danger risks--or "fat-tail events."
These fat-tail issues go far beyond the highly-visible problems that are so much a part of a 21st century economy that is dependent on increasingly complex systems like global-scale supply chains, and far-flung computer systems. All too often, we discover that these complex systems may function well during normal times, but that they are vulnerable to extremely out-sized problems when disrupted by poorly anticipated events.
And, even more unsettling for risk managers, it is not just that it is high-visibility fat-tail risks that appear to be proliferating. There also is evidence that low-profile, low-probability, but high-danger risks are becoming subtly embedded in all sorts of business processes.
Consider, for example, the way in which the design of today's performance-based compensation packages, not just in banking but in almost every sector, underestimate risk factors connected to business decisions, a development which gives employees and managers greater incentives to take risks.
This creates "the incentive to take risk that is concealed," as is pointed out by University of Chicago economist Raghuram G. Rajan in his paper "Has Financial Development Made the World Riskier?"
In today's business environment, the incentives for increased fat-tail risk-taking are further amplified by managers' knowledge that they are being evaluated against others. By either consciously or unconsciously making decisions which take advantage of masked risks, the manager can look as if he is outperforming peers.
According to Rajan, "Typically, the kinds of risks that can be concealed most easily, given the requirement of periodic reporting, are risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks."
In effect, "such managers collect premiums in ordinary times for what could be called disaster insurance," notes the Zurich report. Until the disaster strikes, "they can pocket those premiums."
These and many other fat-tail issues are not just mere theory for risk managers. Increasingly, they are giving rise to very real, conflict-laden situations that represent particularly knotty--and important--challenges for risk managers.
Successfully addressing these issues is likely to require steps that will need major support from top management.
One crucial step is to develop closer alignment between compensation programs and risk management objectives, says Ellen S. Hexter, who leads the Conference Board's work in ERM.
"Once you get that aligned--when people are getting rewarded if they are taking risks in the right way--you start to really influence and change people's behaviors," says Hexter, who has been working on study of the integration of risk management and performance management.
"It requires intestinal fortitude to make that a priority at the top of the organization and say that this is part of how we are going to be compensating people, including the CEOs."
March 3, 2009
Copyright 2009© LRP Publications