After investment declines pushed a number of insurers close to economic insolvency several years ago, there has been a growing push for the industry to adopt enterprise risk management techniques to help keep carriers on solid ground.
As more and more insurers move toward an enterprise risk management framework, ratings agencies are changing their review process to include an analysis of insurer ERM practices.
Ratings agencies say they have always taken risk management into consideration during their reviews. In the past, however, their approach was more segmented with an insurer's various risks separated into silos.
Now that more insurers are using ERM, ratings agencies are also starting to evaluate how well they are implementing this more comprehensive and systematic approach.
"Some of the companies that were pretty advanced with developing this were starting to come in to us as part of the ratings process and saying: 'Here, you really ought to take a look at this ERM process we're doing; this is really important, and it really should be incorporated into your rating opinion,' " says David Ingram, director of enterprise risk management at Standard & Poor's.
The ratings agencies have each taken a somewhat different approach.
S&P, for instance, has developed a set of criteria for its insurance analysts to assess insurer enterprise risk management practices and now incorporates the resulting evaluations into its ratings. Insurer ERM capabilities are assessed by S&P in this review as "weak," "adequate," "strong" or "excellent."
As part of its ERM review, it is also taking into account the new internal economic capital models some insurance companies have developed as part of their own efforts to better understand their capital requirements.
Fitch Ratings, on the other hand, has developed a new stochastic, or probabilistic, economic capital adequacy model called Prism, which allows for third-party analysis of global insurer capital quality.
A.M. Best has decided to stick with its traditional review process, but is asking senior management at insurance companies more questions about their enterprise risk management practices in the interview segment of its rating evaluation process.
Moody's, meanwhile, has also kept its traditional review process, but is assessing insurance company ERM best practices. It also is looking at the companies' internal capital models to see whether they appear to be credible and to find out what they are suggesting in terms of capital adequacy.
In some cases, the ERM review can have an impact on an insurer's overall rating. Insurers with very strong ERM practices may qualify for a higher rating than they otherwise would, even if other areas of the review fall somewhat short.
For their part, insurers that have begun to implement ERM are glad to get some feedback--as well as recognition from the ratings agencies.
American International Group Inc, for instance, says it began reviewing its economic capital modeling methodology with the ratings agencies in the latter part of 2006. AIG says its presentations were well received, and they have formed a solid foundation for further discussions.
Swiss Re, meanwhile, says that it welcomes the convergence of ratings agencies' capital models with economic models.
"We also welcome that diversification is increasingly recognized in such capital models," Swiss Re says in a statement. "Swiss Re hopes that internal views/models will more and more become part of the rating agencies' assessment of re/insurers' capitalization."
THE MOVE TO ERM
Interest in enterprise risk management gained momentum in the years following 2001 and 2002 when a series of financial shocks pushed some European life insurers close to insolvency on a mark-to-market basis.
In other words, even though their balance sheets looked fine on a statutory basis, some insurers would have been in big trouble if their financial obligations had been marked to market, or, in other words, valued the way the capital markets would have valued them.
The problems began when global equity markets went into a tailspin after a lengthy bull market rally. At the same time, interest rates also declined sharply. Then insurers suffered heavy losses as a result of both the Sept. 11, 2001, terrorist attack on the World Trade Center and corporate governance scandals.
In Europe, where many life insurers had substantial investments in the equity markets, the impact was significant.
"If you look at the point where interest rates hit an all-time low on a mark-to-market (or a capital- market value) basis, a lot of them were very close to being insolvent," says Ramy Tadros, managing director at Oliver Wyman Financial Services.
As a result of this financial turmoil, analysts began demanding more information about solvency. Regulators and insurers, meanwhile, began looking at ERM as a way to prevent a repeat of the crisis.
"(These events) prompted the need for a radical rethink of the solvency regulations in Europe and that triggered Solvency II," Tadros says.
Solvency II, which is expected to be in place by about 2010 or 2011, requires insurance companies to restate assets and liabilities on a mark-to-market basis. It also encourages companies to begin using their own internal economic capital models.
"(Solvency II) has spurred the European companies on to spend a lot of time on the quantification end of risk management, and those efforts, I think, have advanced the state of the art in Europe quite considerably over the last decade," says Ted Collins, managing director of Moody's insurance team.
They are now beginning to implement their internal economic capital models, which better reflect that valuation of the entire enterprise, as well as valuing liabilities on a capital-market basis. They are also restating their balance sheets. As they do so, some insurers are finding that, in meeting their statutory requirements, they are actually overcapitalized on an economic, or capital-market valuation, basis.
During the first quarter of 2007, AIG says it conducted a preliminary analysis of firmwide economic capital requirements using year-end 2006 data. That analysis showed that at year-end 2006, on a conservative basis, AIG had excess capital in the range of $15 billion to $20 billion, the insurer says.
AIG says it expects to incorporate the economic capital model and its results more fully into decision-making processes throughout the organization over the next few years.
To keep up with the changes that are taking place in the industry, ratings agencies are beginning to include ERM evaluations in their ratings process.
Standard & Poor's began evaluating insurer enterprise risk management practices in October 2005. With this new evaluation process, risk management has become a separate, explicit, major category rather an implicit one.
By the end of 2006, S&P had completed 241 ERM evaluations.
Of global insurers' ERM programs, about 80 percent were assessed as adequate, 10 percent as strong, 3 percent as excellent and 5 percent as weak.
In its ERM review, S&P considers whether an insurer has its own economic capital model. S&P also is developing a process to review those models and expects to begin doing so around the end of the year.
"As part of our ERM review, it is important for us to understand what models a company is using in doing its ERM processes," Ingram says. "Having a good comprehensive risk model that looks at all of their risks is pretty much fundamental to getting one of our 'strong' or 'excellent' opinions."
An economic capital model, in particular, is the most common way for insurers to meet that standard.
Fitch has developed a new capital adequacy model, but it has not changed its ratings review process and does not have a new enterprise risk management evaluation.
In June 2006, however, Fitch introduced its stochastic economic capital model, Prism. Fitch was able to use Prism on nearly 100 U.S. property/casualty and life insurance groups as part of its beta testing, according to an April 2007 report.
"We think it's the next generation from what the industry or other rating agency peers have used," says James Auden, managing director in the insurance group at Fitch Ratings.
Fitch says that Prism introduces a significant advancement in that it moves from a factor-based platform, as used by the risk-based capital model of the National Association of Insurance Commissioners, to a fully stochastic platform.
Factor-based models take a quantitative, formulaic approach to determining capital adequacy, while stochastic models are more probabilistic. Ratings agencies have been using factor-based models since the early 1990s.
Fitch is now working on the 2006 results and expects to issue a report in late August or early September.
"We didn't have our own model before," Auden says. "We used traditional measures and the NAIC model. We thought, while they may be informative, they didn't capture the elements like an economic model would."
Although this model gives a more detailed view of an insurer's assets and liabilities, the approach ignores the issue of restating the balance sheet on a mark-to-market basis, Oliver Wyman's Tadros says.
"You could apply the Fitch model to a company that is economically insolvent and it will still tell you that it's OK," Tadros says.
A.M. Best is still using its traditional ratings review process, but is asking more questions about ERM in its interviews with senior management. It has not, however, developed a separate ERM rating process or a new economic capital model.
Rather, the assessment of ERM is built into Best's core rating assessment of an insurer's balance sheet strength, operating performance and business profile.
In A.M. Best's view, the critical issue is an insurer's corporate culture and how each company is incorporating ERM into its decision-making process.
"It's important that you get a sense that senior management really understands the primary risks facing the organization," says Ed Easop, vice president of ratings criteria at A.M. Best. "And you can usually tell from talking to senior management if they really understand."
The discussion starts with the topic of the insurer's risk management culture and the tools they have and how they use them to make decisions, he says. Insurers need to be using these ERM tools and models to help them make good decisions, he says.
Companies that have strong ERM practices and good internal capital models, however, are at an advantage because that will weigh in their favor in the ratings process, says Thomas Mount, assistant vice president of property/casualty ratings with A.M. Best.
"By having strong ERM, it works to their advantage and may lead to a better rating outcome, even if other areas are not as strong," he says.
In its review process, Moody's has developed a list of integrated risk management best practices and assesses how well insurers are meeting those best practices.
Moody's expects, as one of its best practices, nonlife insurers to put in place a formal enterprise risk management process.
Another important best practice has to do with how the insurance company management interacts with its board of directors on the topic of risk management, Collins says. Years ago, boards were not all that focused on risk management. But now after the recent financial shocks, boards of directors are now much more interested in the topic and, in some cases, they are requesting to see the company's own internal risk reports, he says.
"They are a lot more involved these days in the risk management oversight of the company," he says.
Another criterion that comes under consideration is whether an insurer has an established, dedicated chief risk officer position.
"Companies are increasingly seeing this as an important role and creating a position to oversee it, and the level of that position is being elevated to one of significant importance within the organization," Collins says. The best practice here, he says, would be for the chief risk officer to report directly to the chief executive officer and to have visibility with the board.
Moody's also evaluates and assesses an insurance company's own internal capital model, "both because that says something about the company's own capital adequacy and it says something important about the company's risk management framework," Collins says.
"Whether they use it in their day-to-day management of the company suggests a level of discipline that is a factor in the ratings," he says.
PATRICIA VOWINKEL lives in New Jersey.
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September 1, 2007
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