Turning Risk Into Reward.

Good enterprise risk management includes a company's vision, strategic plans, financial objectives and tolerance for risk.

Intensifying competition, consolidation, globalization, financial-services convergence and e-commerce are driving change in the insurance industry today. At the same time, the foundations of many companies have been shaken by poor financial results related to lack of focus, aggressive pricing, liberal contract terms, poor due diligence of business partners and inadequate understanding of product dynamics. These circumstances have left many wondering how to design and implement a successful strategy for growth and profitability.

Long-term success is achieved when products are appropriately priced, capital levels are sufficient but not excessive and management understands and has confidence in its financial forecasts. Enterprise risk management is a vital component to achieving these results. When properly executed, enterprise risk management incorporates the essential elements of the company's vision, strategic plans, financial objectives and tolerance for risk. An organization can turn risk into reward by implementing the following eight-step process.

Step 1: Incorporate risk management into organizational values.

The values of an organization define its beliefs and what it considers important. Values form the base upon which the vision, strategies and objectives are established. By incorporating a specific statement that clearly reflects the organization's commitment to risk management, stakeholders will begin to recognize its importance.

Step 2: Support values with actions.

Commitment requires both articulation and action. Repetition is vital to developing new habits and deriving the frill benefits of risk management as a value. Therefore, senior management must look for opportunities to articulate the importance of risk management. Since actions speak louder than words, they need to support their commitment by:

* hiring and developing the talent needed to perform risk-management functions;

* ensuring the availability of appropriate tools to measure and monitor risk; and

* dedicating the time needed to perform risk-management functions.

Step 3: Identify and create a unique competitive advantage.

Every company is challenged to manage growth and profitability without taking excessive risk. An organization cannot focus on one aspect and ignore the other without increasing exposure to risk. The best organizations identify and create a unique competitive advantage that enables them to balance the growth/profitability challenge.

Identifying a unique competitive advantage requires a thorough assessment of internal and external influences and visionary thinking. A company must examine and question everything it does and be willing to reinvent itself. This is a time-consuming process, and most companies willing to make this commitment find that outside resources are best at facilitating a successful process. Once identified, the senior leadership must perform a "full-court press" to develop the concept into reality. Because of the quickly evolving nature of the market, anything less may result in a watered-down version of the envisioned concept.

Step 4: Ensure that pricing is consistent with anticipated practices.

To successfully implement this step, a company must start with high-quality information regarding expected experience and marketing and administrative practices. Although it goes without saying that pricing should reflect anticipated experience and business practices, unrealistic assumptions often are used to achieve the appearance of meeting corporate pricing targets. The product-development team should research or have direct representation of the key functional areas to ensure that pricing reflects practices.

Often compounding inappropriate assumptions is a lack of sensitivity or stress testing to get a firm grip on product dynamics. By making full use of the tools and techniques available today, management can significantly improve its understanding of profitability and product behavior. With this understanding, an organization is well-positioned to develop strategies for mitigating unacceptable risk exposure.

Step 5: Analyze and implement specific strategies.

After unacceptable levels of risk exposure have been identified, strategies to reduce risk to a tolerable level can then be tested. Common risk-management techniques include reinsurance, hedging strategies, portfolio modifications and risk-sharing contracts with business partners.

An important part of developing these strategies is a thorough examination of risk from a macro perspective for the following reasons:

* A macro perspective gives consideration to correlations that increase or reduce overall exposure.

* Understanding the correlation of risk elements will help identify natural hedges that may exist in other areas of the organization.

* The corporate appetite for risk can be significantly greater than for an individual business unit, so it may be possible to structure internal risk-transfer programs reducing business unit risk and costs.

Step 6: Develop monitoring systems for early warning.

Every organization needs to understand emerging experience and sources of profit to achieve long-term success. Maximum value can be derived by identifying and measuring the key drivers of profitability and implementing practical and useful management reports. Management can significantly improve its understanding of these items with a simple comparison of these key drivers with pricing assumptions. Without this information, appropriate corrective action cannot take place in a timely manner. Important considerations for developing effective monitoring systems are:

* Information must be of high quality. Inaccurate, incomplete or delayed access to information dilutes its usefulness and may lead to incorrect decisions.

* The reporting process must be regular and timely. Management cannot take appropriate action if reporting takes place on a sporadic or delayed basis.

* Reports must be understandable to be useful to the decision maker. They should be designed to be user-friendly. Too often, the reports consist of a table of numbers requiring complicated explanations regarding their content and meaning.

Step 7: Perform periodic peer reviews.

A periodic review, audit or assessment of pricing practices and risk-management procedures by a third party can add significant value. This review might be performed by a team from another part of the company or an outside party familiar with the process. The goal and value of peer review are to improve risk-management procedures and transfer best practice information. A secondary objective should be to uncover problems that may have gone undetected. When approached in this manner, a healthy dialogue and learning process can take place.

Most companies lack the necessary resources for a thorough and timely review. Using an outside party for a peer review provides an independent perspective and usually can get the job done more quickly and without perceptions of hidden agendas. Knowledge transfer can be accomplished by using the results in teaching sessions or in the formation of new policies and procedures.

Step 8: Communicate.

The last step, which truly permeates all aspects of sound risk management, is effective communication. Communication is the glue that keeps an organization working together. This starts with senior management, who must ensure that values, vision and strategies are articulated and understood. Pricing, risk management and support staffs also must communicate effectively with management. This is achieved through timely, accurate and complete reporting on assumptions, testing and results. Hidden cushions or conservatism in assumptions serves only to mislead management. It is important that the culture not penalize those who come forward with questions, concerns or bad news. A culture that encourages information exchange and disclosure, recognizes that mistakes will be made and does not look to place blame will develop a healthy attitude toward sharing both good and bad news.

By following these steps, an organization will have an excellent understanding of product behavior and risk. In addition, the organization will develop management and planning tools that will facilitate the achievement of long-term objectives, competitive advantage and, ultimately, success.

Tim Tongson is a consulting actuary in Milliman & Robertson's life practice in Minneapolis.