Solvency II and Risk Management

Part 1: The Principles and Benefits of Risk Management

Part 1 | Part 2 | Part 3 | Part 4

The importance of good risk management
In the past many insurance companies have paid scant attention to Operational Risk, yet operational failures often provide the decisive factor that renders an insurer insolvent. In the UK, analysis by the FSA into insurer failures across the world found that, in many cases, losses caused by adverse claims or market changes were exacerbated by operational failures.

Solvency II aims to create a more realistic measure of solvency capital requirements based on all the risks an insurer faces, including all categories of risk and in particular bringing in the effect of operational risk. It will be a principles-based regime, which moves away from the approach of the regulator telling each insurer what to do and, in effect, encourages each insurer to implement good risk management practices in the way that is most appropriate to that individual firm.

As we explain below, the benefits go well beyond regulatory compliance. Good risk management will make your company more profitable and more competitive.

What is risk management and what does it mean for insurers?
Risk management is the ‘glue’ that links running the business with the capital that backs it (See Figure 1). It is about understanding the nature (causes, effects and likelihood) and scale of risks faced by a company. To be successful, risk management must become integral to the strategic planning of an organisation, to its day-to-day operations and to its capital modelling and actuarial practices. 

Business planning involves an assessment of the risks a company will face as a result of its plans. Defining the approach to ongoing assessment, mitigation and management of these risks will be integral to the success of the plans. Equally, quantifying the cash-flow and capital implications of the plans will require an estimation of the potential risk impacts. As a result of this analysis – or of the actual results through the operation of a business cycle - the business plans may need to be adjusted. For instance, the financial reward may end up lower and/or the capital required may be higher than acceptable.

Understanding the firm’s risk appetite is intrinsic to this process - the key weapon in its armoury. The risk appetite should reflect the business opportunities in the business plan and, therefore, its perceived sources of competitive advantage; its analysis of the types and level of risk to which it is exposed; and its ability to manage those risks. 


What does ‘best practice’ risk management look like?

Best practice risk management will have some key features wherever it is implemented. It will be:

• Governed by strategies, policies & processes set by the Board. The Board should set the risk strategy, aligned to the overall business strategy and covering the planned risk profile of the business and the approach to managing those risks. From this, risk policies and processes should be developed, which support and reaffirm the risk strategy.
• Set in a clear internal controls framework. The Board should also be responsible for setting this control environment. This does not mean the Board should write the control manual, but it should be responsible for creating – and ultimately for signing off - the control framework.
• Underpinned by corporate culture. Good risk management relies on a culture of quality and risk awareness throughout the organisation. The tone of the culture is set by the Board, who must lead by example. Only if the ‘right’ behaviours are visible from and encouraged by senior management will they happen in the front line.
• Reflective of the size and complexity of business. For risk management to be an enabler for the business, rather than a straightjacket, it must be appropriate to the level and types of risk it faces - it should match the characteristics of the business. A small, single-site motor insurer will not require the same level of risk management as a large, multi-line, geographically-spread conglomerate.
• Owned “locally”, to ensure a dynamic and flexible approach. If risk management is to be effective, it must be owned, monitored and managed at local level within the business, which means it becomes part of the normal business processes and management. Without this ownership, it will become little more than a ‘tick-box’ exercise.
• Supported by quality data and information. Risk management can only be effective if the information used for decision-making is available when needed, accurate, and complete.

The benefits of best practice risk management

A robust risk management framework has many advantages beyond regulatory compliance. These include:

• Improved management of risk and capital. Effective risk management enables business outcomes to be more predictable and stable, which in turn leads to a less volatile capital position.
• Closer alignment of organisational goals. Allows an enterprise-wide understanding of business risks, informs the planning process and ensures the key objectives are consistent across the whole organisation.
• Increased transparency. A well-designed and defined risk management framework will improve the transparency of roles and responsibilities, making clear who is responsible for what, identifying areas of overlap and gaps, which will also improve business efficiency and overall quality.
• Competitive edge for successful insurers. By designing and implementing a framework that enables better identification and management of risks, an insurer will understand which types and sources of risk can be opportunities to improve business performance – either by enhancing revenue or reducing costs or capital - which will enable it to better identify and sustain its sources of competitive advantage.
• Improved product development and pricing. A greater understanding of the insurer’s risk profile can help to create better – and more profitable – products. A better understanding of risk pricing and capital requirements enables more accurate pricing decisions to be made.
• Greater visibility of business drivers. An improved assessment of risks and rewards will provide greater visibility of the real drivers of business value, creating an environment for better planning and decision-making.

 

Part 1 | Part 2 | Part 3 | Part 4