embedding erm -- a tough nut to crack

© 2008 Towers Perrin

Embedding ERM — A Tough Nut to Crack

Key Findings from Towers Perrin’s 2008 Global ERM Survey of the Insurance Sector

October 2008

© 2008 Towers Perrin 2

Towers Perrin surveyed major insurersaround the globe about their ERM activities

Chief Financial Officers, Chief Actuaries and Chief Risk Officers were asked about the status of their ERM activity and approaches

Over 350 executives responded, making this the largest global ERM survey of the insurance industry North America (49%), Europe (29%), Asia/Pacific

(19%), Latin America (2%), Africa/Middle East (1%) Life insurance (34%), P/C insurance (33%),

Reinsurance (20%), Multiline insurers (13%)

While the survey was conducted in May and June (prior to the financial crisis), we believe findings still very much reflect the current state of the market


1. Embedding ERM is proving to be a significant challenge. While companies have made progress in integrating ERM into their business, challenges remain. Significant work is required to utilize economic capital (EC) in decision making (55%) and performance management (60%)

2. Size matters. Larger insurers are significantly more advanced in most aspects of ERM implementation and are increasingly looking to realize their competitive advantage. 40% of large companies are already using EC in product design and pricing decisions, with another 42% planning to do so within two years

Six key findings


3. European insurers are better positioned. North American insurers are trailing European counterparts in key aspects, such as EC implementation and its use in decision making. Under Solvency II, these capabilities are expected to lead to lower capital requirements and therefore competitive advantage

4. ERM is influencing decisions. In spite of the challenges of embedding ERM, significant numbers of respondents indicate their ERM program has resulted in key business changes, including risk strategy or appetite (36%), asset strategies (35%) and product pricing (31%)

Six key findings


5. Economic capital standards are emerging. EC methodology is moving toward a one-year VaR approach, with the majority (56%) using a market-consistent terminal balance sheet

6. Operational risk remains a weak spot. Just 7% of participants believe they have an appropriate capability in place, and 37% indicate that significant work is required. Operational risk also lags behind other risks in terms of setting risk limits and EC calculation methodology

Six key findings


1. Embedding ERM is a significant challenge

A significant percentage of insurers are still focusing on calculating EC (as opposed to using it), with just 10% saying they have appropriate EC capability

Significant work is required in the use of EC for performance management (60%) and decision making (55%), but neither is being treated as a top priority

Among European insurers, only 11% say their internal capital models are sufficiently embedded in how they manage the business to achieve Solvency II approval

Only 30% of respondents incorporate risk measures into incentive compensation arrangements


2. Size matters

84% of larger firms calculate EC, compared to 69% of medium-size insurers and 37% of small organizations

44% use EC in strategic planning and capital allocation compared to 19% of small firms; 40% use EC in product design and pricing, vs. 17% of small firms

61% are giving short-term priority to using EC in decision-making compared to 29% of smaller firms

Competitive advantage more often drives ERM activities at larger organizations

Market consolidation seems inevitable as larger companies consolidate with smaller, less sophisticated firms that are unable to keep pace


3. European insurers are better placed

European (EU) insurers are generally more comfortable with their ERM capabilities. 23% of North American (NA) firms feel significant work is needed to manage market risk exposure compared to only 7% of EU insurers. For EC calculations: 45% NA vs. 27% EU

Higher proportion of EU companies have documented risk appetite (52% vs. 40% in NA) and set risk limits for day-to-day management (e.g., for market risk, 88% of respondents in EU vs. 61% in NA)

More European insurers calculate EC: 78% in EU, compared to 45% in NA and 59% in Asia/Pacific (AP)


3. European insurers are better placed

Within 24 months, 80% to 90% of EU insurers expect to be using EC in most major decision-making processes, compared to 60% to 75% of NA firms and 50% to 65% of insurers in AP

74% of EU insurers expect to be using EC in performance measurement within two years, compared to 54% of NA insurers and 50% in AP


4. ERM is influencing decisions

Major changes having been influenced by ERM programs over the past two years include: Risk strategy or appetite (36%) Asset strategy (35%) Reinsurance strategy (33%) Product pricing (31%)

Many already use EC results in decision-making: capital adequacy/capital management (44%), asset strategy (36%) and product design and pricing (28%)

44% cited EC use in decision-making as a 2008/9 priority; priority is higher for respondents in Bermuda (82%) and the U.K. (70%)


4. ERM is influencing decisions

Over the next 24 months, insurers anticipate significantly greater use of EC in decision making — for example, in product design and pricing (up from 28% to 67%) and in performance measurement (up from 17% to 59%)

However, only 30% of respondents indicate that they incorporate risk measures of any kind into incentive compensation arrangements and only 10% use EC for this purpose. Furthermore, 66% of insurers globally have no future plans to use EC in incentive compensation


5. Economic capital standards are emerging

EC methodology is moving toward a one-year VaR approach, with the majority (56%) using a market-consistent terminal balance sheet

Substantial global shift toward calculating EC base risk over one-year risk assessment period, from 32% in 2004, to 56% in 2006 and 68% in 2008

Even in North America, where this approach is less common, use increased nearly 15% since 2006

While 85% of larger insurers apply a one-year risk assessment period, a significant number of medium-size (35%) and smaller (39%) companies continue to use alternative methods


5. Economic capital standards are emerging

Use of VaR or Risk of Ruin as the primary measure of risk tolerance used to calculate EC has increased from 52% in 2004 to 67% in 2008

VaR is most often adopted as a risk measure among multilines (81% of respondents), whereas TVaR is most commonly used among reinsurers (33%) and life insurers (28%)

Although the use of a market-consistent terminal balance sheet is common among multilines (85%) and life (67%) companies, just 37% of P/C insurers adopt this approach


6. Operational risk remains a weak spot

Just 7% of participants say they have an appropriate operational risk management capability in place 37% indicate that significant work is required Operational risk lags behind other risks in terms of

setting risk limits and EC calculation methodology

Operational risk is rated by 37% of global participants as requiring significant work, in marked contrast to insurance, credit and market risks (9%, 11% and 16%, respectively, requiring significant work)

However, operational risk management ranks only seventh among 2008/9 ERM priorities (mentioned by 41% of respondents globally)


6. Operational risk remains a weak spot

Of those companies that have set limits to govern day-to-day risk taking, over 70% now have limits for market, credit and insurance risk, but just 26% have limits for operational risk

In calculating EC for operational risk, relatively simplistic factor-based methods remain the most commonly used approach (43%), with only 17% using stress testing and 16% stochastic methods

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


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