Risk Management Reports

February, 1998
Volume 25, No. 2
 

January Issue
A gremlin in the computer caused many January issues of Risk Management Reports to be mailed without complete addresses. We are re-mailing the copies that the Post Office returns to us. If you did not receive your January 1998 issue, please call (860-434-2917), fax (860-434-3917), or email me (fkloman@aol.com) and I'll have a replacement copy sent forthwith. Sorry about the glitch. Could this be a precursor to the Y2K problem?

Table Manners
The New York Times headline said it all: "So Much for Table Manners." The reference was to the fratricidal lawsuit of 41 retired Johnson & Higgins directors against the 24 directors who engineered the 1997 merger with giant insurance broker Marsh & McLennan. At issue is the split of the $1.8 billion proceeds to be shared. This public display saddens and embarrasses me because I have friends in both camps. I have no idea of the legal niceties of the case, but when grown men argue over splits from a pie that average $36 million apiece for current directors and $12 million for recently retired directors, I begin to see how the past fifteen years of a society overwhelmed with the idea of personal advantage have come to affect us all.

This certainly isn't the only mega-combination. Aon Corporation has gobbled insurance brokerage firms, matching Marsh & McLennan bid for bid. Two firms, Sedgwick and Willis Corroon, could easily join the larger ranks this year. The Big Six public accounting firms are now the Big Four, and could shrink further. Banks and investment firms are rushing to merge, as are insurers and reinsurers.

This activity provokes other questions:

o Who pays for the cost of these combinations? The answer is clients. Partners and employees won't take reduced salaries and bonuses. Shareholders want higher stock values. The costs, therefore, come directly from the customers, you and me. I suspect also that the claimed cost efficiencies will prove to be ephemeral. Do you actually expect fees and commissions to go down after a mega-merger?

o What about the conflicts of interest created by these new organizations? If a Big Four firm is, at once, public accountant, tax advisor, head hunter, and consultant, how independent can it be?

If a mega-broker has placed over $1 billion in premiums with an insurer, how "independent" can it be in evaluating the financial security of that insurer? Won't mega-brokers be too financially entwined with their big insurers to provide the independence of counsel that clients need?

o In the mad rush to protect personal turf in these mergers, what type of person is most likely to survive, the "producers" or the "servicers?" I suspect it is the "producers." Guess who gets the short end of the stick again: the client.

o What is the real effect of new global information technology? Doesn't it really empower smaller organizations and individuals, enabling them to compete at the same level as the larger firm, without onerous overhead costs? Won't risk managers create project teams from a variety of sources, rather than using a single firm, as Tom Peters suggests in his newest book? Doesn't it also permit CFOs and RMs of larger firms to place their risk financing business directly, bypassing intermediaries? Isn't size a temporary illusion?

o What is the real "social" contract among the employees of a firm, especially when it comes to a merger or split-up? Are all stakeholders considered or does a change benefit only shareholders and key employees? The answer to that question may affect future satisfaction with the services of a firm.

When I was a child, my mother, a wise lady from Kentucky, taught me my table manners: eat what is put in front of you; accept more only when offered; thank your host and hostess properly; fold your napkin before asking to be excused from the table; and once having left the table, don't expect any more food until the next meal.

"I don't know that men are better judges than women," said Florence, "but they spend much less time regretting their decisions."

Penelope Fitzgerald, The Bookshop
Houghton Mifflin Co., Boston, 1978

 
 
Words, Words, Words
Lars Nilsson, the risk manager of Sweden's Kammarkollegiet, recently asked me about clarity in the use of risk management terms. He argues that the prevailing ambiguity hampers effective communication about risk issues. I agree. This is a long-standing problem that has yet to be solved.

Nilsson comments on the use and meaning of terms such as risk, deviation, possibility, uncertainty, expectation, and my argument about the Janus faces of risk. He believes that risk "is always about the negative side" and that "risk management is construed as the management of the 'downside.'" This, of course, is the conventional view. I maintain that we must balance the full picture of risk, the possibilities of both reward and harm.

The issues of scope, breadth and definition appear regularly in risk management publications. Stan Kaplan, of Bayesian Systems, Inc., contributed to the discussion in a speech to the 1996 Annual Meeting of the Society for Risk Analysis, printed in Risk Analysis in the August 1997 (Vol. 17, No. 4) issue. Every quarter I screw up my courage and challenge, with trepidation and a feeling of inadequacy, that red and white monster crammed with mathematical formulae and abstract writing. Occasionally I find a piece like Kaplan's that I can understand. Kaplan agrees with Nilsson that "the words of risk analysis have been, and continue to be, a problem." He recalls that the Society established a committee to define the word "risk" and gave up after four years of work! He defines risk through the answers to three questions: What can happen? How likely is it? What are the consequences? These questions involve probability, with mathematical, Bayesian and statistical interpretations. The Bayesian (Kaplan is one) argues that probability is a degree of confidence or certainty, which "does not exist in the real world, it exists only in our heads." Therein lies much of the miscommunication about risk: probability is subjective and "words like 'confidence' and 'belief' have a personal dimension to them."

Kaplan suggests that "we should never ask an expert for his opinion. What we want from an expert is his experience, his information, his evidence." He concludes: " . . . to make a decision we need three things: a set of options from which to choose, an evaluation of the outcomes of each option, and a value judgment on each outcome. . . . Since we will always have uncertainty in the outcomes, we should, to tell the truth, quantify that uncertainty in the form of probability curves." "Making the decision is not the end of the job. It's necessary to get the decision accepted and implemented. For that we need the support of the people affected by it. That means risk communication . . ."

The same issue of Risk Analysis contained another thoughtful article on risk communication. Its authors, Cynthia Jardine and Steve Hrudey of the University of Alberta, in Edmonton, also explore the "multiple and disparate" meanings of risk. Colloquially, it means danger, venture and opportunity. Technically it means hazard, probability and consequence, and in insurance, it means chance and uncertainty. Their exploration of these meanings is one of the best I've read. They agree with Kaplan that these diverse meanings often hamper effective risk communication and decision-making.

After reading Kaplan, Jardine and Hrudey, I asked myself how well the current risk management texts address these issues. Do they acknowledge the scope and breadth of risk management in its current holistic practice? How clear are their definitions? I chose four leaders for this review. Acknowledging that my view of the discipline is considerably broader than many in public policy, financial or insurance practice, I expect some to disagree with this perception. I took the most recent editions: all are new or have been updated in the past two years.

The first text is a classic in the insurance/risk management literature. Risk Management and Insurance was written by Arthur Williams, of the University of Minnesota, in 1964, and has received six revisions, including the current 1995 edition written by Michael L. Smith at Ohio State University and Peter C. Young at the University of St. Thomas. The Seventh Edition, in its opening pages, effectively puts to rest the outmoded idea that risks are "speculative" and "pure," to be managed separately. It acknowledges that the "study of insurance, a major tool of risk management, should be preceded by an understanding of the procedures and concepts of risk management." Risk thus becomes "potential variation in outcomes" and risk management " a general management function that seeks to identify, assess, and address the causes and effects of uncertainty and risk in an organization." Despite this favorable start, however, the text makes no mention of the contributions of the Society for Risk Analysis in the public policy field. Its mention of financial risk and response is limited to two paragraphs on derivatives and swaps, two pages on hedges and six lines on credit risk, out of 680 total pages. There is only one paragraph on contingency planning, arguably one of the most important responsibilities of any risk manager, and nothing on the movement toward a Chief Risk Officer.

The second text is Jim Bannister's How to Manage Risk, in its 1997 Second Edition published by LLP Limited in London. It is intended to be a more practical approach to problems facing an operational risk manager. In this respect, with its numerous checklists and case study comments from its author, a practicing risk management consultant for more than 30 years, it succeeds. Bannister's "important warning" in his Preface is an admonition worth the price of the entire volume: "The world is full of surprises. Many disasters result from failure to anticipate or notice new or old factors that in the event have turned out to have disastrous consequences. So please us this book as an 'assistant.' Take nothing on trust. If in doubt ,check." Bannister's chapters focus on the nuts and bolts of practical risk management with an insurance bias: product liability, professional negligence, directors' and officers' liability, safety and occupational health, property insurance, warehouse fire control, fire sprinkler systems, electrical risk boiler and machinery risk theft and fraud, storm risk management, pollution risk, political risk, credit risk, computer risk and marine risk. If there's a specific risk, there's a chapter with idea, tools and practical examples. This book's advantages are its tight prose, checklists and easy reference to many of the day-to-day problems facing insurance risk managers. Its definition of risk is broad - "future uncertainty" - and it acknowledges that risk management is a "multi-disciplinary process" that requires the use of a "collection of techniques used in a coordinated and flexible manner." The individual chapters, however, focus too much on "insurance" type issues. There is nothing on derivatives, hedges and swaps, and the tools of financial risk management, including RAROC, EVA and CFROI.

There is little on public policy issues and the discussion on risk measurement is largely statistics-based, with nothing on PRA and QRA.

The individual chapters, however, focus too much on "insurance" type issues. There is nothing on derivatives, hedges and swaps, and the tools of financial risk management, including RAROC, EVA and CFROI. There is little on public policy issues and the discussion on risk measurement is largely statistics-based, with nothing on PRA and QRA.

The third text is Volume 1 of the 1997 third edition of Essentials of Risk Management, prepared by George L. Head and Stephen Horn II, and published by the Insurance Institute of America. This is the introductory volume of three that prepare students for the examinations for the Associate in Risk Management designation. Given its insurance roots, it is not surprising to find a focus on "accidental losses" and "minimizing the adverse effects of these losses." It sees risk management as a "protective" function within an organization, and, even though it acknowledges that there are other forms of risk management, it limits the scope to "how to control or finance recovery from accidental losses." Head and Horn note that "investment, business, and political risks are real, and equally, if not more, important than risks of accidental loss in determining the well-being of the people in a household, organization, community or country." "Furthermore, those investment, business, and political risks (along with technological, psychological, medical, and perhaps other categories of risk) can all be managed to at least some extent by human action." If this is so, why shouldn't risks be managed on an integrated or holistic basis? The authors do not answer this question, choosing to retain the focus on "accidental losses" and their treatment. Despite the statement that "this text now focuses on 'risk' in both its accidental and its business contexts," the mention of financial risk management and public policy risk management remains limited (five pages on hedges, nothing on swaps and derivatives, two lines on political risks, and nothing on contingency planning). The major chapters on property, liability, personnel and net income loss exposures have an unmistakable insurance orientation to them, not unexpected given the audience to which the Institute caters. Despite the relatively narrow focus of this text, its multiple case studies, charts and exhibits make it an invaluable tool for the practicing insurance risk manager.

The fourth and final text is the brand-new International Risk and Insurance, written (ten of 28 chapters) and edited by Harold D. Skipper, of Georgia State University. As the sub-title to this book suggests ("an environmental-managerial approach") this is an ambitious undertaking, a departure from conventional texts in the field. It is an appeal for a truly international perspective to risk management, one that is freer from the ethnocentricity and geographic bias in other texts. Skipper et al argue that humans have always sought to reduce uncertainty. Given the current wave of gambling mania in the US, I might dispute that point with him, but I concur with the conclusion that "all manage risk to a greater or lesser degree, by design or default." The purpose of developing a discipline is to try and avoid that "default" option. The Skipper text's definition of risk, "the relative variation of the actual from the expected outcome" has clarity and breadth. He also scuttles the old dichotomy between "speculative" and "pure" risk as being "not simply arbitrary but counterproductive." Well said! Yet he still manages to produce a definition of the "risk management process" that is both wordy and unwieldy: ". . . the identification and evaluation of the possible outcomes associated with events or activities; the exploration of the techniques to deal constructively with these risks, and the implementation and periodic review of a logical plan of action." This is certainly broad enough, but couldn't we make it more concise? Try "a logical plan to assess the outcomes of future events and to deal constructively with them." This text is thorough in its conception of risk and risk management but its focus, again attributable to the insurance orientation in its title, is more on "hazard" than on "financial" and "public policy" issues. A chapter is devoted to political risk (No. 8, by Frederick Schroath, Kent State University) and a section to the international regulatory environment for insurance and risk financing. Social, life/health insurance, health care, and employee benefits all receive due attention. Larry Gaunt's (Georgia State University) chapter on "Risk Management" concisely describes the current movement but focuses on "hazard" risk as compared to "financial" risk (covered in Chapter 6, by Samuel Cox, also of Georgia State University). In my view, separating these two chapters unnecessarily perpetuates the split of risk treatment, and neither chapter acknowledges a connection to public policy management.

Harold Skipper's concluding chapter, "A Future Perspective," effectively pulls together the disparate risk and insurance pieces in this book. He sees a multipolar world replacing the past fifty years of bipolarity. Economic power will be centered in Europe, North America and East Asia, where economies will become more integrated and where reliance on markets will reduce reliance on governments. The "mobility of people, ideas, information, and financial capital" will stimulate new regulatory and tax responses, some on a regional basis. Risk perceptions will be more important: ". . . neither economics nor any other social science offers a fully developed, generally acceptable normative or positive theory of risk to guide society in making some of its most critically important decisions." Here is where risk management can possibly grow into the "integrated approach" that Skipper encourages, one "contrasted with the inefficient, segmented approach largely followed today." He anticipates the measurement and monitoring of a firm's "total risk profile" and "more time and resources to monitoring so-called macro risks in an integrated way." Skipper wisely warns against placing too much stock in his book's predictions. He sees both benefit and harm in the future: " . . .the world must cope with the greater possibility of bad things being imposed by one group on others" and "the growing interconnectedness of people also means that good things accruing to one group may benefit others."

Of the four texts that I reviewed, the last comes closest to my view of describing and explaining the integrated, holistic risk management of the 21st century. Each effort, however, adds to the dialogue and to the clarification of terms that Lars Nilsson wants.

1997 was a rich year for new views: readers should also remember other important books of the year, as reviewed in Risk Management Reports: Peter Bernstein's Against the Gods, (January 1997), John Adams's Risk, December 1997), and Vlasta Molak's Fundamentals of Risk Analysis and Risk Management, (August 1997).

 
Now uncertainty - the sense that not only you don't know the truth but that many complex issues are irresolvably ambiguous - is sometimes the most productive way of allowing you to act while at the same time respecting that others are not going to accept your view, approve your action or follow your example. It produces a tentativeness that permits you to see many things from many points of view. Which is, I believe, the best definition of objectivity.

Alexander Nehamas, Princeton University, in
The New York Times, January 10, 1998

 
 
SpamTM
To users of the Internet, to "spam" is to send unwanted materials, often advertising. It is an unfortunate use of a noble word.

SpamTM, of course, is the trademarked, packed luncheon meat that has been canned by Hormel Foods Corporation since World War II. For some sailors, such as me, it represents the height of galley gastronomy, much more than a crowning delight for lunch.

Fried Spam and scrambled eggs make a superb breakfast at sea. Sliced Spam with mustard and mayonnaise and two slices of bread are, of course, the perfect lunch. And Spam minced into small pieces and mixed with a thick pea soup or studded with cloves and presented as a "roast" will make a dinner that will easily carry you to breakfast, to repeat the same delicious cycle. I grant that there are many skeptics and unbelievers, but to these few knowledgeable yachtsmen, Spam is the acme of culinary achievement!

So it was with great joy (in the Patrick O'Brian sense of the word) that I received several months ago from my daughter a set of haiku composed on the theme of Spam (the edible, not the Internet variety). We searched for some time for the author of these verses, but no one acknowledged them. I repeat them in the hope that a fellow-Spam lover will be identified and credited with these poems:

  1. Blue can of steel
    What promise do you hold?
    Salt flesh so ripe
  2. Can of metal, slick
    Soft center, so cool, moistening
    I yearn for your salt
  3. Twist, pull the sharp lid
    Jerks and cuts me deeply but
    Spam, aah, my poultice
  4. Silent, former pig
    One communal awareness
    Myriad pink bricks
  5. Clad in metal, proud
    No mere salt-curing for you
    You are not bacon
  6. And who dares mock Spam?
    You? you? you are not worthy
    Of one rich pink fleck
  7. Like some spongy rock
    A granite, my piece of Spam
    In sunlight on my plate
  8. Little slab of meat
    In a wash of clear jelly
    Now I heat the pan
  9. Oh tin of pink meat
    I ponder what you may be:
    Snout or ear or feet?
  10. In the cool morning
    fry up a slab of Spam
    A dog barks next door
  11. Pink tender morsel
    Glistening with salty gel
    What the hell is it?
  12. Ears, snouts and innards
    A homogenous mass
    Pass another slice
What, you may ask, does this piece have to do with risk management? Like Spam, it is the ultimate filler.
 
Lunch's shortcoming is that one can only have so many in one day. Tibor Fischer, The Thought Gang
Scribner, New York, 1994

Copyright 1998, by H. Felix Kloman and Seawrack Press, Inc.