Did enterprise risk management (ERM) fail the companies at the epicenter of the financial services meltdown or did the companies fail to properly employ ERM? While this question will vex many for a long time to come, it is especially urgent for insurers to understand whether their ERM practices are actually protecting them, or merely providing an illusory comfort.
A collection of essays, “Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications,” published jointly by the Society of Actuaries, the
Michael Wacek, president and CEO at Stamford, Conn.-based
Wacek says that
Not surprisingly, the inability of risk managers to grasp the impact of derivatives, such as credit default swaps (CDS) on a company, is singled out by Wacek.
“The favorable balance sheet optics provided by CDS enabled AIG management to pursue an extremely leveraged business strategy without attracting much attention and perhaps without itself fully understanding it,” Wacek writes.
Credit default swaps were not designed with transparency in mind. So, the inability of ERM to account for them is at least understandable. Other blind spots are not.
Prakash Shimpi, global practice leader, ERM, at
Jean-Pierre Berliet, founder of Berliet Associates LLC, a New York-based advisory firm on strategy and risk management, writes that it is exactly these types of strategic risks that insurers employing ERM correctly should account for.
“It is not enough for insurance companies to understand and manage the financial risks of their business that can cause insolvency,” he writes. “They need also to manage external “strategic” risks to their business. Until the present crisis, many insurers did not think much about their dependence on the efficient functioning of credit and other financial markets or the overall safety and soundness of the banking system. Now they do.”
Berliet also warns that insurers should not confuse compliance with a fully formed risk management strategy. Indeed, Berliet charges that even the forthcoming Solvency II regulations understate both the need for—and the cost of—capital to insurers in a crisis environment. “Because the insurance industry has been highly regulated, many insurance companies have not developed a deep strategic risk assessment capability. They need one urgently,” he writes.
Wacek, too, contends that the merits of highly functional ERM will eventually become self-evident.
“Over time, the market will punish companies practicing the window-dressing version of risk management and reward those whose ERM proves effective,” he writes.
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