ERM: A TWO-YEAR REPORT CARD

Rough Notes, Oct 2006 by Moody, Michael J

Most rating agencies profess that, as part of their overall rating methodology, they have always been concerned about an insurer's approach to risk management. However, since October 2005, there is little doubt about whether there is explicit recognition of risk management in the rating formulation.

That's when Standard & Poor's (S&P) became the first rating agency to indicate a methodology that would specifically analyze an insurer's ERM capabilities. However, S&P not only analyzed the insurer's ERM capabilities, but more importantly they took the results of the analysis into account when assigning a rating. Among other things, S&P has stated, as part of their analysis, they will assess the insurer's risk management culture, risk control efforts, ability to determine emerging risks as well as their risk and capital models.

Subsequent to S&Ps announcement, other agencies also indicated interest in insurers' ERM programs. In February 2006, A.M. Best stated it would include an ERM program analysis as an integral but separate part of its rating analysis. Moodyte followed shortly thereafter, noting that while its rating process already considered a top level assessment of business risk, they would begin a separate ERM analysis. Fitch Ratings also indicated that their agency was going to begin reviewing an insurer's business model to determine how ERM is embedded within it.

In commenting on the rating agencies' new interest in ERM, consulting group Towers Perrin notes that ERM can be quite valuable because they "consider more than just the quantitative building blocks that contribute to healthy insurance company management." They go on to say, "It also takes into account qualitative issues such as governance, systems and process, risk analysis and, significantly, the culture of the company." At the end of the day, Towers Perrin believes that, "ERM facilitates a rating agency's fundamental understanding of the nature of risk an insurer is taking on, the price it is charging to do so and its ability to measure and monitor."

So now, two years after COSO first introduced its ERM Framework, one industry, the insurance industry, is beginning to see the importance that is being attached to a holistic approach to risk management. Those insurers that were early adopters of the ERM concept will definitely have a ratings advantage for the next 12 to 24 months. However, as the agencies continue to develop their analysis and fine tune their rating methodology, insurers will need to address any shortcoming in their ERM programs.

It should be noted that most of the broader industry-based rating agencies (i.e., S&P, Moodyte, etc.), have indicated a willingness to expand their ERM assessment into other industry segments. As a result, while ERM incorporation into the strategic planning process of the financial service industry has been significant, a much broader based movement is expected soon. Fortunately, ERM has advanced to a point where it can begin providing sustainable, value-added results. And as was the case with the financial service sector, it will be the early adopters who reap the greatest rewards.