North American insurers are currently facing three significant governance challenges, says Moody’s Investors Service in a new report.

According to Managing Director Mark Watson, the report’s author, the challenges are: successfully changing the composition of the board of directors and upgrading management succession planning processes; continuing to evolve executive pay to better align with long-term value creation; and implementing enterprise-wide risk management practices.

“Boards are making progress on each of these challenges,” Watson says, “but Moody’s believes that success in overcoming them is still some way ahead.”

A number of insurers have adjusted their board’s composition in recent years, alongside planning for and in several cases executing CEO changes.

Watson notes that such changes require significant planning, particularly when done in the same timeframe. “Care has to be taken at both levels in considering the skills and qualities required in the boardroom and within management ranks,” the analyst says.

Watson also points out that the insurance sector stands apart from most other financial service sectors in the manner in which insurers’ boards have traditionally selected new CEOs. Large insurers have been much more willing than other financial service firms to recruit CEOs from outside the company.

“Over the past dozen years, a notable number of large U.S. insurers have hired CEOs from outside either directly into the CEO role or into a senior position for a few years, followed by promotion to CEO,” Watson says.

In analyzing current insurance-company governance practices, however, Watson points out that “there are signs that the distinct bias in the insurance industry to bringing in outsiders as CEOs is starting to change; insurance company boards are beginning to recognize the inherent difficulties in such recruiting.”

Insurance company boards have also been modifying executive pay in recent years, in line with broader changes in other North American companies.

Restricted stock or performance-based incentive programs are now used, in lieu of fewer stock options. In light of the expensing of equity-based compensation, there has been a significant shift away from the use of stock options for senior executive pay. Canadian insurers moved away from stock options earlier than their U.S. counterparts. “Insurers are still grappling with selecting the most appropriate performance objectives to drive pay,” notes Watson, adding that “some are still clinging to earnings per share, despite growing criticism of this metric.”

Enhanced disclosure requirements for reporting executive compensation means that insurers may come under greater scrutiny, forcing boards to rethink executive pay radically. “In addition,” Watson points out, “insurers may face scrutiny from policyholders or policyholder advocates, particularly those with retirement products, as their executive pension practices become more visible.”

A variety of factors have made risk management a key area for insurers’ boards and managements teams, including enhanced regulatory scrutiny, a strong external focus on insurers’ capital requirements, and outsized catastrophic losses. “Insurers are pressing forward with efforts to implement an enterprise-wide approach to risk management,” Watson explains, “but most are in the early phases.”

He adds that “Canadian insurers have also focused more attention to risk management analysis and actuarial matters as a result of stepped up activity over the past few years by the Office of the Superintendent of Financial Institutions (OSFI).”

Moody’s believes regulatory requirements on Canadian insurers improve the quality of communications to their boards on risk-related matters. OSFI mandates that insurers apply annual severe stress tests to their capital positions and share the results with the board. Insurers also have to subject their actuarial data to external peer review periodically, in conjunction with the Canadian Institute of Actuaries, and share those results with the board.

“But all North American insurers have some significant hurdles to overcome,” according to the analyst, including siloed organizational structures and difficulties in measuring risks across the company.” “Insurers are notably behind banks on operational risk management, with compliance being a particularly weak spot,” he concludes. “Given the regulatory scrutiny the industry has faced in recent years, we believe that upgrading insurers’ operational risk management capabilities is critical,” Watson says.