ERM report card: does Enterprise Risk Management really deserve all the attention it's been getting?

Ratings agencies have embraced it, conferences are focusing on it, consultants are offering to help you implement it, journalists are writing about it and professional associations are offering courses on it. Does Enterprise Risk Management really warrant all this attention? Here's a primer on its potential value to insurers.

ERM focuses on managing a firm's total risk in order to maximize the firm's value. For an insurer, firm value has two components. The first is adjusted current surplus: the firm's net worth (or surplus) adjusted for differences between book and economic value. Adjusted current surplus reflects past decisions; it's what the firm would be worth if it never wrote another policy and instead went into runoff.

The second component, franchise value, reflects future profits the firm is likely to generate as a going concern. In calculating franchise value, future profits are adjusted for the time value of money as well as for the firm's survival probability--its ability to avoid extreme losses that would impair its profitability or survival. For publicly-traded firms, franchise value is reflected in the difference between their market capitalization (stock price times shares outstanding) and their adjusted current surplus. Maximizing a firm's value means maximizing its franchise value, which is the only value component that can be managed. Yet, in most firms franchise value is invisible, since it is not measured or reported.

ERM quantifies a central issue in managing franchise value: the trade-off between profits and risk. Insurers can fail to maximize their value in two ways: by taking too little risk, and thus generating too little income relative to their capital; or, by taking too much risk, boosting income but making future profits more vulnerable to interruptions from extreme losses. ERM, properly applied, makes this trade-off explicit and enables a firm to estimate the particular combination of risk, capital and reinsurance that maximizes its value.

To measure and maximize their value, firms must be able to measure and manage their total risk, which includes risks pertaining to underwriting, reserves, bonds, stocks and receivables, all measured so that they can be compared and combined. This is a major challenge for most firms where actuaries, underwriters, credit analysts, and investment managers all use the term "risk" to mean quite different things, measured (if at all) in incommensurable units.

ERM establishes a common measure of risk so that different types of risk can be readily compared. This makes it possible for a firm to determine how much it is being paid to take different types of risk, and to decide whether and how it should alter the composition and magnitude of its total risk so as to maximize its value.

What's new and exciting about ERM is its focus on managing risk (and not just income) as a means of enhancing a firm's value, its insistence on measuring risk in ways that can be compared and combined, and its emphasis on managing a firm's total risk rather than the piecemeal risks that comprise it.

Rarely mentioned, though, is the fact that ERM is a very young discipline that is still evolving. This has important implications:

* First, because it requires statistical measurement of risk, ERM thrives on data--lots of it--as well as on risk measures and ways of combining them that have been thoroughly explored and are widely accepted. In fact, the availability of relevant data varies widely, from firm to firm as well as from one functional area or line of business to another. And there is little consensus either on risk measures or ways to calculate total risk.

* Second, ERM needs a group of professionals with appropriate skills. Professional societies and universities are beginning to develop relevant training programs. But at present, it is rare to find individuals who are statistically adept and experienced in analyzing and combining underwriting risk, equity risk, interest rate risk and credit risk.

* Third, ERM needs firms who embrace its vision and are committed to creating the internal infrastructure it needs.

At this stage in its evolution, ERM is a lot like the Model T Ford, which was initially produced at a time when there were few paved roads and almost no gas stations or repair shops. But the ModelT thrived nonetheless.

Just as the ModelT ultimately transformed American life, ERM can bring about a permanent and valuable change in the way insurers do business--provided they are clear about what it can do now, and what it can do when an adequate infrastructure is built for it.

William H. Panning, a Best's Review columnist, is executive vice president at Willis Re Inc. He can be reached at [e-mail].