In late-January, Bermuda-based insurance company XL Capital Ltd. found out the hard way that insurers' enterprise risk management (ERM) capabilities are coming under increased scrutiny. Both Oldwick, N.J.-based A.M. Best Co. Inc. and New York-based Fitch Ratings Ltd. slashed their respective ratings for XL’s P&C and reinsurance units, calling out inadequate ERM practices. In a statement, Best said the downgrade was the result of its opinion that “XL Capital's risk management controls are below expectations,” citing greater-than-expected losses resulting from the 2005 catastrophe season.

To keep carriers apprised of how ERM fits into its rating methodology, A.M. Best issued “Risk Management and the Rating Process for Insurance Companies,” which outlines how risk management is incorporated into the overall rating process.

“For insurance enterprises to remain competitive in today’s dynamic environment, build sustainable earnings and capital accumulation and, ultimately, maintain high ratings, complex organizations–such as insurers participating in the global reinsurance and retirement savings markets–must develop and constantly refine an ERM framework, including the development of internal economic capital modeling,” the document states. The paper identified the three key areas of ERM: culture; identification and management; and measurement.

Yet, it’s not just rating agencies looking at ERM infrastructure. In Europe, regulators also want a peek at how insurers assess risk. A new set of reporting regulations for insurers operating within the European Union, known as Solvency II, will require insurers to prove their ERM initiatives are sufficiently robust.

“Solvency II is a very interesting beast,” says Tom Hettinger, managing director of San Diego-based actuarial consultancy EMB America LLC. Hettinger says Solvency II is unlike the Financial Services Authority’s (FSA) regulations in the UK that allow companies some leeway in how they design and parameterize their risk models. Under FSA, insurers are compliant as long they could get regulators to believe that they had faith in their models. Whereas Solvency II, Hettinger says, is a rigid, top-down approach that will force companies to prove the efficacy of their models anywhere they deviate from the standard risk model.

Sources: A.M. Best Co. Inc., EMB America LLC

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