CarryingMoneyBlog No matter how many regulations or internal fail-safe systems an organization or a government puts in place, preventing systemic economic collapses means accounting for the worst instincts in human nature. Can enterprise risk managers mitigate “people” risk?

That was the provocative question raised by an audience member at a recent enterprise risk management conference hosted by the events division of my parent company.

The question was posed following a wide-ranging panel discussion of the financial meltdown and its implications for corporate governance—entitled, “A Conversation About Risk: What Keeps You Up At Night?”

An audience member asked the experts to explain how companies and regulators can mitigate “people risk” to discourage behavior that is at best reckless, and at worst unethical or even illegal, when the potential for large profits looms.

“One of the clear weaknesses here is people,” said the attendee. “How do you get board buy-in to proceed with caution on risk? How do you mitigate the inherent 'people risk'?”

The responses were intriguing.

“There is a natural human reluctance when things are going well to challenge the status quo,” said Helen Galt, senior vice president, actuary and chief risk officer at Prudential Financial Inc. “Even though some of the markets were defying the laws of gravity, people were reluctant to miss the boat. More attention should have been paid to nightmare scenarios.”

She said CROs need to “challenge management to define their risk tolerance more clearly.”

Ms. Galt later added that collateralized debt obligations (CDOs) packaging subprime mortgages were “embraced because of the high ratings assigned to them by rating agencies”—a level of trust and confidence that turned out to be misplaced.

She suggested that “if you can develop your own internal capabilities to analyze these complex products, you must do so. But if you find you need 300-page documents to fully explain how the product works, it's probably too complicated.”

Ms. Galt said her firm “basically decided we were not going to invest in CDOs. After they were sliced and diced multiple times, it was hard to understand what we were looking at.”

Earlier, Mark Abbott, managing director of quantitative risk management at Guardian Life, had also urged companies to “do your own due diligence and not just rely on the rating agencies. Ask lots of questions about the underlying risks of securities you are considering purchasing.”

He added that firms need “a collaborative environment that allows and even encourages management team members to challenge one another,” with the risk management department having a seat at the table.

Nancy Bennett, a senior life fellow at the American Academy of Actuaries, said “people forgot the risk-versus-return part of the equation,” noting that “there were plenty of signs along the way, if we were paying attention, that the mortgage market was close to blowing up. But no regulator felt it was their responsibility to raise the issue.”

Ms. Galt said the financial markets will “always be susceptible to poor judgments and even to fraud. But an enormous amount of attention is being focused now on risk management internally and externally. There is a lot of positive energy about it, and hopefully that will make a difference.”

The panelists, however, were not eager to see new federal regulations imposed, nor additional government referees put in place to watch over their operations.

“Another systemic failure is possible,” said Ms. Bennett. “But whatever regulatory changes are made, let's make sure it's risk management-based and not politically-based.”

Noting efforts in Washington to have the Federal Reserve and/or a federal regulator council oversee insurers—or at least those posing a systemic risk to the economy–Mr. Abbott said “the idea of people accustomed to handling banking regulating insurance is a frightening thought. We need someone with equal stature at the table representing the insurance industry.”

Ms. Galt agreed that “we're probably going to see some sort of overreaction in Washington on reform, especially since there is little understanding there of the insurance industry.”

She added that “one of our challenges is to educate our future federal regulators on what insurance is all about.”

Good luck with that, right?

In any case, what suggestions might you have for mitigating this ”people risk” exposure? Can enterprise risk management tackle human weakness and the proclivity for greed?

(To learn more about the National Underwriter Company's recent ERM Conference, including the ability to download material from the speakers–from yours truly as well, based on my speech about reputational risk in the insurance industry–go to http://www.summitliveevents.com/sites/erm/Pages/Enterprise-Risk-Management-Program.aspx.)

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