Measuring Risk: Insurers’ day of reckoning arrives
The threat of more natural disasters could make 2006 a watershed year in how the insurance industry measures risk. With American carriers revamping their reporting and management structures, insurers are expected to undertake major initiatives regarding enterprise-wide risk management (ERM).
This won’t be the first time insurers have said they’ve looked at ERM. For at least the past three years, the idea has been the subject of numerous industry conference panels and papers; it’s been promoted as the next major step in how the industry deals with risk.
Yet industry observers say that the increasing specter of mega-catastrophes, evidenced by Hurricanes Katrina and Rita, and the demands of credit rating agencies, make ERM imperative for the property and casualty industry.
“We are looking very closely at the impact of these [hurricanes] and exploring ERM,” said W.G. Jurgensen, CEO of Nationwide Insurance, at the recent Property Casualty Joint Industry Forum in New York. “These risks don’t just come in one area; they usually have friends along for the ride.”
ERM can be a slippery concept. It is often defined as integrating all risks, including financial, operational and strategic risk.
“The ultimate objective is for an insurer to use an ERM framework to better understand and manage the correlation and diversification of risk across the company and use this information to determine overall risk or economic capital,” said Randall Buhlig, managing director in the KPMG Risk Advisory Services practice in Atlanta.
Insurers have traditionally managed risk in “silos,” Buhlig said, measuring underwriting risk in their property and casualty business but not consistently correlating its effect on risks to their invested premium. Another example: Insurers modeling for a major loss event such as a hurricane without figuring out how the event could influence liquidity or credit risk within their investment portfolios.
Ultimately, insurers want to improve their risk reporting via ERM so that management and boards of directors can make strategic decisions about what products to offer, the company’s risk limits and what markets to pursue.
“What insurance management teams and company boards would get with ERM is an ‘aggregated exposure risk report’ showing a company’s exposures compared to risk limits and thresholds across all business lines,” Buhlig said.
Mega-catastrophes such as Katrina are expected to hit with greater frequency, making the integration of risk management more urgent than ever. Some point not only to the disasters that happened, but even to the disasters that were not as devastating as feared.
“The big news of ’05 wasn’t Katrina, it was Rita,” said Edward Rust Jr., chairman and CEO of State Farm, at the Property and Casualty conference. Devastating as it was, Hurricane Rita could have been much worse, Rust said. It could have caused a major economic upheaval.
“If Rita had moved 30 miles towards Galveston, it would have been a major hit to the economy,” Rust said. “Not only from an insurance perspective, but also in terms of the petroleum industry and shipping. That sort of storm hits your equity portfolio, your investment in municipal bonds.”
A new risk management structure means that insurers will need to rethink the probabilities of catastrophes and how they could affect different audiences, said Ronald Pressman, president and CEO of GE Insurance. The industry needs to communicate how changes in weather and the environment are going to change how it underwrites new property and casualty business
“Our time horizon isn’t just a 100-year storm cycle, it’s a 10-year environmental time horizon” Pressman said. “And it’s a one-year financial horizon.”
Capital markets also are putting pressure on insurers to adopt ERM, said KPMG’s Buhlig. Rating agencies are pushing for the change. “Some rating agencies are starting to include risk management and give it equal weight with other factors when determining their financial ratings,” he said. “That is having a powerful influence on insurance executives.”
Insurers will face a battle in getting shareholders and Wall Street to understand ERM, because risk management entails a longer-term view than the capital markets, said Brian O’Hara, president and CEO of XL Capital.
“The pressure from shareholders and analysts to have a strong year is intense,” he said. “That’s why risk management is so important. It’s now a part of margin and the bottom line.”
In the near term, the industry’s financial outlook is stable, according to a survey by the Insurance Information Institute (III) of insurance professionals. Last year’s catastrophes are not expected to severely affect the property and casualty industry’s financials. The forecast calls for an increase in net written premiums of 4.7 percent in 2006, up from an estimated 2.5 percent in 2005.
Analysts expect that supply will fall while demand for insurance and reinsurance will increase, possibly sparking a hard market.
Insurers’ profit margin, as measured by the combined ratio, is projected to be 98 percent. With an estimated combined ratio possibly just below 100 percent for 2005 — even with Katrina factored in — it would mark only the second underwriting profit in the property and casualty insurance industry since 1978.
But industry leaders said the long-term outlook is less clear. Initiatives like ERM have become urgent in light of massive uncertainty.
“Our industry needs to thrive,” said Edward Liddy, chairman and chief executive of Allstate. “If the question is whether our industry can survive, the answer is yes. But [survival] is not the right standard.”
Christopher Westfall is managing editor for KPMG’s Insurance Insider. Copyright2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.
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