Many insurers have failed to apply enterprise risk management to investment risk, credit risk and operational risk, a study by Towers Perrin revealed.

“ERM is about looking at all risk, not just insurance risk,” said Joseph Lebens, principal in Towers Perrin's insurance consulting practice in Hartford.

Investment, credit and operational exposures are “bigger risks than companies thought in the past. They have [previously] focused more on the insurance risks,” he added. “I have to believe that companies are paying more attention to credit and liquidity issues than they have in the past.”

Towers Perrin's 2008 insurance industry ERM survey found that while insurers have made progress integrating ERM into their business processes, more than half (55 percent) believe that substantial work is needed before they can use economic capital metrics to guide risk-based decision-making.

Sixty percent noted that considerable strides must be made before they can link economic capital metrics to performance management. More than 40 percent remain focused on getting the basics right in their economic capital calculations.

Mr. Lebens told National Underwriter he found it surprising that companies didn't see cultural change as the biggest obstacle. While leadership has been behind ERM, “it's had some cultural resistance,” he said. “It's still a matter of imbedding it into the culture.”

He also noted there “aren't many companies out there today that show in their management reports the quantification of the risk–what is the needed economic capital. They see what their combined ratio is, they see traditional insurance measures, but they're not necessarily seeing risk measures.”

Economic capital, or EC, is often defined as the amount of funds a firm requires to cover its risks, including market risk, credit risk and operational risk. How much does a company need to survive a worst-case scenario, for example?

Until companies begin to see risk measures on a weekly, monthly or quarterly basis, he said, “they may say they're integrating into the process, but they're not, really. It needs to be part of their everyday activities, and it's not there today.”

Mr. Lebens noted that today, “between 5 percent and 10 percent of employees could give a decent explanation of what economic capital is and what it represents.”

But despite the acknowledged need for improvement, ERM is influencing many important strategic decisions, according to the survey–conducted during May and June of 2008, prior to the global financial crisis.

More than 30 percent of survey respondents said they have seen changes to their company's risk strategy or appetite (36 percent), asset strategies (35 percent) and product pricing (31 percent) since the previous survey, conducted in 2006.

“The current crisis in the financial markets, the fragile state of the global economy and a North American hurricane season that has resulted in significant insured losses underscore the importance of having clearly defined risk strategies and tolerances in place,” said Tricia Guinn, managing director of Towers Perrin's Risk and Financial Services segment.

“Taking a holistic approach to risk management–one that connects a company's risk tolerance to the decisions it makes and the capital it holds, while fostering a culture of prudent risk management and risk-taking at every level of its organization–has never been more crucial,” added Ms. Guinn.

Insurers appear reluctant to link compensation to risk taking, however, according to Towers Perrin. Only 30 percent of respondents indicated they incorporate risk measures of any kind into incentive compensation arrangements, and only 10 percent use economic capital for this purpose. Furthermore, 66 percent of insurers globally have no future plans to use EC in incentive compensation, the study found.

According to the survey, larger insurers are significantly more advanced in most aspects of ERM implementation. Large companies with revenues in excess of $10 billion demonstrate a superior level of commitment to EC, with 84 percent already calculating EC, compared to 69 percent of medium-sized companies (firms with between $1 billion and $10 billion in revenues) and 37 percent of small organizations (those companies with less than $1 billion in revenues).

Larger firms are also already leading the way in utilization of economic capital metrics: 44 percent of larger companies use EC in strategic planning and capital allocation, compared to 19 percent of smaller firms; while 40 percent use EC in product design and pricing, as opposed to 17 percent of small firms.

Larger companies–already first in line to realize a competitive advantage by fully integrating ERM into their decision-making processes–are also well positioned to acquire less sophisticated firms unable to keep pace, according to Towers Perrin.

Since 2006, the expected impact of Solvency II–the pending change in regulatory requirements for European Union insurers–has swung that market strongly toward consolidation (up from 40 percent to 50 percent of respondents) and away from the need to raise more capital or resort to more innovative financing techniques (down from 55 percent to 39 percent), the survey found.

European insurers lead their North American counterparts in the implementation of EC and its use in decision-making, Towers Perrin said.

These capabilities, especially under Solvency II, are expected to lead to both lower capital requirements and a competitive advantage–in the short and long term–as illustrated in the survey findings, according to Towers Perrin.

European insurers, the survey found, are giving greater short-term priority to the use of EC within their decision-making processes (56 percent), compared to their brethren in North America (40 percent) and in the Asia/Pacific region (38 percent).

Additionally, within the next two years, European insurers said they expect to use EC in most major decision processes (80 percent to 90 percent), compared to North American firms (60 percent to 75 percent) and those companies in the Asia/Pacific region (50 percent to 65 percent).

Fifty-two percent of European firms have documented their risk appetite, compared to only 40 percent of insurers in North America. Survey findings indicate those same companies in Europe are also more apt to set risk limits for such day-to-day management issues as market risk (88 percent) than their counterparts in North America (61 percent).

The survey found that only 7 percent of participants believe they have in place an adequate operational risk management capability, and 37 percent said significant work is required–in stark contrast to views expressed on insurance, credit and market risks (9 percent, 11 percent and 16 percent, respectively, requiring significant work). Operational risk also lags other risks in terms of setting risk limits and economic capital calculation methodology.

In addition, operational risk management ranks only seventh among near-term ERM priorities (mentioned by 41 percent of respondents globally). In calculating EC for operational risk, relatively simplistic factor-based methods are the most commonly used approaches (43 percent), with only 17 percent using stress testing and 16 percent utilizing stochastic methods, involving chance or probability, the survey found.

Among European insurers, the proportion expected to use an internal model for operational risk (51 percent) is significantly behind insurance, market and credit risks (86 percent, 80 percent and 65 percent, respectively).

Special Reports /

ERM Still Lagging Among U.S. Insurers, Although Bigger Carriers Lead The Pack

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