Risk Management Reports February 1996

Volume 23, Number 2

Risk Management Standards?

Today's risk management discipline evolved over many years through the efforts of both practitioners and academics, but textbooks, articles, and practices vary radically. For some, risk management means the arrangement of insurance and similar financing programs. To others it may mean hedging and swaps, commodity trading or quality assurance in a medical environment. Is it possible to forge consensus?

Standards Australia and Standards New Zealand, non-profit research organizations in Australasia, after two years of work, have published a new "Australasian Risk Management Standard." A major step toward consensus, it may be the start of that elusive global "standard."

The project began in 1993 with a group of 31 specialists from both sides of the Tasman Sea They published AS/NZS 4360:1995 on November 5, 1995. Its objective:the creation of a "generic framework" for the risk management discipline, an "iterative process consisting of well-defined steps" to "support better decision-making." Risk management, the Standard concludes, is "an integral part of good management practice" and should become "part of an organization's culture."

The Standard's five sections are brief yet complete:(1) Scope, Application and Definitions, (2) Risk Management Requirements, (3) Risk Management Overview, (4) Risk Management Process, and (5) Documentation, plus a useful set of practical Appendices. The authors see that risk management applies to all forms of organizational risk. This is a significant step forward.

I disagree with two definitions, for "risk" and "risk management." The Standard defines "risk" as "the chance of something happening that will have an impact upon objectives. It is measured in terms of consequence and likelihood." Can consequences be either positive or negative? I've argued that "risk" carries a connotation of harm. My definition may be clearer:" risk is the compound estimate of the probable frequency, probable severity and public perception of harm." The Standard then defines "risk management" as "the systematic application of management policies, procedures and practices to the tasks of identifying, analyzing, assessing, treating and monitoring risk." That's saying that "risk management is risk management!" I still like my wording: "risk management is a discipline for living with the possibility that future events may cause harm."

We still have work to do in reaching a definition consensus.

Two other caveats: the Standard suggests that a Risk Management Policy be defined by "the executive." I prefer approval by the Board, following current practice in the US and UK. If all risks are involved, Board oversight is essential. The Standard suggests an overall review of the entire program "at specified intervals." I believe that an annual review is correct.

The Standard defines the "context" of risk management broadly. It includes "financial, operational, competitive, political (public perceptions/image), social, client, cultural and legal aspects of the organization's functions." In other words, risk is all-inclusive. This perspective eliminates the former fragmentation of risk management that has so impeded progress. The Standard, however, doesn't make the case that risks are inherently inter-related simply by saying it is so. We need more persuasive argument.

The Standard becomes tangled in jargon when it sets forth three steps (risk identification; risk analysis; risk assessment) to describe a process that is easily defined in one term. Isn't "risk assessment" enough? It covers what could happen, how it could happen, the likelihood and consequences of an event, the use of quantitative and qualitative tools to assist in evaluation, and setting risk priorities. Readers of this Standard will be reminded of Dr. Vernon Grose's seminal 1987 book, "Managing Risk:Systematic Loss Prevention for Executives."

The Risk Treatment section emphasizes "risk transfer" as compared to "risk sharing," even though it illustrates "risk transfer" with such tools as "contracts, partnerships and joint ventures," all of which are sharing mechanisms. It suggests that risk retention follows risk transfer, when in fact it should precede it.

Finally, the Appendices to the Standard provide useful working matrices and tools for the practicing risk manager. The "Risk Register" could be a model for a computer-based system for managing all forms of risk.

Is it time to codify risk management within an inclusive "standard?" Are we ready for that "common body of knowledge" that is essential to move risk management from a discipline to a profession? This Australasian Standard is an important first step. With additional input from risk managers, teaching institutions, and organization such as the Institute for Risk Management in UK, the Center for Risk Management in Washington, and the Insurance Institute of America in Philadelphia, we will soon see more progress.

Those interested in a full copy of the Standard should write or call Standards Australia, 1 The Crescent, Homebush, New South Wales 2140, Australia. Telephone: +61-2-746-4748 Fax: +61-2-746-3333

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. . . businesspeople often cannot explain clearly what they do for a living. Usually this is not because what they do is complicated. It is because they want to believe that what they do is complicated, and they want you to believe it, too.

Michael Lewis, "Consultacrats," The New York Times

Magazine, December 24, 1995

The Law and the Profits

I've have repeated some personal observations so often that they have assumed the mantle of dogma, at least in my mind. They are now "laws" from which I cannot escape. It may be time, therefore, to recap Kloman's Law and its two Corollaries.

The Law, offered to a group of insurance brokers in 1971, is that "Insurance is nothing but a prefunded line of credit." Over time, we can agree that premiums must equal or exceed losses for any insurance mechanism to succeed. An insurance company acts as a depository for premiums (the pre-funding of losses) and disburses these funds as losses occur. For individuals and smaller firms, premiums will equal or exceed losses over the long-term, defined as 50 years or more. For the larger organization, the time span is much shorter, making it economic for these firms to assume greater proportions of their own risks and losses. The insurer acts as a fiduciary in holding and managing prudently the funds given to it, much as a bank operates. Its profits come from investment income of the funds at its disposal. An analysis of insurer net income for the past twenty years in the US shows this to be true.

I developed the First Corollary to Kloman's Law in 1985: "There is no such thing as risk transfer; there is only risk sharing." An insurance company effectively operates as the coordinator of the shared risk by many disparate individuals and organizations. It pools the funds of the many for the losses of the few. This Corollary recognizes that the inherent risk remains the responsibility of the organization (or individual) even when some of its potential financial effects are shared with others. Insurance becomes a successful mechanism when the idea of partnership is ingrained in the relationship. The purest form of insurance is thus the reciprocal or the mutual, where each participant accepts and shares risk for all the others. While some cynics argue that mutual insurers are in business solely for the aggrandizement of their executive officers, many operate with this sharing principle paramount. These are the most successful mutuals in both insurance and risk management.

My Second Corollary is the most recent - 1994: "Counterparties are critical" If insurance is akin to credit, and risk sharing is an essential attribute, then the financial condition of this "partner" is the most critical consideration. Not price, not services, not policy conditions. Any risk sharing partnership demands that each party understand and accept the financial condition of the other. The primary responsibility of any insurer is its ability to meet future commitments. Too many buyers fail to respect this Corollary in their haste to get the best deal.

My Law and its two Corollaries help managers to recognize the economic realities in risk financing.

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. . . he came to recognize the opportunity his words provided for leverage, celebrity, and service.

David Guterson, Snow Falling on Cedars, Vintage

Books, New York, 1995

Mrs. Murphy's Law

Speaking of laws, remember Murphy's:"anything that possibly can go wrong, will?" We moved to Lyme, Connecticut in April, 1994. Since most power lines in the country are above ground, we endured numerous power outages, of which the worst was a 24 hour shutdown on Christmas Eve, 1994. Yankee ingenuity prevailed. The weather was mild and our two fireplaces kept us warm. We lit the house with candles. We used water from the downspouts (it was raining hard) for the toilets (our water pump is electric). The store provided bottled water to drink. And we cooked our Christmas turkey at the local yacht club.

As successful as our contingency planning was, I decided as a prudent risk manager to install an emergency generator, at considerable expense. The obvious occurred:we haven't had a single power outage since!

This suggests Mrs. Murphy's Law:"Anything that possibly can go wrong, won't, if you've spent a fortune preparing for it!"

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He had become inured to the tragedy of growing old; his jets of rebellion had faded . . ."

Patrick O'Brian, Rendezvous and Other Stories,

W. W. Norton, New York, 1994

An Insurer's Mission

My comments about the fiduciary responsibilities of an insurance company remind me that an insurer should be more than a seller of insurance. I am impressed by the stated mission of United Educators Insurance Risk Retention Group, a firm that offers not only liability insurance to schools and colleges, but also sophisticated risk management counsel. Arthur Broadhurst, its senior vice president said, at a meeting in Washington in November, that UE's mission is "to think together about liability and risk more intelligently."

A brief yet complete statement of true partnership in risk management.

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. . . he also knew that every man needs an obsession in order to enjoy life, and it was so much better if that obsession was constructive.

Louis de Bernieres, Corelli's Mandolin, Vintage

International, New York, 1995

Broker Float - Deja Vu

It seems to take forever for sound and obvious ideas to make their way into the insurance industry. In 1971, in an article in Best's Review , I wrote: "One of the reasons the property/liability business is experiencing difficulty is that its collection procedures are archaic. When an insurance company writes a policy, it should begin receiving premium as soon as it is at risk. The industry, however, has set up a system in which the agent or broker acts as a collection agency. In some states the broker or agent is permitted to hold and invest funds belonging to the insurance company for up to 90 days. In an age of lock-box banking, this is a complete waste of money. . . . These funds belong either to the insured or to the insurance company. The risk manager should attempt to pay the insurance company directly."

Twenty-five years later the industry has made little progress. Bill Kelly, the risk manager for J. P. Morgan and RIMS president, was quoted by National Underwriter (Nov. 20, 1995) as saying that the common practice of brokers holding premiums as float is "an ingrained anachronism." He went on, "I have to believe at some point all premium payments will be made by wire transfer directly to the insurer on the date of coverage inception, a practice currently followed by a few Bermuda markets." At some point? Why not right now?

Where has everyone been for the past twenty-five years? It was a sloppy practice a quarter century ago; it is inexcusable today.

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There are few businesses in which the suppliers deliberately and persistently refuse to meet demands, but insurance is one of them. Arguably insurance is more important to the economic system now than ever before, but it is becoming increasingly unprocurable.

Chris Best, "Insurance Can Be an Asset," Foresight,

November 1995

Risk Financing Trends

Last fall, Gregory Berg, a principal at Tillinghast-Towers Perrin, prepared a summary of trends in the risk financing market for a non-profit client, reprinted with his permission.

o "There is a dearth of acceptable insurance companies for large commercial buyers of insurance and for 'program' insurance business. In every insurance transaction, the insurer, as the counterparty, is making a promise to pay in the event of a loss. The ability to pay is dependent on the insurer's financial security. The recent restructurings (and rumors of restructuring) among some of the old line primary stock companies (Home, Continental, Cigna, Aetna) helped to create an insecure marketplace. Buyers continue to have difficulty in evaluating the true financial security of their insurers. And perhaps more importantly, buyers have difficulty in evaluating the 'business security' or long term appetite for a specific class of business.

o For many buyers of risk financing products, there is latent risk retention capacity. While major institutions are willing to take large financial risks in new product/service development, they are often overly cautious when facing hazard risks. This has resulted in deductibles and retentions being lower than necessary and being out of synch with the organization's overall risk posture.

o There is continued restructuring of risk financing. For small to medium sized insureds, the group alternative risk transfer (ART) market continues to grow with association captives, self insurance groups, pools and trusts. However, larger insureds have not yet fully benefited from ART; there is still heavy use of unwieldy and old fashioned large deductible programs, retrospective rating plans, and requirements for individual corporate insureds to collateralize their fronting programs.

o Continued advances in actuarial science and information technology are providing the platform for increased sophistication in risk financing programs, particularly in the use of probability and financial theory. The management of risk is made easier by the ability to measure the trade-offs of higher and lower retentions.

o The 'financialization' of risk management will continue to blur the distinctions between banking and insurance. Chief financial officers will also continue to downplay the differences between business and hazard risks. Risk financing solutions will increasingly be offered by investment banks and the capital markets."

I agree with each of these observations, which support my Law and its two Corollaries .

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The strategist did not confuse his devices with the reality of the world, for then what would become of him?

Cormac McCarthy, The Crossing, Vintage International,

New York, 1994

Ripple Effects

Losses are made up of more than the direct financial effects of a particular event. We understand this but seldom take it into consideration in our risk assessments. This point was made by John Marini, of Adjusters International, at a RIMS meeting in Kentucky last fall. He described some of the follow-on losses, or ripple effects, that are overlooked when we develop "maximum foreseeable loss" estimates.

o A fire engulfs and destroys a hotel, but the liability lawsuits following the blaze dwarf the property loss

o A windstorm damages a store only moderately, but looting cleans out the inventory.

o A fire damages a UK plant which then looks to its US branch for replacement parts. These parts are not built to metric specifications and can't be used.

o Property disposal after a fire costs far more than the fire because it is now deemed "toxic waste."

o Replacement water after a fire has a heavy lime content and can't be used.

Consider ripple effects when developing both "maximum foreseeable loss" estimates and functional contingency plans. Any scenario analysis of a loss event should include not only the primary, or direct, and secondary, or consequential, losses but also the tertiary effects. Could additional loss occur as a result of the responses to the loss? Could other forms of loss occur, including liability, employee injury or slowdown, regulatory inspections/shutdown/interruption, increased criminal activity, reduced credit or increased interest costs? Will action taken to mitigate the loss have negative unintended consequences?

The responsible risk manager never stops asking "what if" questions, seeking answers from the most knowledgeable sources.

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So although the universe may look quiet enough at the moment, we can't be sure that something really horrible hasn't already happened.

Paul Davies, The Last Three Minutes, Basic Books,

New York, 1994

February - Spencer Month

February has been designated Spencer Educational Foundation Month by the Risk & Insurance Management Society for the past several years. It reminds us that the future of risk management rests on the young people now entering the discipline. The Spencer Foundation plays a key role in their future, offering ten $10,000 scholarships each year to the most promising students of risk management at the undergraduate, graduate and postgraduate levels. The Foundation also provides mentoring by a Spencer Board member, funds for high school outreach, and special research grants in risk management studies and projects.

Over the last decade the Foundation's assets have grown to just over $1.6 million, but these funds must continue to keep pace with inflation, the increase in qualified risk management students, and the challenging new projects being suggested to the Board.

Your support is essential.. Play in golf tournaments that contribute to Spencer. Play tennis in Toronto in April. Bid in Spencer's Silent Auction on April 21. Watch the brutal head-to-head combat of US and Canadian hockey players, for the ESIS Cup, also on April 21 in Toronto (see RMR November 1995 "Canadian Folk Opera"). In addition, make a direct personal or corporate annual contribution to Spencer. Send checks, payable to "Spencer Foundation," to the Foundation, c/o RIMS, 655 Third Avenue, New York, NY 10017-5637.

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The process of writing had crystallized opinions and philosophical positions that she had not even know she had held. She discovered that her basic understanding of economic processes was Marxist, but that, paradoxically, she thought that capitalism had the best ways of dealing with the problems. She considered that cultural traditions were a stronger force in history than economic transformations, and that human nature was fundamentally irrational to the point of insanity, which accounted for its willingness to embrace demagoguery and unbelievable beliefs, and she concluded that freedom and order were not mutually exclusive, but essential preconditions of each other.

Louis de Bernieres, Corelli's Mandolin, Vintage

International, New York, 1995