In our view, the best run companies put the management of risk and capital at the heart of their decision-making and will therefore use Solvency II as an opportunity to further strengthen and embed ERM within their organisation. Effective ERM provides a framework for identifying, measuring and managing risk and capital on a systematic and consistent firmwide basis. As such, it can create a more informed and assured basis for strategic planning and performance management, while equipping insurers to meet the demands of the new Solvency II regime. The quality of ERM and its embedding into the organisation are also increasingly important elements of rating agency financial strength evaluations and how companies are judged by analysts and investors.
As Figure 1 highlights, people and rewards are a key foundation for effective ERM. Tying compensation to risk-based performance objectives can provide a powerful lever for instilling risk awareness in the decision-making and underlying culture of the enterprise.It can also help to articulate and apply the risk strategy and risk appetite in a way that is meaningful throughout the organisation. One clear benefit is ensuring that risk management becomes a frontline priority rather than someone else’s responsibility and hence avoiding the poor understanding and mis-pricing of risk that lie at the heart of the financial crisis. From a Solvency II perspective, risk-based remuneration can provide useful evidence that risk and its capital implications are being considered as part of business decision-making.
However, our research and work with clients indicate that few insurers have been able to develop a comprehensive risk, capital and performance management process capable of bringing together all the elements outlined in Figure 1. Risk-based reward is generally one of the least developed and least integrated areas.[1]
[1] ‘Does ERM matter? Enterprise risk management in the insurance industry’, a study published by PricewaterhouseCoopers on 24.06.08. To download or order a free copy, please visit www.pwc.com/insurance
The heightened stakeholder focus on rewards in the wake of the financial crisis could provide further impetus for integrating remuneration within ERM. Among the most common regulatory demands are closer alignment between risk and reward and deferring a greater proportion of compensation to encourage a more sustainable longer term perspective.
Inappropriate incentives may not have been a direct cause of the financial crisis, but they undoubtedly added fuel to the fire. However, while there is clearly a need for some reform, there may be a danger of overreaction. In particular, blanket measures such as capping bonuses may assuage the critics for now, but cannot be viable in the longterm if they fail to support the overall strategy of the business.
Amid the current uproar over executive pay, some firms may also make the mistake of solely focusing on directors’ remuneration rather than addressing reward, motivation and desired behaviour in the enterprise as a whole. Looking beyond top-tier management is particularly important in relation to risk, as while the board should set the risk appetite and strategy for risk management, risk isprincipally monitored and controlled by the front (underwriting and claims) and mid-offices (actuarial, risk management and internal audit).
Bringing compensation into the ERM framework can provide a more strategically-aligned organisation-wide solution. Reward arrangements cannot in themselves move the ship in the right direction - in this case bringing risk into the heart of decision-making - but they can help companies to reach their objectives far more quickly.
As with any such major programme of change, aligning rewards more closely with ERM cannot be achieved overnight. Neither can it be imposed from the top. As Figure 2 highlights, we believe that the all-important firmwide support and motivation for change needs to be rooted in a genuinely compelling business case, which focuses on the discernible benefits for the organisation and its stakeholders. As with ERM overall, the case for a risk-adjusted approach to compensation is likely to focus on the opportunities to deliver more sustainable returns and strengthen stakeholder confidence.
Once the underlying business case is accepted, this can then form the basis of a strategy for implementation and an assessment of how this is likely to impact on the organisation. While it is important to get input from HR, this is primarily a business rather than HR project and therefore success demands active executive sponsorship and clear direction from business unit leaders. Securing the understanding, buy-in and input of staff will require engagement, communication and training. This includes explaining how and why the business model is changing; what behaviour will be expected from staff as part of this new approach; how they will be assessed and how this fits into their career progression.
A further challenge is defining transparent and meaningful key performance indicators (KPIs) that will drive the right performance and behaviours for the group, business units and individuals. No single metric can achieve this, so companies should take the
time to discern what collection of measures are most suitable and subject them to regular review to ensure that all relevant risks are being captured.
The contribution of the risk management function can be exceptionally difficult to translate into appropriate compensation, especially as its success is often measured by the absence of unforeseen losses (‘no surprises’) rather than more positive KPIs. A further challenge is that the rewards for risk management and other mid-office functions may be geared to the performance of frontline teams. This can create an inherent conflict of interest in which risk officers may not want to challenge underwriters and other front-office personnel as this could have a negative impact on their bonus potential. This highlights the importance of aligning compensation to risk-adjusted measures and long-term value creation.
The basis for performance-related pay is clearly an important way to motivate behaviour. However, it is important to look at rewards in the round, including fixed pay, benefits and career development. In particular, if base salaries are too low and staff are therefore relying on meeting incentive targets to make up for the shortfall, this could encourage excessive risk-taking. At a time when the downturn is likely to reduce the bonus pool, a careful balance between fixed and variable pay is especially critical. Attractive prospects and a strong sense of staff engagement can also help to enhance commitment to the company, which can in turn help to underpin a culture of risk awareness, customer focus and long-term thinking.
The underlying requirement is effective oversight and accountability. A number of remuneration committees are looking to strengthen governance by focusing on pay arrangements across the enterprise rather than just within the board. With compensation in the spotlight, this may also be a good juncture to review the composition of the remuneration committee to ensure it encompasses an appropriate mix of skills and experience. Creating a formal firmwide governance structure, which brings together the remuneration committee with HR, compliance and risk management, would help to ensure there is appropriate and demonstrable oversight of the determination of rewards within the business.
Solvency II will bring ERM to the forefront of decision-making within many businesses. The most successful organisations align rewards with their strategy and will therefore use the development of ERM under Solvency II to drive changes in compensation. If not, there is likely to be a conflict between what gets paid and what gets done.
Risk-adjusted rewards can help to drill risk awareness into the culture of the organisation and turn ERM into a meaningful aspect of how performance is managed, judged and remunerated. However, changing the way people are rewarded is a huge undertaking. Success depends on a compelling business case, a coherent firmwide strategy for implementation and, above all, understanding and support from within the organisation.