What are the Challenges facing the Risk and Insurance Sector?
The challenges facing the risk and insurance sector should be set against the background of the past decade and a half. One phrase that could describe this period is ‘sweeping change’. Some of the features of this period that pose challenges to the risk and insurance sector are financial deregulation, the new markets that have opened up as a result of globalisation, the new economy boom (which was right sized), the spread and reach of the Internet, and an increased uncertainty resulting from terrorist threats and public health crises such as avian flu.
Traditional risk management is characterised by a highly disaggregated method of managing a firm’s risks. Under this approach various categories of risk are managed in separate units within the firm. However, demand is growing for a more holistic risk management approach that enables better risk quantification and analysis in view of the broader scope of risks arising from globalisation, industry consolidation, deregulation, increasing regulatory attention to corporate governance and technological progress.
Globalisation and financial deregulation have created a new set of opportunities. They have led to responses such as industry consolidation, outsourcing and convergence of services in financial institutions across banking, insurance and investment. These changes have increased the complexity of financial institutions necessitating a more integrated approach to risk assessment and management.
Emerging markets have opened up immense opportunities for investment in industry, services and financial markets. These markets are, however, fraught with risks such as fraud risk as well as risks arising from the piracy of ideas and products. Geopolitical risk has also gained prominence, a notable example being the volatility in oil prices as a consequence of crises in the Middle East. Recently, the ethical dilemma faced by Google when it agreed to modify Internet access in China has highlighted reputation risk. Today, effectively managing these risks is a challenge for the risk and insurance sector, especially as these risks are also linked with opportunities.
Change has created new risks. Demographic changes and implications for economies and backlashes against outsourcing are some of the macro-level risks. The Internet, for instance, has created a risk of unauthorised downloading of music and consequent losses for the record industry. Terrorist threats have introduced a lot of uncertainty and pose risk across all risks both pure and financial.
In an uncertain world, it is difficult to predict how change will affect business. This raises the issue of how to perceive and manage risks. Risk management has taken a ‘silo’ approach to the management of risks posed by changing business, compliance and regulatory demands. Risk cannot be completely eliminated at a reasonable cost, instead it must be managed. What is required here is a more comprehensive and coordinated approach to managing risk portfolios. Risk management has to be embedded into business processes to become effective risk management.
The above discussion builds a strong case for adopting enterprise risk management (ERM). ERM enables firms to manage risk by shifting the focus of the risk management function from a primarily defensive to an increasingly offensive and strategic activity. This approach has become more relevant in view of the additional challenges posed by new and emerging regulations, compliance challenges, active investors, and recent corporate failures.
The insurance sector specifically faces many challenges in the globalised marketplace. The insurance sector has to cope with complexity resulting from convergence of services, building products for diverse markets and the changing nature of risks, insuring hitherto uninsurable risks and dealing with major catastrophes, such as Hurricane Katrina, and the risks posed by terrorist threats.
To expand further, insurers are facing reducing margins due to increasing competition together with a reducing cushion from investment returns. Insurers are also struggling with effectively managing their risk. The industry has struggled with overcapitalisation, which has led to weak returns on the one hand and insolvency on the other. There is a need for insurance sector companies to develop new approaches and risk products that protect them against financial and non-financial risks.
Emerging markets like India have opened up their markets to investment in financial services. However, insurers need to be cognisant of the geopolitical risk that these investments involve. For instance, there are demands for a decrease in foreign participation in the insurance sector in India. Insurers also need to create culturally compatible products. They need to study the social communication of risk and risk perception in these countries. The results from these studies could have counter-intuitive outcomes. Another factor to consider is the lower efficiency of financial regulation in these countries.
Commercial challenges faced by insurers include the need to strengthen customer relationships and to develop tailored and targeted products and services in the light of more exacting demands and increased competition. Insurers also need to sharpen underwriting, cut overheads and reduce claims leakage.
Compliance and regulation is another challenge for insurers. There have been new and more exacting regulatory demands following a spate of corporate scandals. However, insurers could integrate these regulatory demands and use the investment as a basis for improving governance and decision making.
Natural catastrophes such as Hurricane Katrina have led to record losses and have highlighted the scale of risks faced by insurers in an increasingly complex and uncertain financial, geopolitical and environmental climate. All these changes have underlined the importance of quality data and the need for effective validation to monitor and control aggregations and concentrations of risk. There may also be a need for fundamental changes in the insurance sector business models, including transforming capital requirements, new pricing methods, and a different approach to underwriting and claims.
Moving on to opportunities, demand for pensions and health insurance is likely to rise as the percentage of older age groups in the population increases. Insurers need to respond to these demands in good time. In the past, the insurance sector lost out on significant opportunities to benefit from the evolution of risk management. For instance, insurance sector companies failed to capitalise on the demand from banks that needed to find some way of insuring against their credit risk in the late 1990s. Banks developed their own market to tackle credit risk through credit derivatives, now a lucrative, fast-growing US$ 5 trillion market.
In conclusion, how should risk be viewed? As a hazard control or an opportunity? Uncertainty can be treated as a powerful starting point for innovation and renewal, rather than as a threat to be minimized. There should be a value creation approach to risk management. In fact, ERM makes risk management part of the firm’s overall strategy and enables companies to make better risk-adjusted decisions that maximise shareholder value.
Insurers will need to continue to develop products and services that provide competitive solutions to integrate risk management problems. The development of ERM capabilities can help to protect insurers from losses, earnings surprises and reputational damage as well as provide a platform for strengthening governance, decision making and regulatory compliance.
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