Risk Management Reports

February 2002
Volume 29, Number 2
 

Cogent Comments

That my readers constantly challenge me is one of the rewards of writing this monthly commentary. So I lead off this month with some of the pithier comments from the past few months.

Jim Stone: Jim is the Chairman of Boston’s Plymouth Rock Assurance Company, a consortium of contrarian insurance companies in the northeastern US. I telephoned him a few weeks ago to congratulate him on his appearance on a television segment that dissected the insurance industry’s drive for Federal reinsurance of terrorism exposures. We moved on to the rapid rise in insurance premiums since September 11, 2001 and the equally rapid introduction of new capital to the insurance and reinsurance businesses. I count at least $27 billion in start-ups (Axis; Endurance Specialty; DaVinci Re; etc.) and new money being ploughed into existing organizations, all in anticipation of much higher insurance rates. But, Jim cautioned, how long will these high rates prevail? He noted that it was less than a year ago that everyone was complaining of excess capital in the world property and casualty insurance business: too much money running after too little business at too low rates. Did September 11 really change matters that much? Even if the P/C industry absorbs as much as US$70 billion, the upper estimate of insured losses, the effect on overall policyholders’ surplus (insurers’ equity) will be minimal. Add this new capacity, eagerly hunting the higher premiums. Jim Stone suggests that, with continued over-capacity, competition will return quickly and rates will start to fall. If many larger corporate insurance buyers radically increase their retentions and participate in new pooling vehicles, taking their premiums completely out of the commercial market, the insurance industry may find itself sinking into the same hole. It will be interesting to watch the so-called “hard” insurance market as it develops in 2002 and 2003!

Mike Oswald: Mike, with CreditLink, in Australia, sent me this observation last May. “What,” he asked, “do auditors and risk managers have in common with footballers (soccer players to those of us in the US)?” The answer: “They are all susceptible to falling in love with models.”

Charles Shoopak: Mr. Shoopak is not a reader but his letter to the Editor of The New York Times last May is worthy of repetition. He wrote: “I recently came up with a new business model that I call Placebo Consulting. The business model is simple: companies spend millions each year on outside consultants without ever testing whether they are effective. At Placebo Consulting we provide personnel who appear as if they are experts but actually know nothing. The hiring company would assign a small part of a project to Placebo as well as to an established firm and compare the results. If Placebo produced similar or superior results, it would call into question the expenditure on high-priced consultants. Higher initial costs associated with duplicate work on test samples would be more than offset in long-term savings by reduced use of consultants. . . . At Placebo Consulting, we’re as good as the next guy!” Mr. Shoopak is not a reader but his letter to the Editor of The New York Times last May is worthy of repetition. He wrote: “I recently came up with a new business model that I call Placebo Consulting. The business model is simple: companies spend millions each year on outside consultants without ever testing whether they are effective. At Placebo Consulting we provide personnel who appear as if they are experts but actually know nothing. The hiring company would assign a small part of a project to Placebo as well as to an established firm and compare the results. If Placebo produced similar or superior results, it would call into question the expenditure on high-priced consultants. Higher initial costs associated with duplicate work on test samples would be more than offset in long-term savings by reduced use of consultants. . . . At Placebo Consulting, we’re as good as the next guy!”

That reminds me of the famous Malcolm Forbes’ “dart-board” theory of investing, using random throws to the stock page to determine investments. He compared his results to those of renowned securities analysts. The dart board generally out-performed the experts! Later Burton Malkiel summarized this idea in his book, A Random Walk Down Wall Street. It all goes back to Hans Christian Anderson’s story about the Emperor who had no clothes!

Is anyone willing to try Placebo?

Peter Law: I’ve quoted the retired risk manager of Schlumberger numerous times in the past. He can be counted on to yank my leash. Last year we traded several emails on the subject of the role of the risk manager as potential “whistle-blower” for corporate misconduct or misdirection. Should a risk manager sit in his or her kennel and growl, step out and bark, or go so far as to bite? “While I am in favor of all of the specialists who try to preserve their companies’ profitability being proactive,” Peter wrote, “in the real world, the corporate climate frequently inhibits a specialist from coming out of the kennel. My observation of the corporate world is that greed and arrogance are frequently the causes of financial disaster and they will not be tempered by those whose jobs are to enhance profitability by minimizing or avoiding disaster.”

I fear that Peter is right. His words are now being echoed in the Enron case in the US. It illustrates his comment. At Enron, despite numerous warning signs and even a detailed letter from an officer to the CEO, no one internally blew the whistle early enough or took corrective action. Enron even had a Chief Risk Officer, who, one supposes, should have been known what was unfolding! The Economist, on January 12, 2002, summarized the usual fate of whistle-blowers: harassment, reprimands and termination of employment. This is hardly encouragement. It attributes the problem to “cultures in which managers are under intense pressure to ‘stretch’ financial targets and then reach them.” The problem continues: some internal staff know of immoral or even criminal decisions that affect the future of their companies but they are intimidated from stepping forward to suggest changes.

The Europeans tried the idea of the ombudsman, someone who could be the recipient of early and bad news (from anonymous sources) and who could initiate responsible action without fear of retribution. Few if any companies in North America use ombudsmen and I hear little of the idea outside Scandinavia. Too bad.

Howard Kunreuther: In December, this University of Pennsylvania professor delivered a paper in Paris on “Risk Management of Extreme Events: The Role of Insurance and Protective Measures.” In it he reviewed the conditions of the insurability of risks: the abilities to identify and quantify probable occurrences and losses, to set premiums for different classes of customers, to raise required capital, to set rewards for and measure effects of protective steps, and to fit into the multiple roles of the private and public sectors, including federal reinsurance.

The UK, France, Israel, Spain and Sri Lanka, among others, already offer one response: each provides a large measure of public sector financing. In the US (at least so far) we allow the private sector to muddle its way through the mess, even though there is tacit agreement that the Federal Government is the insurer of last resort. This relationship will be studied at great length, not only in North America but elsewhere (For other comments, see “The Unraveling” in RMR December 2001).

At the end of his paper, Howard raised several important questions on terrorism, its costs and its financing:

  • Can one develop meaningful scenarios to estimate the future probability of terrorist activities?
  • Can one develop estimates of losses for “insurable” events?
  • How much extra premium should be charged for the “ambiguity” of the terrorist risk?
  • Is there adverse selection associated with terrorism?
  • Is there a moral hazard associated with terrorism?
  • Are losses from terrorism highly correlated?
  • Will the premiums charged by insurers be affordable?

Howard concluded with the critical question: what roles should the government and private sector play in providing protection against terrorism? The Kunreuther analysis is a helpful contribution to re-defining the roles of individuals, organizations, the insurance industry and the public sector.

Ben Thomas: Ben, a consultant with Willis in Wellington, New Zealand, emailed me in November, asking permission to distribute for comment a quote from Irvin D. Yalom (. . .certainty is inversely proportional to knowledge.) He noted that this appears counterintuitive to risk management theory and common sense: more knowledge leads to better risk assessment and greater certainty.

Though contradictory on the surface, this comment asks us to look deeper. Peter Bernstein alluded to the idea behind the Yalom quote, in his book, Against the Gods. Centuries ago, faced with all forms of uncertainty, man opted for faith in gods or a god, bringing absolute "certainty” to some minds. Increasing knowledge unhinged our superstitious beliefs but it has brought with it the growing "certainty" that all is uncertain. What we profess to know are only reasoned probabilities.

Therefore Yalom's observation (admittedly taken out of context: they are the words of a psychologist who is a protagonist in the novel) is much like a Zen koan: it challenges the mind to reconcile what appears to be a contradiction. The more we think we "know," the more we realize how little we know. Blind faith equals certainty (witness our adversaries in Afghanistan), while knowledge increases uncertainty! Anthony Lewis echoed this in his final interview (before retirement) in The New York Times, on December 16, 2001: “Certainty in people who are sure they are right is the enemy of decency and humanity.”

This is the philosophical underpinning of risk management!

David Block: I quote my favorite Southern medicine man several times a year (for the last time, see RMR November 2001), primarily because of his ability to give a different slant on our risk perceptions. Last June he sent me an editorial from the British Medical Journal that argued that “accidents are not unpredictable” and that the term “accidents” should be purged from our lexicon. This inspired David as follows: “ ‘Risk’ is a portmanteau with secret pockets that delight you, and some others, in their very recognition, let alone in the contents, let alone in what the contents may conjure! ‘What does this lapis stone in this odd shape hidden in plain sight tell me about what I DON’T know?,’ you ask, ‘and who hid it?’ ‘If this odd stone is in plain sight, how can I change its shape so that it fits into its proper place, the shapes and places that I DO know,’ ask others. No loose ends and poor fits for some; loose ends and poor fits are the very substance of life for others. If we know the dimensions of only our own briefcases and mathematics, we shall have no surprises, and no risks, and no accidents.” David concluded, “Risk tells some why they shouldn’t; risk tells others why we should!”

As investors know only too well, analysts on Wall Street cannot be relied upon to dig deeply into companies’ books. Eager to help their firms generate business selling securities to investors, Wall Street analysts have made a habit of missing corporate misdeeds altogether or ignoring what they see.

The New York Times, January 14, 2002

Copyright H. Felix Kloman and Seawrack Press, Inc.

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