Good governance a priority: achieving effective corporate governance requires ceding real power to the board.

After two years of corporate scandals--including, most recently, revelations of mutual fund abuses that affect life insurers' fund operations and variable annuity businesses--improving corporate governance has become an urgent priority for all companies. But so far, the focus has been on structural and process changes tied to new regulatory requirements. To achieve truly effective corporate governance, insurers need to view this issue as a strategic challenge. They need to define what good governance really means and what they have to do to attain it. Then, a meaningful, cohesive and effective governance framework can be put into place.

Various definitions of corporate governance have been advanced. From our perspective, effective governance will have been achieved when boards truly represent the interests of shareholders--and when, in exercising that responsibility, they thoroughly review, challenge and oversee the company's business strategy and the effectiveness of its implementation, including, of course, the company's compliance with sound business practices and all laws and regulations. In the end, this mission is built on the board's oversight of the performance of management and the businesses that management runs.

This definition requires more substantive changes to governance processes than yet have been suggested. It calls for challenging strategy, but not formulating it. It calls for assessing and evaluating business performance, but not running the business. And it calls for ensuring the adequacy of controls over the risks embedded in all key business processes, including many critical risks outside the scope of Sarbanes-Oxley.

To attain effective governance as we have defined it, boards of directors must meet three crucial tests. First, they must be informed, engaged and willing to challenge management. Second, they must fully represent shareholders' interests. And finally, they must be focused on the effectiveness of management, key business processes and the performance of the business.

How much progress have we made toward these goals? Clearly, power has shifted to boards, which will now probe deeper into company affairs. The bar has been raised with respect to what it takes to be an independent director, and audit committees have been strengthened. But most companies have not yet separated the roles of the chief executive officer and the chairman--a key test of whether real power has been ceded to the board. Until this happens, effective governance will be an illusion.

While accounting transparency and disclosures have certainly improved, which will benefit shareholders, more needs to be done to protect shareholder interests--for example, by improving the transparency of performance information, aligning compensation with long-term value creation, eliminating conflicts of interest and strengthening the rights of shareholders.

Finally, proper oversight of management and business performance is at the heart of effective governance. And this is where much more tangible change is needed if effective governance is to be achieved.

Bringing about change in these and other areas will require directors to have a deep knowledge of a company's operations and business processes. They will need to be truly independent of management, take responsibility for oversight of the business, and devote much more time to the job than they have committed in the past.

Beyond changing the characteristics of directors, boards as a whole must obtain more insightful information on the business's performance and how management proposes to address any performance issues. They must look closely at the risks the company faces and how those risks are measured and controlled. And they must continually challenge the effectiveness of controls over critical business processes such as underwriting, asset/liability management, distribution and marketing functions, and regulatory and compliance matters.

In the near term, the first priority is to identify and eliminate conflicts of interest. Second, we must quickly demonstrate that there is adequate board oversight in the key areas of executive performance and compensation. Finally, we have to do more to ensure that the products we sell are used for legitimate business purposes, and that the accounting for them by their users is appropriate.

In many respects, the work of in, proving governance has just begun. How CEOs and boards respond to this challenge will determine whether we are headed toward more abuses, more litigation, and more regulation--or the kind of business environment that we all think we've always had: a tough but fair marketplace.

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young, New York. He may be reached at [e-mail].