Reinsurers Leading The Way On ERM Adoption

"They are sophisticated when it comes to developing ERM systems, and it's a cultural phenomenon at these companies," Dickey says. "It's accepted from the board to the lowest person, and they make sure that message gets through to everyone. They spend time and effort analyzing where the risks are and how much effort to put into those risks."

The presentations given by those companies that Dickey sees "show us where their concerns are, how they are handling them and how they control them," he says.

One reason for their level of sophistication, Dickey says, is regulatory: Solvency II. "You need to have a capital model that you actually use and prove that you use; and you have to have all the governance issues handled as well," he explains.

The major primary insurers, meanwhile, are trying to catch up with their reinsurance peers.

Stefan Holzberger, vice president of rating criteria & regulatory-policy development at A.M. Best says, "It's probably safe to say that in terms of the primary companies, the large national and multinational carriers are doing their best to keep pace with the European and global reinsurers in terms of ERM."

THE ERM SCENE AT SMALLER & MID-SIZED INSURANCE PLAYERS

With the mid-market and smaller insurance players, "they are still in the developmental stage, figuring out what ERM means to them and where it can provide an advantage that justifies the costs," Holzberger says.

Smaller companies, Holzberger notes, may adopt a partial ERM platform for a piece of their business, but not for their entire enterprise. "It might be a simplified version of ERM, sophisticated in one area of the organization," he says.

An insurer, for example, might have strong modeling capabilities for its catastrophe exposure but a different process for looking at investment exposure.

Holzberger says that while many small to midsized companies in the U.S. believe there is something to be gained through ERM, many are only moving slowly towards building an ERM infrastructure.

They are not yet at the point "where they can say they are making business decisions based on the information they gather through the ERM process,' he says.

And in a market where profits might be squeezed, he adds, it may be harder to convince boards to spend the money necessary "to bring in the expertise and modeling capability required to go full-board with the ERM program."

Dickey adds, however, "We realize that a small company doesn't need the same level as Swiss Re, for example, so we can adjust our own expectations and look at what they do for ERM to make sure it is effective for their level."

COMPENSATION CONUNDRUM

Holzberger points out that ERM may be slow to catch on in some companies because it may be linked to changes in the compensation structure.

He explains that to be effective, ERM has to be accepted throughout the organization, not just at the top. And convincing people to move to a different compensation structure "is no easy task and for many companies that is one of the biggest [cultural] challenges."

An example of a different compensation structure that ERM might call for, Holzberger explains, is with a company that writes catastrophe business—say, homeowners' policies in Florida.

"The manager of that line of business had historically been paid at the end of each year based on the loss ratio or how profitable that business was. That's the old scenario," he says.

Under the new ERM scenario, the company might say that "'in a year where catastrophes aren't so severe, of course you'll have a low loss ratio and you'll make a lot of money. But we know sooner or later the year will come when you get walloped and lose money,'" he says.

"So as part of the ERM process, companies are going to set a higher hurdle for employees to get their bonus or extra compensation because they will average the long-term volatility of the business [instead of paying out handsomely] in a quiet cat year. Line managers may not like that much."

Similarly in the banking industry, a loan officer writing subprime-mortgage loans might have great numbers on the surface, "but does he really understand the risk associated with writing all those loans?" Holzberger asks. "Hopefully the bank does, and hopefully it is compensating him by factoring in the risk of those loans, not just looking at the fees coming in."