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The Actuary The magazine of the Institute & Faculty of Actuaries

Does your ERM sing and dance?

We are living through one of the most testing periods in financial history, during which it will be critical for insurers, supervisors and regulators to use their recent experience to determine the elements of risk management that have worked well and those which need to be improved. A vast array of literature has already been built on lessons learned from the financial crisis and some key themes are emerging:

>> Weaknesses in corporate governance including assigning insufficient powers and ability to escalate concerns to the risk management functions; placing inadequately trained staff in risk management positions; and using compensation structures that misalign incentives. An interesting aside here is the banking industry recommendation that the chief risk officer has the ability to escalate a concern to the CEO or board — this is a long-established right and responsibility of the appointed actuary or actuarial function holder to a life insurer.

>> Failure to articulate and communicate an aggregate risk appetite, to cascade this risk tolerance down through the business and to monitor adherence to the risk appetite and limits.

>> Systems incapable of producing aggregate risk information on an accurate and timely basis and too inflexible to allow investigations of a wide range of possible economic scenarios and to permit more granular analyses. This proved to be a significant impediment to risk monitoring and analysis.

>> The complexity of assets and liabilities held exceeding the capability of existing models to capture both the risks and the ability of management to understand the risks.

Possible solutions
Most large financial services organisations have taken significant steps in an attempt to address these issues. For example, recent months have seen insurers review product designs to reduce the level of exposure to unhedgeable risks by removing some onerous guarantees, changing charging structures and dramatically reducing the range and riskiness of funds offered under variable annuity contracts. A number of insurers have divested businesses that no longer match their desired risk profile. There will inevitably be further activity on this front when valuations improve or strategic reviews are completed. Also, despite the relatively high prices of protection, there have been a number of risk transfer transactions to remove or reduce the level of financial and non-financial risk held.

Business rationalisation and risk transfer are also firmly on many insurers’ agendas because they will need to be considered by all companies wishing to gain approval for their internal models for calculating the Solvency Capital Requirement under Solvency II.

System reviews, process streamlining, control variates and grid processing are important parts of the solution for many and may help companies produce faster, more reliable and more secure results to an audit standard. Firms are often targeting quarterly production of results; however, business decisions are made on a daily basis and a more nimble approach is required to run alongside heavy-duty results production engines.

The use of replicating portfolios in representing the value of a business is one of the more recent techniques used to improve risk monitoring and risk management information. Using this technique, real-time monitoring of the solvency position and capital requirements becomes practical. Replicating portfolios can also drastically reduce the time and resources necessary for generating the market-risk section of risk dashboards, allow more sophisticated aggregation of market risks with non-market risks, facilitate a better understanding of the nature of the liabilities and offer a robust performance-measurement approach.

Replicating portfolios can be implemented relatively quickly (often in a matter of months) and inexpensively, but insurers should take care not to fall into the trap of buying a black-box solution that is not understood. Skill and understanding are required in the scenario selection under which the cash flows are generated, the universe of instruments that could be included in the replicating portfolio is chosen, the fitting is measured, the degree of cash flow-bucketing figured and the optimisation algorithm used.

The crisis has been painful for the financial services industry, but now is the time to take advantage of the lessons learned and the new techniques available. Make your ERM framework a dynamic one, not a flat-footed one!

Jargon buster
A replicating portfolio is a portfolio of financial instruments chosen to match a portfolio of insurance liabilities as closely as possible. The replicating portfolio, once derived, can act as a proxy for the insurance liabilities — for rapid revaluation in risk monitoring, capital calculations, performance measurement and even simply interpreting the liabilities.

Mark Chaplin is a consulting actuary and Vanessa Leung is a consultant, both working in the Insurance & Financial Services Practice at Watson Wyatt