I. Early Practices
Applications embodying a certain degree of holistic risk management thinking appeared very early on. For example, as early as 1979, XL Environmental Ltd. proposed an integrated risk management program for the chemical industry—though that merely considered several different insurable risks together and offered some new types of insurance products or risk management programs. XL Environmental Ltd. was a capital-providing company whose customers were manufacturers and distributors of chemical products. The main risk exposures its customers faced were liability payments arising from environmental pollution by chemical elements during production, and product liability that could arise during sales. The occurrence of these risk exposures would weaken a company's profitability and affect its ability to repay debts. To address this, XL Environmental Ltd., through its insurance operations department, provided these chemical manufacturer and distributor customers with a comprehensive risk management program involving insurance, risk control, and claims management. The insurance it offered differed greatly from the scope of coverage set in the standard insurance provided by insurance companies: in its policies, the coverage included not only environmental pollution liability losses but also product liability losses arising in the course of product sales.
By the 1990s, with the rapid development of the world economy and in an environment where natural disasters frequently struck humanity, the idea of integrated risk management, once proposed, immediately won favor among business people from all walks of life. Experts and scholars began to explore concrete implementation methods and techniques, and many financial institutions set about applying this idea to their own actual risk management activities. IRM research and practice take the interrelation between pure risks and speculative risks as the starting point, and its process develops from the partial toward the holistic—for example, beginning with the integrated management of several important risks and then gradually transitioning to genuinely holistic risk management practice; and gradually extending the theories and methods of financial risk management (such as financial engineering) to situations that include both pure risks and financial risks.
As an internal management integration approach, the integrated risk management approach has been promoted and applied in many large enterprises, most commonly in banks and insurance companies. Enterprises that have preliminarily implemented integrated risk management programs have already achieved results and benefits, greatly improving their competitiveness.
The banking industry is where the integrated risk management approach is most widely applied; the insurance industry is where the most integrated risk management products have appeared, followed by the securities industry and banking. Other fields where it is widely applied include government departments in policy research on ecological management, macroeconomic management, and industry management.
II. Application in the Banking Industry
The banking industry counts among those with the most applications. Existing achievements include: integrating the management of credit risk in banking with the management of other financial risks; and integrating banks' asset-liability management with enterprise operating risk management. For example, as early as 1999, the Piraeus Bank Group developed and used an integrated risk management program, consolidating asset-liability management and enterprise operating risk management into a single department and using an integrated computer information system to provide reports combining asset-liability management with enterprise operating risk management. In 2001, the Group further integrated asset-liability management with market risk and credit risk management. In addition, some financial services institutions are developing and exploiting IRM's enormous potential market; many insurance companies are also developing and using information system software that combines liability management with asset management; and still more insurance companies have shown strong interest in and desire to use IRM and its software packages.
Credit risk is one of a bank's most important risks, and it is also an insurable risk. Nowadays, more and more banks are abandoning traditional credit insurance and turning instead to the IRM approach, combining credit risk with financial derivatives to spread and transfer credit risk through the capital markets.
III. Application in the Insurance Industry
(1) Applying Integrated Risk Management Thinking to Liability Business
Many of the new policies now issued by insurance companies bundle together multiple insurable risks—and even traditionally uninsurable risks such as interest rate risk and other financial risks—providing broader coverage at lower premiums. For example, comprehensive policies, package policies, and blanket policies concentrate many different types of risk in a single policy, providing an aggregate limit of protection above the retention for each type of insured risk loss. In 1997, Honeywell pioneered a policy that simultaneously provided protection for four types of risk (property, liability, directors and officers liability, and exchange rate fluctuations), one of which was a financial risk—exchange rate risk. This is an example of a policy combining pure risks with speculative risks.
(2) Applying Integrated Risk Management Thinking to Asset-Liability Management
Insurers not only face the problem of expenses exceeding income in their underwriting business; the assets they hold—such as bonds, stocks, and real estate—also face the risk of depreciation. The overall risk facing an insurer depends on the combined effect of the risks of its asset portfolio and liability portfolio. Imagine that the policyholders an insurer covers present unexpectedly high claims while, at the same time, the stock market crashes and the insurer's equity holdings shrink sharply—what would the insurer's situation be? Clearly, the insurer would be in an 'adding insult to injury' predicament. Conversely, if policyholders present unexpectedly high claims but, because of price conditions in the financial markets, the insurer's assets appreciate substantially, then the insurer's assets play the role of 'timely assistance', enabling the insurer to smoothly weather the crisis of extraordinary claims payments.
One way insurers use integrated risk management for asset-liability management is to exploit the mutually offsetting nature of insurance risks and financial risks, so as to reduce the volatility of risk losses and strive for stable profits.
A typical application of this idea is that an insurer, while underwriting insurance for crops (such as barley) against natural disasters, also makes appropriate futures or options investments in those crops. For example, when an insurer underwrites crop insurance for a large farm whose main product is barley, the risk factors are losses from crop failure caused by severe weather (such as serious drought) or excessive rain. The insurer can invest in a certain amount of barley futures or barley call options to reduce its own risk exposure. When severe weather actually occurs, the market price of barley is also likely to rise sharply. Thus, on the one hand, the insurance company has to make huge claim payments to compensate for the farm's crop failure; on the other hand, futures or options prices will rise, and the resulting additional gains can, to a certain extent, offset the losses from insurance claims.
(3) Applying Integrated Risk Management Thinking to Financial Management
Insurance companies exploit the mutually offsetting nature of different risks, repackaging or bundling some of the important risks they underwrite and transferring the unbearable portion of losses through reinsurance, in order to improve their financial position and meet regulatory requirements. Finite risk reinsurance is one such example.
Finite risk reinsurance is in fact an innovative integrated form combining a reinsurance contract with a financing contract. Unlike traditional reinsurance, during the finite risk reinsurance period the cedant and the reinsurer jointly establish an experience account—also called a risk management fund—to manage the underwriting risks during the coverage period and the operation of the funds. Such insurance contracts generally provide multi-year coverage, with the reinsurer bearing protection only for limited risk losses, the level of protection generally being based on the premiums paid and accumulated during the policy period. The reinsurance cedant and the assuming reinsurer can share the operating results. For example, if the insured losses during the policy period are lower than the premiums paid, or if the investment returns on the accumulated premiums are favorable so that the fund accumulation exceeds the total losses, the cedant can also receive a partial premium refund. In extreme finite risk reinsurance policies, almost no risk transfer may occur—for example, when the accumulated premiums equal the accumulated incurred losses, the reinsurer merely establishes a risk fund for a period of time, and in that case such a reinsurance policy is merely a financing instrument.
The finite risk reinsurance contract is a typical solution embodying IRM thinking. First, such a contract is a form of insurance aimed at solving financial problems. Since financial problems are themselves the result of combining various risk factors of an enterprise, a finite risk reinsurance contract is not an ordinary contract transferring a single underwriting risk, but a solution to an enterprise's overall risks. Second, finite risk reinsurance contracts are generally multi-year contracts whose main risk management mechanism is to spread underwriting risk and financial risk by smoothing underwriting losses across different years during the reinsurance period—in other words, this kind of insurance achieves risk diversification through the natural hedging of underwriting risks over multiple years. Because of the special operating mechanism of finite risk reinsurance, this kind of insurance not only helps spread the original insurer's underwriting risks and financial risks, but also helps the original insurer meet regulatory requirements and conduct reasonable tax planning, thereby helping it increase surplus, smooth profits, expand business, and improve investment returns. This risk financing method is also used by ordinary enterprises, where it is called a finite risk policy; in that case, it is the insurance company that establishes the risk fund and provides the financing.
(4) Other Application Examples
For example, IRM thinking has many applications in insurers' policy design. Insurers have also extended this integrated risk management thinking to providing customers with holistic protection products. Insurers often design special insurance products for particular customers based on the characteristics of their assets and liabilities; these products bundle together some of the important risks the customer faces and, exploiting the mutually offsetting characteristics of these risks, structure the claims clauses and set the insurance price, so that these products—unlike traditional insurance products—provide broader coverage at a lower price. Multi-trigger insurance contracts are a typical new product of this kind.
Take the dual-trigger insurance contract as an example. The main difference between this kind of policy and a traditional policy is that payment of insurance proceeds depends not only on whether an insured event occurs during the policy period and reaches the payout level (called the first trigger), but also on the occurrence of another specific non-insurance event (called the second trigger). Generally speaking, this specific non-insurance event is an indicator closely tied to the insured's financial condition, such as raw material prices, product prices, interest rates, and exchange rates. In other words, if the insured has merely suffered the impact of an insurance risk while another key indicator affecting its financial condition has not deteriorated, the insurer does not pay; compensation is paid only when the insured is 'hit by a double blow'. This kind of policy is designed to control the overall risk of an enterprise's insolvency.
IV. Application in Ordinary Enterprises
By using ART (alternative risk transfer) products—combining insurance protection with financial risk prevention techniques—Honeywell and Mead saved roughly 20%–30% in risk transfer costs by bundling various risks together.
V. Application in Government Macro-Management
As early as 1997, the Canadian government had already put integrated risk management in government departments on the government's agenda and began research and practice on implementing integrated risk management in government service agencies at all levels. In the Canadian government report 'the Report of the Independent Review Panel on Modernization of Comptrollership in the Government of Canada (1997)', the government emphasized the importance of implementing modern risk management in government public service departments. In response to the government's call, the Treasury Board of Canada Secretariat took the lead in forming a research team on integrated risk management for the public service. Composed of and participated in by federal agencies, educational institutions, and a number of individual researchers, the team developed an Integrated Risk Management Framework (IRMF) suited to risk management in public service organizations.
The IRMF advocates the implementation of a systematic, holistic risk management approach and system within federal public service organizations, emphasizing the importance of risk communication and risk tolerance within public service organizations. Their main purposes in establishing the IRMF were to:
(1) Promote innovation in the management of government service departments at all levels, so as to enhance the service effectiveness of public service departments, maintain the government's credibility, reliability, and image of diligence, and ensure that government administrators do not infringe upon—and indeed protect—the interests of the public.
(2) Promote the wider application of advanced risk management ideas and methods. The IRMF can provide public service departments and their staff with a practical guide to help them, in the decision-making process, identify and assess the important risks associated with policies, plans, programs, and their operation, and manage these important risks in a measured and orderly manner, thereby strengthening the government's responsibilities and obligations.
The IRMF has four components; the basic content of these four components and the objectives expected from implementing the IRMF are as follows:
(1) Depict a risk profile at the organizational (or corporate) level. The essence of this component is the identification and assessment of important risks at the organizational level; they hoped to achieve three key results:
① Through analysis and study of the organization's internal and external environment, discover the organization's potential threats and favorable opportunities;
② When making risk management decisions and plans at the organizational level, fully grasp and be aware of the organization's current risk management state, including challenges, opportunities, capabilities, practical experience, and its cultural atmosphere;
③ Be able to draw up the organization's risk profile, the important contents of which include key risk areas, risk tolerance, and the capacity to mitigate risk.
(2) Establish an IRM functional system. This functional system meets the following objectives and requirements:
① It is the command center for risk management, able to promote the formulation of risk management policies and operating rules within the organization and advance the communication, understanding, and application of risk management plans.
② It can draw on and coordinate with existing organizational decision-making mechanisms—including management departments at all levels, clearly designated responsible persons, and performance reporting units—to facilitate the smooth implementation and roll-out of IRM programs and methods, and can use various performance evaluation methods, such as independent review and assessment by audit departments, to reasonably evaluate IRM performance.
③ Organize and guide the development and use of the entire organization's ERM capability (including the corresponding human capital and management tools and processes) cultivation plans and building measures, so as to respond in a timely manner to the constantly changing internal and external environment of the organization.
(3) Advance the practice of IRM. The practice of IRM is expected to meet the following conditions:
① The risk management processes used by all departments are coordinated and consistent;
② Organizational decision-making and the ranking of matters by importance take into account the results of risk management practice at all levels;
③ The methods and measures used to support decision-making and communication with stakeholders are continuous and stable.
(4) Promote the continuous progress and development of the risk management mechanism. For this element, the IRMF expects to achieve the following results:
① Learn from experience and lessons to identify a suitable working environment for IRM;
② Integrate learning plans into the organization's risk management practice process;
③ The results of risk management can be used to drive management innovation, capability building, and continuous improvement for individuals and teams within the organization;
④ Ensure that experience and practical results can be shared within the organization and across management at all levels.
In accordance with the established objectives and requirements, the IRMF sets out in detail the basic risk management process and the key links for public service organizations, and gives the general meaning and implementation rules of these links.
The Canadian government also applied integrated risk management thinking to the risk control of the 'Y2K (millennium bug)' problem; the application of these methods has been extended to government online services and integrated planning management.
VI. Application in Financial Regulation
According to the results of a questionnaire survey conducted by SAS in July 2006 of 339 financial institutions worldwide, improving business results and meeting regulatory requirements are the main driving forces pushing financial institutions to implement ERM; in addition, there are improving enterprise management performance, being able to price reasonably on a risk basis, saving allocated capital, and reducing credit risk losses. Judging from the survey results obtained, the analysts concluded that, on average, applying an ERM system can reduce capital requirements by 10%. More specifically, for a bank requiring a capital allocation of US$10 billion, of which US$6 billion is allocated to credit risk, conducting advanced, systematic ERM management would reduce the capital allocation by US$600 million; at a 10% annual return on capital, the bank could thereby increase its net income by US$60 million in a year.
