A Closer Integration of Catastrophe Risk Management and ERM

by John Rollins, Vice President, AIR Worldwide

As enterprise risk management (ERM) continues to gain prominence in the insurance industry, players of all sizes and in all market segments are either launching ERM initiatives or refining current practices.

ERM is a framework for “mapping” (identifying), measuring, monitoring, and managing a wide variety of risks, both independently and in combination. An ERM platform enables a company to analyze enterprisewide costs and benefits associated with various business scenarios and management choices and to translate the results into known measures of shareholder value.

Rating agencies have taken notice because the risks most prominent in ERM are those that materially impact the financial strength of the entity and therefore matter the most when issuing a rating. For insurers, they include:

underwriting risk
asset risk
operational risk
credit risk
catastrophic risk

As a consequence, rating agencies are now beginning to examine and incorporate insurers’ ERM practices as part of their rating processes.

Catastrophic risk is among the most intense threats to solvency for many insurers. Because of the evolution of catastrophe models over the past 20 years, cat risk is also among the most tangible and quantifiable components of the “risk map” used in ERM. A strong cat risk analysis function provides a great foundation for the daunting task of integrating the measurement and management of key risks into an enterprisewide ERM platform.

Cat Risk Management as a Pillar of the ERM Framework

Cat risk is often the single largest influence on the overall enterprise risk profile. Catastrophes are infrequent, severe, and unpredictable — exactly the kind of shocks that define the most extreme outcomes in an ERM analysis. In statistical terms, cat risk greatly expands the “tail” of the enterprise risk profile (distribution of net worth) over any significant time horizon and drives the volatility of a company’s earnings and capital.

What’s more, the interactions between cat and other key risks in the ERM map — such as operational stress on claims handling, processing, and financial reporting systems; regulatory actions following events; and asset risks associated with timing of liquidations — all tend to amplify the overall impact of catastrophes on an organization. This “positive correlation” means cat risk can shake up the enterprise risk profile even more when you integrate it with other risks in ERM. A company must measure and manage cat risk both independently and jointly with other risks to maintain a credible ERM process and stable financial strength ratings.

How Are Rating Agencies Handling Cat Risk in ERM Evaluations?

Standard & Poor’s considers extreme-event (cat risk) management one of three pillars in an insurer’s ERM framework and is using cat risk management practices as one of five criteria for classifying an insurer’s ERM capabilities as excellent, strong, adequate, or weak.

Fitch’s Prism model directly incorporates cat modeling results from AIR’s CATRADER® product — both in isolation and through correlation assumptions with the other risks modeled in Prism — into its quantitative relationships that determine estimates of economic capital. This formalizes the connection between ERM and cat risk management practices.

Finally, A.M. Best has made major changes to its Supplemental Rating Questionnaire that more robustly address cat risk. Quantification is expected of the Tail Value at Risk (TVaR, statistically the average of simulated annual losses beyond a given severity threshold), in addition to the historical statistics of Probable Maximum Loss (PML, percentile of the annual loss distribution) and Average Annual Loss (AAL). Further, there are new detailed questions about the attributes of the exposure data and analysis options used in the cat risk evaluation, both of which materially affect the results.

Effectively Communicating Catastrophe Risk Management Capabilities in an ERM Assessment

Rating agencies expect a detailed explanation of the data, assumptions, and models used to measure cat risk. They also want an indication of the enterprisewide human capital and financial structures devoted to cat risk management and assurance that measurement and monitoring are continuous rather than piecemeal or periodic. Insurers should demonstrate that the use of cat models is both pervasive (with its results incorporated into scoring and decision making in each business unit) and ongoing (with its results used to frequently update the targets and tolerances used in those decisions).

Language and framework are important when communicating cat risk management practices. The evolution of basic model outputs and statistics (such as average annual losses and exceedance probabilities) into today’s sophisticated measures (such as TVaR and marginal contributions to portfolio PML) has been sanctioned by the rating agencies as they push for more complex disclosure and discussion of these outputs. The insurer must demonstrate not only its capability of producing and using these measures, but an understanding of why they are useful and the implications of these signals for enterprise risk management actions.

Conclusion

Ultimately, ERM is all about making the right decisions — both daily and strategically over time. By embedding both ERM and cat risk management practices into every aspect of business, insurers are positioned to achieve better and more stable financial results — and with that, greater confidence of both owners and external stakeholders.

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