NU Online News Service, Oct. 2, 12:50 p.m. EDT
While models and mathematical analysis are important in monitoring risk, there's nothing like digging beneath the surface to truly understand exposures, according to a new report on "The Financial Crisis and Lessons for Insurers."
The paper--authored by Shaun Wang, Ph.D., and sponsored by the Society of Actuaries--looks at the subprime mortgage problem and subsequent financial crises, as well as the role of enterprise risk management in addressing future events.
Mr. Wang--a professor at Georgia State University who has worked in the reinsurance industry, and as a researcher and consultant--said two important takeaways of the study are that insurers need to see the "macro picture," and that they need to own their own risks.
For example, looking at the subprime crisis--which he compared to the underwriting cycle--Mr. Wang said organizations were not concerned about the true quality of the underlying mortgages they were risking their capital on.
What they needed to do was "look behind the risk structure," he said, pointing out that while charts of housing prices continued to climb, a look at the underlying data would have shown household debt levels and income information. "They need to get into the substance," he added. "Based on research, people are still staying at the appearance level."
"This is uncharted water," he said, adding that business models "need to change to survive."
Mr. Wang observed that the property and casualty industry has three major risks to consider:
o Macro economic risk
o Systemic risks with the underwriting cycle
o Natural catastrophes
"If there is another major event--this is already a fragile economy--it would trigger a chain of events," he said, noting that companies need to observe the reality and study the inter-reactions that could result.
While leadership and culture are a given in establishing a successful ERM plan, he noted that ERM must go beyond an organization's culture, to the development of tangible intelligence among facets of the organization.
"This can make ERM more relevant," he said. Actuaries, underwriters and others in the organization need to "work together to make ERM more useful."
He also noted that in identifying systemic risk, companies must compare themselves to their peers, but also go outside of their industry.
Companies investing in many aspects of the economy, for example, need to check out other firms' investment performance and analyze potential impact, he said.
According to the paper, there are ERM strategies and principles that financial firms and insurers should focus on for an enterprise-wide approach:
o A strong risk management culture must start at the top.
o Using risk management is most effective when used to prevent rather than manage crises.
o The financial system is interconnected, so businesses need to look at what others are doing in the industry, not just their own risks and processes.
The study suggested that companies also need to:
o Establish a robust liquidity management system.
o Develop a counterparty risk management system and limits.
o Keep watch on high-profit areas, as these are the areas where the greatest risks emanate.
o Refine tools to systematically aggregate exposures.
o Understand the limitations of models and the related assumptions.
o Incorporate a wide variety of economic scenarios for stress tests.
Companies can use these guidelines in helping to apply an enterprise-wide approach to risk management, the Society of Actuaries said. Both inside and outside of the insurance industry, it is essential to look at ways not only to mitigate risk but also maximize opportunities for businesses in today's difficult economic climate, according to the group.
In examining the mortgage and financial crises, the paper also addresses the related issues of liquidity and diversification, and their roles in the downturn.
Diversification, for example, was widely thought to be a solely risk mitigation and profit-building strategy. The paper advises the C-suite--CEOs, COOs, CFOs and chief risk officers--to understand that diversification brings its own risks that need to be considered in an evaluation.
In conjunction with the release of this research, the American Academy of Actuaries provided recommendations for regulatory improvements. Specifically, these include:
o Developing a systemic risk regulatory structure for the financial services sector.
o Determining appropriate constraints and capital requirements on investments.
o Establishing new regulatory transparency requirements for rating agencies and third party advisors.
The research conducted to complete the paper, and the regulatory recommendations developed as a result, are part of actuaries' ongoing efforts to help businesses navigate past the financial crisis and prepare for emerging challenges on the horizon, the Society of Actuaries said.
For a copy of "The Financial Crisis and Lessons for Insurers," visit www.soa.org.