Erm Bests Ratings and the Financial Crisis

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ERM, Best’s Ratings, and the Financial Crisis by Gene C. Lai Executive Summary ã ã ã ã ã The objective of ERM should be to maximize the wealth of all stakeholders, including stockholders, policy-holders, creditors, and employees. To have a successful ERM process, a company needs to have an effective risk culture, and have the support of the CEO and other executive officers, such as the CRO or CFO. The ERM process should include capital modeling tools, and hold high quality and sufficient capita
  ERM, Best’s Ratings, and the Financial Crisis1 of ERM, Best’s Ratings, and the Financial Crisis byGene C. Lai Executive Summary ãThe objective of ERM should be to maximize the wealth of all stakeholders, including stockholders,policy-holders, creditors, and employees.ãTo have a successful ERM process, a company needs to have an effective risk culture, and have thesupport of the CEO and other executive officers, such as the CRO or CFO.ãThe ERM process should include capital modeling tools, and hold high quality and sufficient capital.ãAn effective ERM will have a positive impact, not only on the BCAR but also on Best’s overall ratings.ãIn addition to the traditional ERM, and recent improvements such as dynamic hedging models, aneffective ERM needs to consider the systemic risks that made some insurance companies insolvent inthe recent financial crisis. Introduction The recent financial crisis has raised some questions, such as why enterprise risk management (ERM)was not able to prevent some large insurance companies from either insolvency (for example, AIG) orsuffering large losses of their market value (for example, Lincoln National), and whether rating agenciesproperly perform their jobs. 1 It is critical that insurance companies have effective ERM programs, andthat rating agencies provide adequate ratings to prevent insurance companies from bankruptcy. Initially,many insurance companies adopt ERM because rating agencies consider ERM as part of their rating.Adopting ERM for the sole purpose of fulfilling the requirements of a rating agency may not be the bestpractice. A recent survey conducted by Towers Perrin showed that 32% of companies names identifying andquantifying risk as the main purpose. We believe these companies are moving in the right direction, but moreimprovements to the current ERM process are needed. Effective ERM To have an effective ERM, a company needs to have an effective risk culture. To achieve an effective riskculture, a company needs to start from the chief executive officer (CEO) and other senior executive officers(including the chief financial officer (CFO) and/or the chief risk officer (CRO)).ERM usually involves a process that identifies and assess risks, determines a response strategy andtechniques, and implements and monitors the risk-management program for the enterprise. The objectiveof an ERM program is to maximize the wealth of the stakeholders, including stockholders, policy-holders,creditors, and employees sustainably over the long term. It should be noted that wealth maximization is notequivalent to risk minimization. Risk and return are trade-offs. Insurance companies need first to establishtheir risk tolerance level and minimize unnecessary risk.Some major categories of risk are credit risk, market risk, underwriting risk, operational risk, and strategicrisk. Detailed items for each category of risk can be found in one of Best’s articles. 2 In terms of credit risk,insurance companies should pay special attention to counterparty risk if they hold credit default swaps(CDSs). The recent collapse of AIG provides a good lesson for insurance companies not knowing thecounterparty risk.As a result of recent events such as September 11, 2001, the financial crisis which started in 2008,and major hurricanes in 2004 and 2005 (including Katrina, Rita, and Wilma), longevity issues haveincreased the risk profile of insurance companies. Insurance companies have to take action to deal withthe increased uncertainty and volatility that they face. In addition, the regulatory changes regarding EUSolvency II and principles-based requirements have also resulted in improvements to the traditional riskmanagement programs. Recent developments in ERM include catastrophe modeling, dynamic hedgingmodeling, and an enterprise-wide view of risk for insurance companies. Catastrophe modeling aims to  ERM, Best’s Ratings, and the Financial Crisis2 of deal with the rapid escalation in natural disasters caused by global warming, because it has been moredifficult to predict catastrophic events. While the retirement of the baby-boomer generation presentsopportunities for insurance companies to manage retirement savings, it also creates capital market-basedrisk. Insurance companies havedeveloped some products that guarantee certain returns on the investedassets. The guarantees create additional risks related to capital market performance. To reduce the risk ofthe guarantees, insurance companies have developed and implemented sophisticated hedging models toprotect both the policy holders and the companies against adverse movements in the capital markets. Therecent financial crisis has shown that the hedging programs are far from perfect. Many insurance companieshave suffered from rating downgrades and potential bankruptcy. The new emphasis on ERM today is aheuristic approach, rather than a silo approach. Not only the risk of individual unit, but also the correlationsamong the units, are critical to the success of ERM. More importantly, ERM today should pay more attentionto systemic risk, which can be defined as the risk of collapse of an entire financial system or capital market.One reason for the recent failure of the financial systems is that ERM does not consider the systemic risk. ERM, BCAR, and A. M. Best Ratings There are different rating agencies that rate insurance companies. Among them, A. M. Best is deemed asone of the most important. This chapter therefore focuses on the relationship between ERM and A. M. Bestratings. A. M. Best expects each insurance company to customize its ERM process to their integrated riskprofile and risk management needs in order to maintain acceptable ratings. The ERM process should includecapital modeling tools (such as dynamic financial analysis) to maintain appropriate capital. The process alsoneeds to include a discussion of the impact of the company’s ERM on its rating in its annual meetings.The objective of A. M. Best’s rating system is to “provide an opinion of an insurer’s financial strength, andability to meet ongoing obligations to policyholders.” One of the most important factors of Best’s rating isbalance sheet strength. Best uses the best capital adequacy ratio (BCAR) to proxy balance sheet strength.BCAR is defined as the ratio of adjusted surplus to net required capital (NRC). The main components ofadjusted surplus are reported surplus, equity adjustments, debt adjustments, and other adjustments. NRCincludes fixed-income securities, equity securities, interest rate, credit risk, loss and loss-adjustment-expensereserves, net written premium, and off-balance-sheet. The BCAR formula also contains an adjustment forcovariance, reflecting the correlation between individual components. BCAR is similar to the calculation ofthe National Association of Insurance Commissioners’ (NAIC’s) risk-based capital, but BCAR includes someimportant risk factors that are not considered by the NAIC’s risk-based capital. BCAR can make adjustmentsto respond to various market issues such as rate changes, the stage of underwriting cycles, and reinsurance.It should be noted that more than two-thirds of an insurance company’s gross capital requirements of BCARcomes from the company’s loss reserve and net premiums written. Less than one-third of the gross capitalrequirements comes from investment risk, interest risk, and credit risk. After Best calculates a company’sinitial BCAR, it performs various sensitivity tests including the catastrophe, terrorism stress test.While BCAR is a critical quantitative model to measure financial strength and serve as a consistent baselinefor Best ratings, it is not the sole basis for determining the final ratings. A corporate culture of risk awarenessand accountability in daily operations, operating performance, business profile, and the quality of capitalare also very important considerations for Best’s ratings. ERM has an impact on a company’s financialstrength, operating performance (such as relative earnings and loss-ratio volatility), business profile (forexample, catastrophe and terrorism risk exposures), and the quality of capital. Thus, an effective ERM hasan important impact on the Best rating. An insurance company with a strong ERM can be allowed to lowerits BCAR, compared with another company with a relatively weak ERM. It is even possible that an insurancecompany can keep its BCAR lower than the guideline level, on a case-by-case basis, and vice versa. ERM and the Financial Crisis This section does not intend to examine the causes of the recent financial crisis, but to discuss whetheran effective ERM can mitigate the negative impact of the financial crisis on insurance companies. In theinsurance industry, AIG is now 80% owned by the US government. MetLife and Prudential, among otherinsurance companies, may seek the aid from the government. Why did ERM fail to prevent these companiesfrom near collapse? Here are some possible answers. First, even though the concept of ERM has been  ERM, Best’s Ratings, and the Financial Crisis3 of popular for more than 10 years, insurance companies had not very seriously implemented ERM untilrecently. The current process is not perfect; while it considers the correlations among individual risks, itfails to consider the systemic risk facing the whole financial system, and the counterparty risk of derivativesecurities. To prevent future failures, the ERM approach needs to recognize that the solvency approach maynot be appropriate in a financial crisis environment. Insurance companies need to have more capital thanBCAR requires, because additional capital is difficult to obtain during a financial crisis. Second, CROs needto resist the temptation of selling complex products without really understanding the consequence of sellingthose products. The CDSs of AIG is an example. Finally, insurance companies should focus on their corebusiness, underwriting business, rather than investing in exotic derivatives. Case Study ERM and the Ratings of USAA and its Subsidiaries In December 2008, A. M. Best confirmed it had given USAA and its subsidiaries (hereafter USAA) thefinancial strength rating (FSR) of A++ (superior) rating, issuer credit rating (ICR) of “aaa,” and the debt ratingof “aaa.” The ratings reflect “USAA’s superior capitalization and strong operating results through focusedbusiness and financial strategy.” Diversified sources of earnings, capital accumulation, and strong ERMare also key factors for superior ratings. In addition, good catastrophe management, a sound reinsuranceprogram to preserve the finance capital, and a conservative investment strategy were mentioned. The USAAcase demonstrates that Best’s ratings reflect the effectiveness of USAA’s ERM. Conclusion ERM has been becoming more and more important in recent years. The recent financial crisis makes ERMeven more critical for the success and survival of an enterprise. To have a successful ERM process, acompany needs to have support from the CEO and other executive officers such as the CRO or CFO. TheERM process should include capital modeling tools, and hold sufficient high-quality capital. An effective ERMwill have a positive impact not only on the BCAR but also on Best’s overall ratings. In addition to traditionalERM, and recent improvements such as dynamic hedging models, an effective ERM needs to consider thesystemic risks that made many insurance companies insolvent in the recent financial crisis. More Info Books: ãMoeller, Robert. COSO Enterprise Risk Management: Understanding the New Integrated ERM Framework  . Hoboken, NJ: Wiley, 2007. Articles: ãBest, A. M. “Risk management and the rating process for insurance companies.” Methodology Report  (January 25, 2008).ãKenealy, Bill. “Sifting through the ashes to assess ERM’s value—In a collection of essays, actuariesponder the role of risk management in the financial crisis.” Insurance Networking News  (March 2009).ãMueller, Hubert, Eric Simpson, and Edward Easop. “The best of ERM—A. M. Best’s enterprise riskmanagement (ERM) criteria further confirm ERM as a central tool for insurers to manage their risk,capital and strategic decisions more effectively.” Emphasis  (March 2008).ãMosher, Matthew C., FCAS, MAAA. “Special report: A. M. Best comments on enterprise riskmanagement and capital models.” A. M. Best, February 2006.ãA collection of essays: Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications  . Society of Actuaries, Casualty Actuarial Society, and the Canadian Institute of Actuaries,2008. Online  ERM, Best’s Ratings, and the Financial Crisis4 of Notes 1 In addition, Prudential Financial Inc. and Hartford Financial Services Group Inc. reported losses of morethan $1 billion in the second halfof 2008.2 See “Risk management and the rating process for insurance companies.” Best’s Methodology  (January 25,2008). See Also Best PracticeãBuilding Potential Catastrophe Management into a Strategic Risk FrameworkãInternal Auditors and Enterprise Risk ManagementChecklistsãApplying Stress-Testing to Operational Risk ExposureãEstablishing a Framework for Assessing RiskãUnderstanding and Calculating the Total Cost of RiskFinance LibraryãMastering Risk, Volume 1: ConceptsTo see this article on-line, please visit
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