Assessing real risk: realistic risk management requires more than traditional financial reporting and risk measurement techniques. (Property/Casualty: Loss/Risk Management Insight).

Capital is scarcer than ever. Depressed financial markets, catastrophic events, rising costs of guarantees and options, deferred acquisition cost write-offs, concerns over reinsurance security and corporate scandals in the financial community have taken their toll on the insurance industry. The result is share price volatility as the industry suffers relative to others.

Meanwhile, shareholders are demanding a premium to reflect higher agency costs associated with investing their monies in the industry, which is complex and not known for transparency. This pressures senior management to ensure that financial management methods are in place to optimize returns on capital employed commensurate with the risks taken--from insurance, credit and market risks to operational and strategic risks.

Increasingly, investors and regulators are focusing on value creation, efficient capital allocation and risk management. Insurers are seeking ways to quantify the potential impact of risk exposures rather than to simply identify risks. Realistic risk measurement and management are key areas that companies must integrate to move toward fact-based decisions in line with the economics of organizations.

Traditional financial reporting and risk measurement techniques are no longer sufficient for realistic risk measurement. Some argue that accounting approaches like GAAP, with its focus on matching income and expenses, miss the dynamics of the business. In contrast, the latest trends in performance measurement stress the need to consider the economic value of the business and put more weight on valuation of assets and liabilities.

Underpinning the economic approach is the practice of measuring assets and liabilities consistent with their market value--a much easier task for most assets with observable market prices than for insurance liabilities, where there is no deep, liquid market. However, consistency between the valuation of assets and liabilities is key to applying a new risk measurement framework.

Market-value techniques for measuring liabilities range from exit values to entry values to option-pricing techniques. One theme is common: the need to project all future cash flows on a best-estimate basis with appropriate adjustments for risk and discounting these cash flows to their present value.

The economic-value approach offers new insights into risks inherent in a portfolio, enabling companies to gain a competitive edge. For example, asset-intensive products may show less favorable results at issue as well as volatile profit emergence. Embedded guarantees and options may be considered more costly as their true economic value is uncovered and long-tailed casualty liabilities may be viewed differently once effects of discounting are balanced against adjustments for risk and uncertainties.

Decisions must be made to define the methodology and tailor the realistic risk measurement framework to a company's needs. These include defining the risk universe, identifying diversification benefits, and aggregating and allocating risk capital. Also, special consideration is required in treating stranded capital due to regulatory, statutory accounting or rating agency requirements, double taxation and agency costs. Profit measures have to be selected as well as overall reporting format and level of detail.

Once the framework is in, its real power becomes apparent as companies understand the levers they need to pull to optimize profitability. The framework should positively influence the behavior of those writing and managing risks within the company. Therefore, executive compensation schemes should be designed to reward optimal performance and ensure accountability for risks taken.

Some insurers, especially in Europe, are more advanced in applying value-based concepts such as embedded value. All European Union-listed companies will be required to report under International Accounting Standards by 2005 which, longer term, will likely require fair value for insurance contracts. If U.S. insurers don't act to understand the effects of such measurement frameworks, they risk being outflanked in an increasingly global, competitive marketplace.

Widespread benefits are possible from implementing a realistic risk measurement framework: the ability to optimize return on capital employed, increase the efficiency of capital structures, have a sharper focus on new business value creation, and gain a better understanding of remote possibilities. These lead to improved management of risks. But inaction can lead to inefficient deployment of capital culminating in an onerous cost of capital, ill-informed decision making, poor product and business-line performance and reduced investor confidence.

Doug French is global director of Insurance and Actuarial Services and Emma McWilliam is a senior manager in the Insurance and Actuarial Services practice at Ernst & Young. They can be reached at [e-mail] .