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Rewriting The Risk Agenda

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The economic crisis has had an enormous impact on financial services companies, including insurers, as well as on the regulators and customers of those companies. All will benefit by heeding the sage advice “never to waste a crisis.” For insurance companies, a main focus right now should be on developing a new risk agenda.

While the crisis is partly behind us, the challenge now is for companies to understand the implications of lessons learned on their business models. Continuing to do business in pre-crisis mode is not an option. Rushing headlong into radical change is not viable either, because so many unknowns remain, primarily with regard to the emerging new regulatory environment.

Now is the time for a simple, but deeply serious, rethinking of current business models and risk management practices, and for looking at the “best” of best practices in governance, risk management, product design and management. This thoughtful process will help ensure that companies make changes in their risk management to allow them to deal effectively with both new regulation and future market and economic unknowns.

Demystification – listening to stakeholders

The contours of the post-crisis world are still emerging, but it is clear that insurance companies need to listen more carefully than ever to their various stakeholders. First and foremost, customers now seem strongly, if a bit resignedly, willing to trade off a portion of financial return for stability and to avoid downside surprises. After months of roller-coaster market volatility, lower but guaranteed yields are more attractive to many than the higher yields of much more complex products with higher inherent, but seldom well-understood, risk.

In parallel with enormous consumer and investor concern, regulators and legislators everywhere will continue the drumbeat for regulatory reform, investor safeguards and rigorous testing of reserves and capital under extreme scenarios. This drumbeat arises from a new recognition of and insight into the shortcomings of recent risk management practices.

Rating agencies will recalibrate their role, casting their ratings criteria to align with new federal and state regulatory codes and awarding their highest ratings to companies that commit to the most transparent and plainly spoken terms.

The expectation for stronger company governance and transparency will continue to frame the concerns of boards of directors. For that matter, product distributors, financial advisors, investors and consumers have also come to distrust the “black box” complexity of exotic transactions and products. This demand for simplicity and plain talk will likely be embedded in their best practices as well as in regulations, and hence will not go away any time soon.

The new risk agenda

Regulatory change is coming. Everyone knows it is on the way, but the specifics are not yet clear. In the interim, today, and in the immediate future, companies have an opportunity to fix what became broken and ensure that their risk management fundamentals are as strong as possible. This means:

? Revising and strengthening governance and risk management decision-making, oversight and incentive structures. This includes tackling the stubborn challenges of meaningful risk aggregation and enterprise risk management.

? Taking a back-to-basics approach to understanding risk in the post-crisis world in which extreme market shocks probably cannot be avoided.

? Reassessing and confirming that risk management and actuarial teams, models and modeling capacities are as strong as they can be to handle the new regulations and financial reporting regimes when they arrive.

? Establishing “hard” risk appetite, tolerances and limit structures and ensuring those structures are embedded into the business models and reward systems of product divisions and geographic entities.

? Going back to the drawing board to re-engineer an effective risk culture into the organizational DNA.

? Innovating product design to reduce vulnerability to unmanageable risk and still provide compelling products that address consumer financial needs and expectations.

Setting a strong and steady course

The course ahead over the next few years for insurance companies-and the entire financial services industry-will be every bit as challenging, but hopefully not as confusing and nail-biting, as the recent financial crisis. The certainty is that there will be a steadily increasing demand from all stakeholders for transparency, regulation and scrutiny of company risk management and overall performance. The uncertainty lies in the details of new financial reporting requirements, the exact new structures for systemic risk regulation, capital and solvency frameworks and the final market-based principles that will inform a new global accounting framework.

Companies with the best future performance will likely be those that chart a straightforward course for using strong risk management to protect, sustain and create value. There is much virtue in this simple approach.

Doug French is a principal and Insurance and Actuarial Advisory Services leader in the Financial Services Office of Ernst & Young LLP, based in New York. He can be reached via email at [email protected].


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