The economic crisis that began in the fall of 2008 was many things: an affirmation of the interconnectedness of the financial markets, a wake-up call for legislators and regulators, a validation of risk management, but also a reminder of its inherent limitations.
The crisis was especially momentous for financial managers within insurance companies, who were called upon to make sense of markets where stock prices and credit ratings swung wildly, and formerly clear distinctions became subject to interpretation.
During a time when "toxic asset" became a part of the lexicon, portfolio managers were suddenly subject to an entirely new level of scrutiny, chief investment officers and chief financial officers were required to demonstrate increased transparency into the assets they managed and their exposure to counter-parties.
Accordingly, many of the decisions made during the height of the crisis were tactical-unloading a higher-risk asset regardless of a short-term loss. "Many companies de-risked by selling at bottom," says Cliff Gallant, an equity analyst at Keefe, Bruyette & Woods, a New York-based investment bank.
In addition to the urgent need to detoxify, some traditional capital management options, such as accessing public debt markets, vanished for a period of time. Other formerly routine tasks, such as hedging and setting surplus and reserves, suddenly took on a new sense of urgency.
"The fourth quarter of 2008 was a watershed event," says Kevin Kelley, CEO of Bermuda-based Ironshore Inc. "It changed the landscape of the financial services business as well as the P&C industry."
One of the primary changes to the landscape is how insurers view their investments. "By and large, most of the industry is managing their asset portfolios on a much more conservative basis-shorter durations and a much greater eye to safety of principal and liquidity," Kelley says.
Another traditional means of hedging risk-buying reinsurance-also has changed, as carriers look to spread their risk around to a greater number of players in the secondary market. "Customers and intermediaries no longer want to have concentrations of counterparty exposures," Kelley says.
RISK & REWARD
Because no company came through the crisis entirely unscathed, it helped to widely illuminate the state of risk management across the breadth of the insurance industry.
"2008 and 2009 were great test years for the insurance industry, and with one major exception, they performed remarkably well," Gallant says. "It was a time when good behavior was rewarded."
The companies that fused financial management with solid risk management practices fared better than those that divorced risk-taking from core corporate objectives, Gallant adds.
"The fundamentals of good risk management haven't changed, but there have been failures within other financial institutions of the proper application of sound risk management principles," says Gideon Pell, SVP and chief risk officer for New York-based New York Life Insurance Co.
According to Pell, one of the keys to managing risk is remaining true to a company's corporate mission. Freed from quarterly expectations, mutual companies may have an advantage in that they don't have to make short-term decisions. In the case of New York Life, the company's risk management practices are inseparable from its vision of providing long-term policyholder value, Pell says. "As a mutual, we're not about chasing large short-term returns that involve outsized risks. Stable growth in a controlled manner is much more important to us than looking to chase returns."
Pell says a successful financial risk management strategy should seek to dampen volatility- both on the upside and downside. "It's all about prudent risk-taking-understanding the risks that we are taking, knowing what risks we are comfortable taking, and those which we are not advantaged to take," he says. "You have to be financially disciplined to do that, especially when times are good and there is the appearance of gains to be had seemingly with 'little or no risk.' If it seems too good to be true, it probably is."
A similar commitment to a disciplined investment philosophy also helped Minneapolis-based Allianz Life Insurance Company of North America weather the storm, says Ross Bowen, the company's VP of profitability management. "From the beginning, Allianz was fairly conservative, which helped us come through the crisis well," he says.
Much of Bowen's bailiwick revolves around determining the company's exposures-and thinking ahead: Is the stock market or bond market the greatest source of risk? Is the economy expanding or contracting?
"In profitability management, I have to think about both the policyholder and the shareholder," he says. "I want to make sure we offer a good value proposition to the policyholder because this is a very mature and competitive marketplace."
MODEL BEHAVIOR
For those tasked with managing financial risk at insurance companies, one mitigating benefit of the crisis is that it has raised the profile of their craft.
"In some ways, the crisis has made my job easier," Bowen says. "Allianz leadership recognizes that we need to bring resources to bear, and they are more willing to listen."
Throughout the industry, many of these resources are spent on developing stochastic models of ever-increasing complexity. Areas such as reserves calculation and surplus calculation are both being done in the stochastic world. Dynamic financial analysis attempts to look at risk holistically, and can be used in areas such as business mix, asset allocation and determining the need for reinsurance. "You have to think about what a major natural disaster would do to the financial markets right now," Gallant says.
Bowen notes that the push toward greater use of stochastic modeling predates the crisis.
"We've had to develop tools to do more sophisticated modeling to manage our profitability and risk," he says. "We need the ability to value liabilities every day. There are so many things that are interconnected that you must have a holistic view of the business, and have it heavily supported by technology."
The rise of modeling has paralleled advances in computing power and modeling software. Inexpensive distributed computing options means that complex, Monte Carlo simulations can now be run in just a fraction of the time required just a few years ago.
"Since the global financial crisis, we have six times the computing capacity that we had before, and we've increased staff," Bowen adds. "We're not just throwing computers at the problem-we're also working smarter."
Likewise, New York Life's Pell is quick to point out that while modeling imparts a degree of precision, you have to apply common sense. Advances in computing power may have improved the speed of stochastic modeling, but while getting the answers quicker is helpful, it doesn't replace the inherent need to ask the right questions. "Risk management is more than just the model," he says. "You can't automate it. Making the right decisions is very dependent on the judgment of the people reviewing the model results in combination with other factors."
Ironshore's Kelley concurs. "The physical tools are secondary to the macro trends in the business," he says.
Indeed, one of the charges leveled in the wake of the financial crisis is that financial services firms used sophisticated risk management systems as an excuse for taking more risks. Pell says understanding what's driving the results the models spit out is paramount. Further, you have to take a step back and ask whether the assumptions on which the model is based make sense. "Risk modeling in itself is not sufficient," he says. "You need to apply judgment and question your assumptions."
Pell says a new worry is that risk modeling has become so discredited that people will not rely on their models enough. "We have to be careful we don't go to the other extreme," he says. "You need sophisticated tools in order to understand the behaviors of instruments and policyholders in different environments. But you need to understand the limitations of those models. You need to do sensitivity analysis on the assumptions and the data that goes into it."
TRANSPARENCY
The scope and complexity of the information that financial risk managers must wade through to make determinations highlights the need for carriers to rethink how they aggregate and reconcile financial data. Just as successful modeling requires a synthesis between modeler and machine, there are other toolsets that aim to make the stewards of a company's financial portfolio more effective by freeing them of previously manual duties. Some such progress is being made in the areas of accounting risk and compliance reporting for institutional investors.
"Investment portfolios have grown substantially over the last 10 years, so it is just getting too onerous for human input on some of these things, especially during the present financial crisis, where credit ratings are changing so rapidly," says Courtlandt Gates, CEO of Boise, Idaho-based Clearwater Analytics.
Gates says the speed at which corporate ratings, not to mention corporate structures, now change calls for a software-based solution. He cites the example of Bank of America (BOA). A few years ago, a portfolio manager might have a starkly different view of the BOA shares scattered throughout internal and external portfolios after the bank's acquisitions of Countrywide Financial or Merrill Lynch. "If you're not staying on top of corporate actions and mapping these things up to the parent company, you're not going to know," Gates says. "There are a lot of things you can't expect an investment manager to do on a timely basis."
Gates says the focus on the relationship between transparency and risk spiked in the wake of the crisis as chief investment officers and chief financial officers scrambled to gauge their exposures and counterparty risks. "Three years ago people were thinking more about returns and weren't really thinking about risk," Gates says. "Well, the world has changed."
THE CULTURE
Though the insurance industry largely avoided being consumed by the conflagration, it does seem to have landed close enough to the flames to have its practices around financial risk annealed. For Pell, this means driving risk culture down the organization, and clearly expressing risk management goals to the workforce. While every employee need not be a quant, all should respect the integrity of the risk management culture of the organization.
"Risk management needs to be embedded across the company and made operational," Pell says. "In a sense, everyone at this company is a risk manager to some degree given the nature of our business of providing long-term guarantees to our customers and policyholders."
Indeed, it seems one of the greatest challenges to combating financial risk is avoiding complacency. Gallant cautions that just because insurers survived the last crisis in no way inoculates the industry from future financial turmoil. "I'm not predicting this, but if we do have a double dip, it might look nothing like the first."
NEW RULES
Rating agencies and regulators increasingly are demanding greater transparency. Solvency II, the forthcoming regulatory requirement for insurers domiciled in the European Union, is another reason insurers are implementing new financial asset management technology. Once enacted, Solvency II will impose requirements around insurers' capital levels, governance, risk management and disclosure and practices. Consequently, carriers will be required to "show their work" more than ever before.
Stateside, the American Academy of Actuaries Life Capital Adequacy Subcommittee (LCAS) and Variable Annuity Reserve Work Group (VARWG) have been leaders in the C3 Phase II project, which is part of a broader Academy initiative on risk-based capital and principle-based reserving. "The industry is moving away from a formula-based approach to reserving to one that's principles-based," Bowen says. "That's been going on for several years."
Another regulatory shift for which financial risk regulators will need to account is the coming convergence of accounting rules. The melding of the generally accepted accounting principles (GAAP) of the U.S.-based Financial Accounting Standards Board and the international financial reporting standards (IFRS) issued by the International Accounting Standards Board will present challenges for financial risk managers.
CAPITAL MANAGEMENT PRACTICES SHIFTING
Life insurers are adjusting the way they calculate capital requirements, a new study from New York-based Towers Watson finds. The report, "Evolving Capital Management Practices," queried 30 CFOs, and found they expect to make greater use of economic capital when determining capital requirements.
"Capital management is becoming a top priority for many companies," Jack Gibson, leader of Towers Watson's life insurance consulting practice in the Americas said in a statement. "That more than three-quarters of CFOs (77%) said that capital management practices-primarily determination of capital requirements, monitoring of capital position and management of capital levels-are receiving greater attention at their companies than they were in January 2008, speaks volumes to where they are focused."
The survey shows the shift is largely related to the financial crisis. "The global financial crisis and recession have put pressure on life insurers' capital positions," said Todd Erkis, Towers Watson director. "The amount of capital required has increased, while life insurers' available capital has decreased. At the same time, the options available to raise capital have become more limited and more costly."
However, CFOs were generally optimistic about the economy moving forward, with most respondents indicating they think that GAAP net revenue and GAAP net income will increase at least 4%, compared to the same quarter last year. They also were bullish on premium growth, with 54% of respondents predicting growth in new life and annuity premiums over the same quarter last year; 25% expected premiums to stay the same, and 21% predicted a decrease.
