ENTERPRISE RISK MANAGEMENT
By Michael J. Moody, MBA, ARM
ACE executive discusses the company's ERM strategies and progress
"There is no question in my mind that we are having
tangible effects by increasing risk awareness."
--Donald Watson, Vice President, Enterprise Risk Management, The ACE Group
A new report by PricewaterhouseCoopers (PwC) has confirmed that the insurance industry now has enterprise risk management (ERM) on its boardroom agendas. And many insurers are now viewing ERM as a key driver in obtaining a competitive edge in this challenging market. However, the report titled "Enterprise-wide Risk Management for the Insurance Industry" goes on to note that a gap remains between the designing and planning stage and the implementing stage at some companies. These lagging companies frequently struggle with necessary infrastructure, including the establishment of processes and finding people to properly implement these holistic programs.
One insurer has made strides in implementing a proactive ERM program over the past few years. The ACE Group (ACE) of insurance and reinsurance companies, founded in 1985 and headquartered in Hamilton, Bermuda, currently has about 9,000 employees and has a presence in over 50 countries worldwide.
Background
ACE's enterprise risk management program began in earnest in September 2002, when they hired Donald Watson as the vice president of Enterprise Risk. Watson came to ACE from Standard & Poor's where he had most recently been the director of the North American Insurance practice. His previous position gave him an excellent insight into insurance company operations and the success factors of the market leaders. ACE's management believed that this vantage point would provide an excellent background for the ERM program.
ERM program elements
The primary focus of ACE's enterprise risk management program is embodied in three strategic goals. According to Watson, the first goal "was to identify the various risk factors that could impair the financial condition of ACE." Watson notes that these were, by definition, "much bigger risks" than those identified through traditional risk management. Watson uses several "rules-of-thumb" in screening risks. He says "these are risks that can have an impact either on the quarterly financial performance (i.e., earnings) or on the financial condition of the company (i.e., the capital of the company)."
The identification process at ACE started during Watson's second month. He pulled together 15 to 20 senior executives for an analysis of the company's risk. While he had some ideas about what the key risks were, he needed their help in fine-tuning that list. As a result of these discussions, they "set up a grid pattern by which they could subjectively determine how critical the risk was." They then sought a three-dimensional view of each significant risk: How likely was it that the risk would occur? If it occurred, what would dollar exposure be? And what was the time frame? The key focus was, "Is this something that will impact the company this year, or some time in the future?"
Watson says the second goal was "to assemble the corporate resources to mitigate or otherwise manage the risk exposure." Early on, it was decided to "leave the risk ownership where it is incurred." This approach allows operational management to maintain risk ownership so that they can retain both the management and reporting of the risks.
The final goal of the ERM program, Watson states, was "to provide a comprehensive view of ACE's risk profile to the board and executive management on a company-wide basis." He realized that in order to complete this goal, it was important to have the correct reporting relationship. Watson's position reports to the CEO and the audit committee of the board, which he believes is the proper reporting structure for ERM.
ERM's role
It would be easy to explain Watson's role in the ERM process as one of a consultant. Since the company's risks reside within the individual operating units, Watson's primary method of accomplishing his responsibilities are to work with the operating personnel to identify, measure and then mitigate risks. But his role goes beyond traditional consultancy.
Watson points out, "Consultants are never charged with implementing their recommendations." And make no mistake, Watson is charged with implementing the ERM program. If, for example, he is uncomfortable with how a risk is handled, his role and responsibility is to bring it to the attention of executive management and the board. "If this is something that we should do something about and we cannot do it within our existing organizational structure, then the board must make a strategic decision," Watson says.
Value creation
A key component to ACE's ERM process is the value creation aspect. When asked if ERM makes a difference at ACE, Watson is quick to point out, "There is no question in my mind that we are having a tangible effect by increasing risk awareness." Watson points out, however, these have been corporate accomplishments that require the active involvement and support of a number of operating groups.
Watson says that if you had looked at ACE's financials three years ago, two items would have caught your attention. The first was asbestos exposure, but there is little that can be done in this area short of ensuring adequate reserves and supporting tort reform--which ACE has always done.
However, the other item that received attention was a $15 billion reinsurance recoverable asset. "Now this is something that the company could do something about," observes Watson. And over the past two years, ACE has done something about it. Among the key strategic actions taken by ACE are: significantly strengthening its reinsurance security requirements, looking for better quality reinsurance, and increasing internal retention. As a result, over the past year, from 2002 to 2003, ACE has reduced, both on a relative and an absolute basis, the amount of reinsurance recoverables.
Watson says, "Look at the change in gross premiums, and look at the change in net premium. It is astounding that we have been able to reduce this item in two years." How is it possible to make this type of change so quickly? It requires first the recognition of the problem, then agreement that it is a significant issue and finally the cooperative efforts of many to change the status quo.
At the end of the day, does significantly reducing the reinsurance recoverables actually represent value creation? That's an easy one for Watson. "As we develop a consistent track record we will improve our investors' trust." Watson notes, "ACE's share price has improved over the last few years for many reasons, and it has improved more than many other property and casualty companies." One of the reasons, he is certain, is the better position of their reinsurance recoverables.
Sustainable value creation
"Is this sustainable value creation over time?" That is the $64,000 question according to Watson. For an answer, he says you can look at the other primary financial service component, the banking industry. He notes that banks have adopted ERM in a major way. "The banking industry should be a role model for ERM," Watson says. ERM is responsible for major changes in the banking community.
For a number of years, banks (mostly the major money center banks) believed that they should be in the risk business. If you looked at banks prior to 1985, you would see significant volatility in their financial results. The volatility was caused by one problem after another, emerging markets, developing countries, real estate speculation; it was a string of charges and write-offs. But then in the mid 1980s, banks figured out that they should not be in the risk business. So the big money center banks exited the risk business and became risk averse.
As a result of embracing the ERM approach, banks have made a real comeback. In the early 1980s the average return on equity for a bank was in the 10% to 12% range. By moving to ERM, banks have been able to take out the big losses that had followed them every five years or so. Today, the return on equity for a bank is in the 18% to 20% range. Based on these results, it would appear that sustainable value creation is possible with ERM.
The logical question that one is left with is: If banks have been able to reduce their earnings volatility by implementing proactive ERM programs, can insurance companies do the same thing? Can we eliminate the pricing cycles that have plagued our industry for years and stabilize our earnings by following an ERM approach? It is certainly food for thought. *
The author
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF), an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.