Risk Management Reports April 1996
Volume 23, Number 4
Hurricanes for 1996
Observers of the catastrophe insurance market remain concerned about the potential problems for many insurers from a major hurricane striking the US East Coast. After Andrew's $16.5 billion hit in 1992 and the bankruptcies of several smaller insurers, pessimists warned that a serious blow could cause damages exceeding $50 billion and wipe out numerous carriers. Since then, we've experienced higher than expected frequency of storms but lower damages. Last year set a new record of frequency with nineteen named storms and eleven hurricanes. According to the hurricane guru, Dr. William Gray, at Colorado State University, 1996 should be a "less active" season. Let's hope he's correct.
Some of my readers will remember the hurricane that brushed the Atlantic Coast and twice startled Bermuda last summer. Named "Felix," it was unusual for its erratic path, its mass of unstable hot air, the fact that it stalled out periodically, and that its forecast was worse than its actual results. I wish to confirm that there is no connection whatsoever between the characteristics of Hurricane Felix and the editor of this publication.
. . . we live in a discoverable world, but . . . most of what we discover is an unfathomable mystery that we can name - even defend against - but never understand.
Harry Crews, "A Childhood," Classic Crews,
Poseidon Press, New York, 1993
The unexpected, the surprise, generally disrupts our day, unless, of course, it's a generous bequest from a rich uncle. Surprise has always been anathema to risk managers, who prefer the predictable. This litany is repeated in many of the texts for the discipline, including Fred Church's Avoiding Surprises (1982), still one of the best available, and No Surprises:Controlling Risks in Volunteer Programs (1993), a booklet from the Nonprofit Risk Management Center in Washington. Yet the future of risk management rests on the acknowledgment that surprise is an integral part of human and organizational experience. Managing surprise intelligently is the new goal, not avoiding it.
I was reading Patrick O'Brian's biography of Pablo Picasso last fall and came across an old Spanish saying:"Que no haya novedad!" Initially this struck me as a possible motto for risk managers:"may you have no surprises." I used it in a speech in Budapest, translating it into both French and German:"Qu'il n'y ait de surprise!" and "Auf dass sie keine unangenehemen ueberraschungen erleben!" On reflection, however, I've changed my mind (see Hurricane Felix above?). I suggest the more modern version of this motto for risk managers should be:"Que haya novedad!" May you have surprises, and may you be prepared for them.
Any occupation that consists mostly of the repeated application of rules is a target for automation. That could put paid to lots of "experts":there is good software nowadays to write wills, prepare accounts and even to diagnose illnesses. Although lawyers, accountants and doctors will still be needed to deal with special cases, the world could probably get by happily enough with fewer of them.
"Checkmate to Plumber's Mate?" The Economist,
February 17, 1996
The Dey Report
Does your board of directors receive regular information about risk assessments and responses? Does your organization report periodically on risks to its shareholders and other stakeholders? If you are a Canadian company listed on the Toronto Stock Exchange, you are doing both. Canada is in the vanguard of countries requiring board responsibility for strategic risk management. I commented on the Cadbury Committee Report in UK (RMR, April 1994) and on last year's Australian/New Zealand Risk Management Standard (RMR, February 1996) but had overlooked the Dey Report, issued by the Toronto Stock Exchange in December 1994.
Entitled "Where Were the Directors?", the Dey Report addresses corporate governance in Canada, restructuring boards and their responsibilities. Its recommendations are now applicable to all companies listed on the Exchange. Its authors conclude that one of the "principal responsibilities of the board of directors" is "the identification and monitoring of the principal risks of the business." They extend this responsibility beyond the traditional shareholders, directors and management, to "employees, the community, suppliers, creditors and customers." They argue:"Notwithstanding the primary responsibility of the board (to shareholders - ed.), the longer term interests of shareholders will not be well served if the interests of other stakeholders are not addressed."
The Report defines five main responsibilities of a board.
1) Adoption of a strategic planning process
2) Appointment, training and monitoring of senior management
3) Communications policy (shareholders, stakeholders and the public)
4) Integrity of corporate internal control and management information systems
5) Managing risk:The board must understand the "principal risks of all aspects of the business," seek the "proper balance between the risks incurred and the potential returns to shareholders, and monitor the systems that manage these risks "with a view to the long term viability of the corporation."
Cadbury, the Dey Report and the Australasian Standard require explicit board oversight of the management of all risks and the balancing of those risks with possible rewards. This means that risk managers, whether involved in credit, investments, operations, currency, the environment, insurance, health and safety or security, should coordinate their work and describe their respective risks within a common framework. This will enable the board to review their efforts knowledgably and discharge its responsibility. Risk management cannot remain a fragmented exercise of independent specialists.
The Toronto Stock Exchange followed its 1994 report with the December 1995 Allen Report, "Toward Improved Disclosure." It details how companies should disclose information required by boards and stakeholders. It also suggests a reasonable limitation of liability for officers, directors, issuers of stock and their "experts" in return for recommended disclosures. If timely, accurate and material information is disclosed, the report proposes to limit the company's liability to the greater of C$1 million or 5% of its market capitalization. The cap for individual directors' and officers' liability would be the greater of C$25,000 or 50% of total compensation from the issuer during the preceding 12 months (including the fair market value of options, potential pension benefits and other deferred compensation). I see this as a reasonable proposal.
Four nations in the English-speaking world have now given boards the responsibility of understanding and monitoring the risk assessments and responses of their companies. This is a significant step toward a strategic view of risk and its management . These initiatives have all come from the private sector, not government. This in itself is refreshing!
"You can't fight the government," Coville's father said to him. "You can't fight for it and you can't fight against it. I could have told you so, but I knew that would be something you would have to learn yourself."
Howard Frank Mosher, Where the Rivers Flow North,
Penguin Books, New York, 1985
(add cartoon here, from The New Yorker, across two columns)
Caption: An Ex-Risk Manager?
Credit at bottom: Drawing by Leo Cullum; @ 1995
The New Yorker Magazine, Inc.
Is there more to "risk" than the possibility that a future event may cause harm? Several years ago students at the University of St. Gallen in Switzerland argued with me that the word "risk" includes positive as well as negative connotations. Rick Moscicki, a Tillinghast-Towers Perrin principal from Dallas, recently called me to task on the same point. He prefers the more classic definition of risk as "possible deviation from the expected." Risk, he argues, has implications of reward as well as harm. Consider both sides of the utility curve.
I agree with him. Buddhism cautions us to understand the "five enemies:water, fire, kings, thieves and unloved ones" (from "Awakening in the Land of the Pagodas," by U Maung Maung, in Focus, No. 16, 1995). This clearly defines risk by its harmful elements. Yet most of the more recent organizational definitions of risk implicitly include "reward." Matthias Haller, a professor at St. Gallen, sees two simple components - risk of action and risks of condition. Bankers Trust describes them as credit, market and event risks (the latter defined as "long-tail events involving business continuity and operational/legal risks." Guinness PLC expands the list to include brand equity, customer satisfaction, product quality, catastrophe, regulatory, cultural and trade war risks. I prefer my more simplified allocation of risks to the four areas of operational, legal liability, political/regulatory and financial/market. However risks are described or sub-divided, they present us with dual faces - harm and reward. This is understood in The Economist survey on "Corporate Risk Management" on February 10, 1996 (see RMR, March 1996). We need a more inclusive definition. As a starter consider:"risk is the possibility that future events may cause unexpected rewards or harm." Comments?
Rick Moscicki also questions my use of the words "living with" in my definition of risk management ("a discipline for living with the possibility that future events may cause harm"). He thinks this implies a passive acceptance of the reality of risk. What I meant by "living with" is a proactive acknowledgment that risk never disappears but is simply pushed into other guises and forms. All risk requires some form of management. I suspect part of this can be attributed to my early insurance upbringing. Insurance seldom eliminates risk although it all too frequently gives the illusion of doing so. We create risks by our actions and we must accept responsibility for their effects, favorable or unfavorable. We must "live with" them.
This serves to reemphasize that risk management remains an evolving discipline, one that affects almost every aspect of organizational management.
. . . plurality of reference is in the very nature of language, and its management and exploitation are what literature is all about:words tend to be not merely ambiguous but emotional.
Anthony Burgess, A Mouthful of Air, William
Morrow & Co., New York 1992
Insurer Expense Ratios
"Property/casualty insurers' expense ratios haven't shown any significant improvement," says Best's Review for February 1996. The industry continues to report an incredible (to me) 26.1% ratio of expenses to premiums. I think that this is excessive. Consider that 43% of the largest P/C companies (ranked by premiums) have expense ratios over 30%, topped by American Bankers Insurance Group with an astounding 57.3%! How can companies justify these levels to their customers, especially in a period of down-sizing and expense reduction? Saying that lower expenses are impossible is no excuse. New Jersey Manufacturers Group reported the lowest ratio:2.7% and four companies reported less than 15% (USAA Group, GEICO Corporation, Community Mutual of Ohio and 20th Century Insurance - all personal lines companies). Of more importance to corporate risk managers is the ratio of American International Group - 16%, a full ten points under the average. AIG may be a company that you love to hate, but it operates more efficiently that the rest of the pack.
The bulk of expense is, of course, commissions and brokerage fees, accounting for over 45% of all expenses. Any material improvement requires rethinking the insurance delivery system. Eliminating commissions would quickly reduce the expense ratio (AIG reported only 4.7% in commissions and brokerage expenses) but the buyer would pick up much of the differential in new fees. At the very least they would save some state premium taxes, since most fees are not subject to tax. Aren't buyers, personal as well as commercial, capable of managing their own purchase decisions on insurance, with limited advice and counsel from agents and brokers? I think so, even though agent and broker associations and regulators may disagree.
If the insurance industry is to survive and meet competition from other forms of financial services, it will have to offer its financial product at a much lower expense margin, probably less than 5%. Given last year's Best's number, it has a long way to go.
A shark is never seen without its retinue of these (pilot) fish, who are his purveyors, discovering and distinguishing his prey for him; while he in return gracefully protects them from the ravenous hungry dolphin.
Benjamin Franklin, "Journal of a Voyage," in J. Raban,
ed., Oxford Book of the Sea, Oxford University
Press, London 1993
Recent stories about a high level excess insurance facility with a capacity of $4 billion for the pharmaceutical industry, reminded me of a better idea advanced over ten years ago. Hugh Rosenbaum, then one of my partners and still a principal in Tillinghast-Towers Perrin, saw the radical contraction of insurance capacity during the tight market of 1985-86, and suggested a simple, effective solution.
He called it post-loss funding. A group of "comparable" organizations would agree to share equally each others' losses, as defined, above a high threshold. No funds would be set aside in advance. Each organization would depend on written contracts with and the financial capability of the others to respond if and when a loss occurred. A law firm would be engaged to assess the loss and arrange for the appropriate participant payments. Six keys supported this idea. First, the attachment point would have to be much higher than any experienced losses:truly catastrophic and at the point of randomness. It would also increase each year according to an agreed index. Second, the plan should avoid, if possible, "target risks," situations that could cause losses to several of the participants at the same time. Third, it would be a legal commitment, approved by the respective boards. Fourth, the partners would have to demonstrate to each other a superior financial condition over time and the potential to remain that way. Fifth, liability coverage would be on a "claims made" basis. Sixth, legal counsel would be engaged on advice of a possible claim to arrange for payments after the loss.
An example:twenty companies would subscribe 5% each to any loss and loss management expenses up to $500 million in excess of a threshold of $500 million. When the actual loss was paid by the unfortunate partner, each of the others would contribute 5%, leaving the affected company with a "deductible" of its own 5% share.
Rosenbaum's idea was not without problems. Would it be possible to find 20 organizations with the requisite long term financial strength, each of which would be willing to sign such an agreement? This would be a difficulty, given levels of competition. Could these companies agree on a common definition of "risk" and "covered losses?" Each participant would probably argue that its risks are substantially less than those of the others! Could companies from different industries agree this form of "pool" in order to reduce the potential of multiple hits?
The post-loss funding pool remains a challenging idea.
. . . it's not easy to pierce the illusion that Time goes somewhere from which it cannot be recovered except in the counterfeit form of history, the representation or reproduction but not the actuality.
Thomas Berger, Killing Time, Delta Publishing,
New York 1967
Ethics:Where to Begin?
If I were a pessimist I would withdraw entirely from this world in which the unethical and irresponsible seem to dominate. Too many people, especially in the US, are either actively unscrupulous or oblivious to the moral and ethical dimensions of their actions. Look at F. Lee Bailey, a lawyer and "officer of the court" and his incredible interpretation of fiduciary responsibility and managers of money like Michael Milken, Joseph Jett, Nicholas Leeson and Robert Citron. Look also at the insurance industry, where too often insurance claims adjusters start with the premise that the insured is inherently dishonest and that all claims should be initially denied. The fact that many claimants do inflate claims, grasping for every possible penny, may well be a direct response to the prevailing attitude of insurers.
But I am an optimist. I have faith that current conditions can be changed and that the majority of out citizens are inherently ethical. Signs of progress? Senator Bill Bradley decides not to run again for the Senate, decrying the degradation of that institution, but continues to encourage change, beginning at the state and local level. The subject of "ethics" appears more often in the curricula of our leading business schools. An insurance task force is studying ethics in insurance. An Institute for Global Ethics operates from Camden, Maine, encouraging thought and action on specific situations (for more information contact The Institute for Global Ethics, PO Box 563, Camden, ME 04843 USA. Tel:207-236-6658 E-mail:email@example.com).
For the insurance industry, John Long's Ethics, Morality and Insurance (Bureau of Business Research, Indiana University, 1971) remains the single best text on the subject. I also wrote about it in Risk Management Reports, Vol. XVII, No. 2 (1990).
The ethical precepts are universal and eternal. We need only practice them.
Sound unrelated to concept is nothing but noise
Anthony Burgess, A Mouthful of Air, William
Morrow & Co., New York 1992