Organizations must address incentive compensation as part of risk mitigation

While there’s no one-size-fits-all approach to incentive compensation design, organizations can follow some key principles to mitigate risk, notes a recent joint paper from three actuarial groups.

“Insurance companies’ risk management practices came under great scrutiny as a result of the financial crisis,” notes the paper recently published by the Joint Risk Management Section of the Canadian Institute of Actuaries, the Casualty Actuarial Society and the Society of Actuaries, and written by consultants from Towers Watson.

“Ensuring that the structure of incentive compensation does not promote unnecessarily risky behavior has been the subject of many recommendations by regulatory agencies, Congressional mandate and commentary from professional organizations,” the authors write.

While one plan won’t work for everyone, an organization has the basics of an Enterprise Risk Management framework in place to create a successful, balanced incentive plan, the paper argues.

“Identifying employees who have the potential to expose the company to material adverse risk is another essential step,” the authors write. “…, a rigorous analytical approach should focus the organization’s intelligence on the full range of business risks and map employees from every function to specific risk taking scenarios.”

Incentive plans should also balance performance focus and risk sensitivity, the paper says. “Managing these tradeoffs is the crux of traditional plan design. However, in the effort to motivate growth in profitability and shareholder return, risk balancing mechanisms are not always applied,” it notes.

Monitoring such programs is also critical, as regulators are increasingly seeking “quantitative ‘proof’ of the degree to which incentives are adjusted for risk taking,” the paper says.

“Finally, embracing this work will have the benefit of aligning with the development of insurance companies’ Own Risk and Solvency Assessment (ORSA) frameworks,” it adds.