The right focus? Emerging approaches to measuring risk and managing capital enhance solvency. Will they do the same for shareholder value?

In response to growing concerns about life insurers' risk management practices, regulators and rating agencies are developing new risk and capital models and increasing their emphasis on sound risk-management principles. This is a positive development for the industry, and it will formalize the risk management culture that many insurers have been adopting.

However, emerging regulatory and rating agency approaches to risk and capital management contain an inherent and understandable bias toward the concerns of policyholders and debt holders. This may limit their usefulness for creating shareholder value, a key objective for publicly owned insurers. In adopting a risk and capital management framework geared toward that goal, insurers face these challenges:

Accommodating Different Organizational Approaches. Rating agency discussions suggest a strong bias toward a centralized risk-management function with the power to influence decision-making throughout the company. While some degree of centralization may be needed to assure consistent adoption and independent oversight of risk functions, the implied involvement of the chief risk officer in line decision making may not be desirable. The assumption and management of risk are core elements of all insurance company activities. Therefore, making the operating areas accountable for understanding and controlling the risks would be preferable, since this is where the principal business risks are accepted and managed.

The Role of Risk Limits. Rating agencies are understandably concerned with the methods used to establish, monitor and enforce risk limits. But many companies lack sound practices for setting risk limits, and many more lack the systems needed to enforce the risk limits they have set. More challenging is the notion that the insurer's risk limits in specific businesses or product lines must be aligned with its overall corporate risk appetite. Few companies have defined their risk appetite, and even fewer have the discipline to consistently cascade risk sub-limits to business traits or product lines that "roll up" to corporate limits. Insurers should be cautious about tackling a process that depends on subjective assumptions about risk distributions and their correlations.

Risk Versus Reward. More problematic is the regulatory and rating agency focus on limiting risk taking without considering the price/reward received for assuming the risk. Enforcing risk limits that are not modified by return expectations could lead to sub-optimal performance as the company rejects risks that exceed absolute limits even though they are priced to provide adequate risk-adjusted returns. The wholesale adoption of a creditor perspective for managing risk may not be appropriate for investor-owned companies.

Emphasis on Solvency-Based Capital Models. The regulators' and rating agencies' focus on measuring economic capital is driving insurers to develop their own solvency-based capital adequacy models to drive decision making at the business-unit and product level. Is the pressure to use these measures at ever more granular levels desirable, given the highly subjective nature of these processes? And is the solvency-based model for risk measurement, capital allocation and pricing consistent with shareholder objectives?

Economic capital and risk-adjusted profitability measures depend on highly judgmental and sensitive assumptions about experience and the correlations between various risk sources such as interest rates and policyholder actions. While these models generate valuable insights, their absolute measures should be used with care. This is recognized by regulators and rating agencies in their "calibration procedures" for establishing capital guidelines.

Management should be equally wary about using fully diversified capital measures and product allocations for managing business-unit capital levels and pricing products. Already there is evidence that fully diversified capital measures and allocations to products are leading to weaker capital levels and lower prices. Both actions have the potential to significantly reduce consolidated capital and earnings levels despite meeting fully diversified risk-and-return targets.

Also, as noted, the solvency-based capital measures used by most companies at the urging of regulators and rating agencies focus on risk from the creditors' perspective, not the shareholders'. These creditor-oriented models ignore many risk events that could harm shareholders, such as a ratings downgrade or a loss of investor confidence. Once solvency is protected, risk measures that look at earnings volatility and value-damaging events may be a more appropriate focus for management.

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young. He may be reached at [e-mail]. Richard Goldfarb of E&Y contributed to this column.