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The Actuary The magazine of the Institute & Faculty of Actuaries

Risk management: ERM opportunities

In recent years, the volatility of interest rates, exchange rates and prices of major commodities has stimulated growth in the demand for professionals who can develop and exploit financial risk management tools. Meanwhile, advances in the theory and practice of creating and pricing derivatives have facilitated the supply of new financial engineering techniques to manage these exposures. However, the credit crisis and its aftermath highlighted information loss implications where these models have proven to be inadequate, in a world of asset bubbles and extreme volatilities, and where the associated financial engineering tricks and their implications have not been highlighted at board level.

In this context, the actuarial profession has the opportunity to define strategic risk management as something broader than analyzing disclosures of corporation’s contingent capital, liabilities and equities to determine their exposure to basic economic risk factors. An important issue for investors, regulators and other stakeholders is to assess the performance of corporations in managing and transforming their liabilities and equity instruments to manage their insurance and pensions-related risks. However, legal and institutional conventions underlying the classification of equities and liabilities do not currently facilitate a functional analysis of enterprise risk exposures resulting from managerial discretion over both retained and transferable capital structures. Moreover, infrequent high-impact events are not normally identified by risk managers, who focus myopically on mean-variance events. This provides an opportunity for the actuarial profession to use its expertise in linking insurance and pensions risks at enterprise level. The profession is also much better equipped to understand the effect of extreme events and non-normal distributions on corporate wealth.

Missed opportunity
It is a pity that neither the corporate governance nor internal control aspects of enterprise risk management (ERM) are really pursued actively by the actuarial profession. This seems disappointing given the important roles performed by actuaries in both financial and industrial companies. The profession could set out to provide a reference document for those new to ERM in relation to the broader link between risk, insurance and pensions. It could accredit programmes in financial risk management and compel its students to undertake sophisticated and extensive training in ERM. This will give the profession a leading edge.

Two lesser known risk management terms never really explored concern risk appetite and risk tolerance. Risk appetite and risk tolerance are vital to the actuarial implementation of ERM. Risk appetite is defined by the ERM framework as: “[Setting” boundaries of how much risk an entity is prepared to accept. Risk appetite is a higher level statement that considers broadly the levels of risks that management deems acceptable, while risk tolerances are narrower and the acceptable level of variation around objectives.”

Surprisingly, there is no actual link with disclosure and reporting of exposures to risk. The situation for financial firms is more complex because customers are also concerned about risk exposure and banks and insurers are heavily regulated to protect their capital adequacy. Policyholders and depositors cannot diversify their risk by using many insurers or banks because this is costly, and they do not perfectly monitor the managers of these institutions because monitoring is costly and requires specialised expertise. Moreover, the existence of government insurance guarantee funds in other areas of general insurance, for example motor vehicle cover, reduces incentives for monitoring and creates moral hazard. This form of moral hazard may explain the risk-taking behaviour of managers in such industries. Monitoring by customers is also impeded by the opacity of key financial statement items such as insurance loss reserves.

Risk and capital
It also seems surprising, given the debate about Solvency II, that there is no explicit link made by the actuarial profession between risk management and capital management. Nowhere is there full discussion of the various links between the two processes and their consequences. For example, one can address risk management either by hedging that risk using derivatives, taking out insurance or reinsurance or retaining that risk. However, it is not clear which option should be taken. Yet both risk and capital management are important aspects to a general insurance firm. Risk capital is an important form of protection, but this is costly and a role of risk management is to reduce risk capital.

One of the rationales for recent innovations in derivatives, risk transformation and related products is to facilitate firms to hedge the credit, solvency, liquidity and market risks associated with the recent changes in banking (Basel II) and insurance (Solvency II) risk-based capital regulatory requirements.

From a functional perspective, financial intermediation is one important activity that generates value for general insurance firms. An equally important economic function is to provide risk-pooling and risk-bearing services for their stakeholders, and these services are a primary driver of the need for risk management. Indeed, both assets generated by the intermediation function and liabilities generated from the risk-pooling function are sensitive to inflation and interest rates, creating a need for asset liability management. However, currently, assets and liabilities are defined by reference to institutional form rather than by function. Accounting as a structure is directed toward value accounting. It is therefore an ineffective structure for identifying risk. Standard definitions of liabilities and equities also ignore the range of capital resources available to a general insurance company, and thus distort the view of a firm’s capital cost and its return on equity. This is because there is no consistent risk management conceptual framework that embraces all of the corporate capital resource instruments available to a firm, including debt, equity, insurance, derivative and contingent capital.

While the UK Actuarial Profession makes huge strides in exploring this topic, with its code of ethics, standards for accreditation and expertise, it should make a leading contribution to the topic of defining and clarifying the role of ERM and its broader implications for the link between financial risk management, insurance and pensions management.

The Profession should, in my opinion, also provide a comprehensive conceptual framework that makes connections between key functions within an organisation such as internal control departments and those responsible for managing and setting organisational risk tolerances. The Profession should develop proposals for enhanced risk disclosures that enable financial statement managers to assess the effectiveness of corporate management of risk exposure in capital rising. This requires redefining financial liabilities and equities to reflect functional risk management rather than an institutional form to facilitate exposure reporting.

The Profession should also consult widely with its membership to ask about the adequacy or otherwise of their clients’ or employers’ risk management activities that enable them to assess their firm’s ability to manage pensions, insurance and financial risks for given capital and earnings at risk. Finally, there should also be a clear link to actuarial standards. It is hoped that, in this connection, the Profession could secure the legitimacy and authority of its views on ERM by lobbying the Board for Actuarial Standards (BAS) to incorporate an ERM perspective in its conceptual framework and specific standards for adoption by companies.

Defining ERM Enterprise risk management (ERM) is: “A process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk within its risk appetite, to provide reasonable assurance regarding the achievement of the entity objectives.”

By requiring organisations to establish a risk appetite against which its actions are measured, and communicating the results to investors through quarterly and annual papers, the ERM framework proposes to enhance the transparency of an organisation’s financial reporting and extend the benefits of internal control management to areas beyond financial reporting.

Paul Klumpes is professor of accounting at Imperial College London