Standard & Poor's initiated agreat deal of activity surrounding enterprise risk management (ERM)when it announced that it was going to specifically rate insurers'ERM functions and that those ratings would influence insurers'credit and financial-strength ratings. At the time, S&P offeredspecific ERM criteria from a variety of perspectives, one of whichwas termed strategic risk management (SRM).

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The word “strategic” is much used, but implicit is the act ofinvestment: allocating capital to a given product or line ofbusiness intended to generate a profitable return. The foundationof corporate investment is the business plan, which frequentlycontains a detailed description of the proposed investment as wellas pro forma results.

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Because a pro forma is a forecast and the future could developunfavorably, some level of risk adjustment to that forecast isnecessary. There are a number of ways to accomplish this—one ofwhich is through a model.

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Capital models form the bedrock of some ERM functions, and theycan be valuable for the insights and measurement capabilities theyoffer. However, no model can provide a complete picture of thefuture, and thus no model should be exclusively relied upon foreither risk adjustment or forecasting.

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For example, corporate strategists frequently assess businessplans using other forms of qualitative and behavioral informationthat, together with quantitative input, form the basis forstrategic decisions. As we define it, SRM effectively does the samething for risk.

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SRM leverages common ERMcapabilities around accumulations and modeling analyses, but itextends those analyses by seeking to identify and track the “weaksignals” of a developing ambiguous threat that could trigger aconcentrated loss. Successfully accomplishing this depends heavilyon the efficient use of internal and external forms ofquantitative, qualitative and behavioral information. This can beextremely demanding to gather, but such information is necessary toproperly risk-adjust strategic decisions.

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We note above that the term strategic implies an investment act.In a risk-management context, investment could entail a variety ofthings, such as:

  • Finding economical ways to hedge a developing ambiguous threat:For example, prior to the recent financial crisis a number ofastute financial observers (including some insurancecompanies) purchased favorably priced credit-defaultswaps. These purchases resulted in significant levels ofprofitability during the crisis—but more importantly, the purchasespreserved the integrity of the hedging enterprises during the mostsevere financial episode since the Great Depression.
  • Finding efficient methods of preserving the integrity of abusiness model: For example, and as history has shown,insurance-policy terms and conditions can slip incrementally overthe duration of a soft market. Such incremental deviations generatea number of risks—especially if the deviant activity is notreflected in capital/risk models. However, if deteriorating marketbehavior is identified and tracked early on,  strategistscan make product-mix and/or market-position decisions to mitigaterisks.
  • Changes to the business strategy and business plan to takeadvantage of a perceived future market change which competitorshave not yet identified: For example, a small number of insurersthat correctly identified an impending financial crisis rapidlyexited lines of business such as Directors & Officers,Financial Institutions, Bankers Blanket Bonds, Fidelity Guaranteeand, to a lesser extent, Professional Liability.
  • Pseudo-risk-free, high-yielding investments: For example,following the partial nationalization of Royal Bank of Scotland andLloyds Banking Group in the U.K., a number of insurers purchasedhigh-coupon corporate bonds issued by these twoU.K.-government-backed banks because they were effectivelyrisk-free. Conversely, insurers that were concerned about thepotential for a major subprime-mortgage event switched out ofmortgage-backed securities once they realized that even someAAA-rated instruments included tranches of subprime exposures.

Many risk-mitigation solutions entail a blending of riskdistribution (e.g., reinsurance/retrocession and hedging) andbusiness-model-related activities. This is an important point, asmany risk-management functions have been built around externalcriteria and thus are documentation-oriented. SRM still requiressome level of documentation, of course, given the currentregulatory environment.

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However, the end result is not documentation; rather, it isstrategic actions designed to economically and efficiently preservethe integrity of a business model, even under—or especiallyduring—conditions of extreme distress. Successfully doing this overtime will go a long way toward facilitating ratings-agency andregulatory compliance, which is important in an increasinglyregulation-based global economy.

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Paul Delbridge contributed to this article.

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