Welcome to this August edition of the Insurance Market Update, in which we focus on issues in the life insurance industry. Insurers are in the midst of major development work driven largely by the continuing development of Solvency II.
Measuring and managing risks is at the heart of Solvency II. A key factor to successfully achieving this is for insurance companies to encourage and embed risk-related behaviours across the organisation. This is treated under the Risk Based Performance Management ("RBPM") framework which we will cover in this month's publication.
In his article, Matthew Cox analyses the key steps insurance companies need to cover in implementing the RBPM framework. He then addresses some of the main challenges facing insurers in its design and implementation. Finally, he gives some suggestions on how to derive value from the RBPM framework and how it will interact with the different areas of risk governance.
We hope you find this edition informative and, as always, your comments and suggestions for future themes or topics are welcome.
Rabih Gemayel
Interim Editor
ragemayel@deloitte.co.uk
RISK BASED PERFORMANCE MANAGEMENT
By Matthew Cox
Insurance companies face a plethora of new risk governance requirements, not least from the European Commission (EC) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and their continuing development of Solvency II. The forthcoming regulations are likely to require widespread changes to the way an insurance company approaches and deals with risk within its operating model.
One of the over-arching intentions of Solvency II is to offer insurance companies incentives to measure and better manage their risk situation. As well as more detailed reporting of risk information, it is expected that an insurance company will need to demonstrate that it encourages and instils the right risk-related behaviours across the organisation.
What is Risk Based Performance Management?
A risk based performance management ("RBPM") framework enables the performance of an organisation, its business units, products or individuals to be assessed relative to the economic effects of risk taking activities.
Regulators and external stakeholders such as rating agencies are increasingly interested in seeing how insurers consider risk in the planning and management of their business on a day-to-day basis. They want to see that organisations understand the risks that they face, are aware of the interaction between risk and capital, factor this into decision making and measure performance against targets aligned with risk appetite.
What will Insurers Need to do?
There are three key steps in the development of an RBPM framework:
- Define Risk Based Performance Metrics
Risk based performance metrics are required in order to support RBPM. The choice of metrics will be influenced by theoretical, practical and cultural considerations. In defining the risk based performance metrics an organisation can choose ratio or nominal metrics. Ratio metrics compare the relationship between two measures, one of which should be risk based. For example, the ratio of International Financial Reporting Standard (IFRS) profit generated by a business unit compared to the risk based capital the business unit utilises. An example of a nominal metric would be the amount of risk based capital a business unit requires. - Set Metric Targets and Embed in Performance Management
Processes
Organisational, business unit, product and individual risk based performance metric targets should be set, based on risk appetite. These then need to be incorporated into a balanced scorecard which is clearly linked to reward and contains both quantitative and qualitative assessments of performance. - Measure and Report Performance
Risk based performance metrics should be calculated and reported with sufficient frequency along with qualitative factors to support a meaningful assessment of organisational and individual performance.
What Are the Key Challenges an Insurer Will Face With the RBPM Implementation?
Insurers will face a number of challenges achieving a well designed RBPM framework. These challenges will include:
Design Challenges
- Deciding which risk adjusted performance metric or metrics are the most appropriate for assessing performance at different stages in a business's life cycle (e.g. IFRS, cashflow or value based metrics). The performance of an insurance company will have many different drivers ranging from investment returns to new business pricing and marketing. Therefore, to provide a meaningful assessment of the performance of an organisation a range of risk based performance metrics will be required to measure the different sources of performance.
- Determining the organisational and managerial levels in the organisation which are assessed using risk adjusted performance metrics and developing appropriate performance scorecards and individual objectives.
- Ensuring that the chosen risk adjusted performance metrics are 'future-proof' given the potential changes to IFRS insurance accounting and the calculation of Market Consistent Embedded Value (MCEV).
- Determining how shared-services and non-profit generating units which incur significant operational risk as opposed to insurance and investment risk are included within the RBPM framework.
Implementation Challenges
- Obtaining the information required to calculate the risk adjusted performance metrics in a timely manner and at the desired frequency.
- Implementing appropriate data accuracy and management standards.
Cultural Challenges
- Ensuring sufficient executive and management understanding of the RBPM framework to enable them to understand how their actions will be assessed.
- Embedding the use of the RBPM framework into existing performance assessment and the ongoing management of the business and related decision making processes.
What Are the Possible RBPM Options?
There are a range of RBPM options depending on the insurer's ambition level and appetite to invest.
The more complex the RBPM is, the greater the design, implementation and cultural challenges the insurer will face. Consequently, a trade-off arises between developing an RBPM framework which, for example, assesses performance at an organisation-wide level, versus an RBPM framework which assesses performance at a more granular level in the organisation and, hence, is a core tool for the management of business units and products.
How Can Insurers Derive Value From RBPM?
Although a primary driver will be to address the developing regulatory expectations, the development of an RBPM framework to support the implementation of Solvency II provides a number of strategic opportunities for firms to:
- Improve the effectiveness of risk management by encouraging behaviour in-line with organisational risk appetite.
- Improve investor relations through the voluntary provision of higher quality quantitative and qualitative risk information.
- Improve rating agency relationship through the voluntary provision of consistent risk information and demonstrating that the organisation understands and manages key risks.
- Provide management information supporting a more complete view of the performance of the organisation.
- Provide management information to support and subsequently evaluate key business decisions.
How Does RBPM Link to Other Risk Governance Areas?
The development of an RBPM framework is an integral component for the successful implementation of a wider risk governance enhancement programme. As such, an RBPM framework will both rely upon and support other areas of organisational change taking place within an insurance company seeking to address the developing requirements for dealing with risk within its operating model.
Conclusion
RBPM provides the means to align management's actions and behaviours with an organisation's risk management objectives, driving and protecting shareholder value. This makes RBPM key to success in the transition to Solvency II as well as being a powerful tool in the effective management of an organisation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.