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monitoring aggregate catastrophe accumulations and placing We also provide an extensive guide to the implementation
facultative reinsurance than casualty exposures. RM and issues faced by firms that implement enterprise risk
Underwriting need to ensure that adequate consideration is management. There has been a dramatic change in the
given to stress scenarios intended to mirror the probabilities role of risk management in corporations.
and correlations underlying the risk capital calculations,
especially as respects individual subsidiary legal entities. Twenty years ago, risk management often denoted the
tasks associated with the purchase of insurance. Treasurers
Risks in the underwriting "cycle": Price levels in non- also performed risk management tasks, but they focused
mostly on hedging interest rate and foreign exchange risks.
life insurance tend to move in multi-year cycles as the result
of varying levels of industry capital, economic outlook, Over the last ten years, corporations have taken into
competition and similar considerations (refer Figure no. 1 account additional types of risk. In particular, they started
below). Theoretically, an actuarially correct price for each to pay much attention to operational risk and reputation
account can be consistently determined based on desired risk. Most recently, strategic risks have been added to the
ROE and anticipated loss trends. Actual prices, terms and panoply of risks considered.
conditions will deviate from the actuarial price based on
marketplace conditions. More and more, the risk management functions are
directed by a senior executive with the title of chief risk
officer (CRO) and the role of the board in monitoring risk
measures and setting limits for these measures has
increased at many corporations.
Figure no. 1 A corporation that chooses to manage risks can do so in
two fundamentally different ways: it can manage one risk
Increased risk results from a failure to systematically at a time, or it can manage all of its risks holistically. The
measure deviations from the actuarial price and to fully latter approach is often called enterprise risk management
recognize such deviations in current financial results, (ERM). In this article, we argue that firms that succeed at
particularly during times when marketplace pricing is less ERM have a long-run competitive advantage over those
than the actuarial price. RM needs special attention that that manage and monitor risks individually.
actual pricing, terms and conditions are monitored and that
loss reserves and current financial results reflect deviations Our argument is that, by measuring and managing its risks
from actuarial pricing. systematically and consistently and by aligning the
incentives of employees to optimize the tradeoff between
Risk capital is required for uncertainty in this measurement risk and return, a firm increases sharply the odds that it
due to the increased risk of understated loss reserves and will be able to achieve its strategic goals.
added volatility as a consequence. We explain how
enterprise risk management creates value for shareholders. In the following, we first explain why ERM creates value
In contrast to the existing finance literature, we emphasize for shareholders and gives firms a competitive advantage.
the organizational benefits of risk management. We show We then describe how ERM should be implemented. First,
how a firm should choose its risk appetite and measure risk we explain how a firm should choose its risk appetite.
when implementing enterprise risk management. Second, we show how it should measure risk.
Third, we discuss the mechanisms that allow the firm to
take and retain the risks that create value and lay off the
others. Though ERM is conceptually straightforward, its
implementation in practice is not. We therefore provide an
extensive guide to the most important difficulties that arise
An idea can turn to dust or magic, depending on the talent that rubs against it.
14 June 2015 Life Insurance Today
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