Harnessing the Elusive Risk Factor.

Enterprise risk management focuses on overall risk exposure of a company to determine the capital needed to support it.

Chief executive officers, underwriters, actuaries and investment professionals are nearly unanimous in describing their critical decisions as evaluations of return relative to risk. But if risk and return are the two critical variables in insurance decisions, in practice only one of them gets much attention.

Over a given year, of the numerous meetings, memos, reports and computer printouts generated by a typical insurance firm, nearly all focus on return, defined as earnings, measuring past earnings, forecasting future earnings or budgeting target earnings. For most insurers, the key variable that is analyzed and managed is earnings, the numerator in return on capital or return on surplus.

The reason: Earnings are measurable, whereas risk is elusive. Dollars of earnings are easy to imagine, discuss and compare. But we lack a common language or measure that can be applied to different risks. The question of how much risk a firm is taking appears to be an imponderable, unanswerable question that the industry has dealt with by adopting rules of thumb, such as premium-to-surplus ratios or, more recently, risk-based capital measures.

But this is changing with a new way of thinking that focuses on measuring and managing the overall risk exposure of a bank, an insurer or a nonfinancial corporation. This way of thinking, called enterprise risk management, began in banking as that industry attempted to create a level regulatory playing field across international boundaries. Since banks in countries with weak regulations would otherwise have a competitive advantage, the industry sought consistent international standards regulating the amount of capital that banks must have.

This decade-long effort had three consequences of profound significance for all firms:

* agreement on a crucial principle underlying international banking regulation: the amount of capital a bank must have should be proportional to the amount of risk it has assumed;

* development of a new set of concepts and methods for talking about and measuring different kinds of risk; and

* bankers' active use of these concepts and measures to manage their business. Like insurers, they focus on expected return relative to risk exposure. But unlike insurers, they focus on managing the denominator--risk--and the capital required to support it, rather than on the numerator.

These new concepts and measures of risk have come to permeate every aspect of a major bank's activities. Consider how this knowledge is being applied at a major international bank. At 4:15 every afternoon, the CEO of this bank receives a report telling him the bank's profit or loss during the preceding 24 hours and its current exposure to various risks, categorized by type and source. His staff uses this information to determine the amount or capital me bank needs to support those risks and what actions should be implemented to alter the firm's total risk exposures so that the needed capital matches the bank's actual capital. On the trading floor, analysts are studying a complex derivative security the bank owns by testing its behavior under thousands of possible market scenarios. They will use the results to assign a capital charge to the security that is proportional to its risk. Nearby, a banker is proposing a transaction that will protect a client's income from adverse changes in the exchange rates of five different countries where its product is sold. If successful, the transaction will enable the client to increase its credit rating, reduce the cost of its debt and increase its return on equity.

At the heart of each of these typical activities lies a relatively new, highly sophisticated quantitative discipline for pricing, measuring and managing financial risk. This discipline, financial engineering, approaches complex risks by analytically breaking them into more fundamental units that can be measured, priced and recombined.

Inventing a way to measure something can have profound consequences. To safely reach their destinations, ship captains always have needed to know and manage both the latitude and the longitude of their ship's location. Until the 18th century, though, only latitude could be measured precisely, a fact that resulted in numerous shipwrecks. It took John Harrison, a British inventor, to develop a clock precise enough to enable navigators to measure longitude for the first time. This eventually gave British ships an enormous competitive advantage and enabled Great Britain to become master of the sea and a global empire.

Like Harrison's invention, the concepts and tools of enterprise risk management offer a way to measure something that has heretofore proven elusive. If appropriately adapted to our own industry, these concepts and tools can become as valuable for us as they have been for bankers as we navigate our way through an increasingly complex and turbulent economic and regulatory environment.

William H. Panning, a Best's Review columnist, is senior vice president of Willis Re Inc.