Risk Management Reports January 1996

Volume 23, Number 1

Issues for 1996

Here we are, edging nervously toward the Millennium, only four years away. As 1996 begins, I have tried, as in prior years, to identify those issues of most significance to risk managers. The year promises challenges: major elections in Russia and the US, new leaders in Israel and Sweden trying to establish their authority, leaders under pressure in Canada, France and UK. Economically the bull stock market that took the US for a ride in 1995 is likely to peak.

The major risk management issues continue to be counterparty security, environmental liability and the necessity to re-define the discipline of risk management. Within my four segments of risk (operational; liability; political/regulatory; and financial/market), the issues are:

Financial/Market Risks

o Counterparty Security The financial security of an organization's risk financiers, insurers and reinsurers is a paramount issue of 1996. Perhaps the single most important event will be whether or not Lloyd's will continue after June 30. Will Equitas be funded and the litigation resolved or will Lloyd's slide into full runoff, as some of its Names suggest? In the US, have we seen the end of massive infusions of capital to compensate for past environmental and other liability claims? I doubt it, especially after the Aetna-Travelers merger. Insurer consolidations will continue and more will be announced in 1996 in the effort to cut costs and reinforce balance sheets. Over 3500 non-life companies serve consumers in the US, too many for efficient use of capital. 1996 will see more movement toward the eventual goal of 50-100 insurance "groups."

One problem will be the proposed CIGNA approach of segregating "good" from "bad" business in separate structures. Can policyholders trust the reserves established in the "bad" companies? As Myron Picoult asked (in Business Insurance on December 4, 1995), "If the reserves and various guarantees that CIGNA is setting up are as sacrosanct as the company makes them out to be, then why is there a need to set up a separate company?" The quality and potential continuity of an insurer will be far more important to a buyer than cost.

o Credit There has been a steady decline in both public and private responsibility toward debt in the US. Congress can't seem to grasp the idea that we must not only eliminate the annual budget deficit but also decrease the national debt. Neither the Republicans nor the Democrats, for all their talk about 7 to 10 year's deficit reduction, have addressed the larger problem of reducing the debt! This attitude carries over into other aspects of public and private life. Orange County defaults; Rockefeller Center and Dow Corning try bankruptcy. The social and economic stigma of bankruptcy diminishes and becomes a game. The effect will be reflected in the personal debt arena. Perhaps it's time to reinstate debtor's prison, especially for those legislators who chronically overspend our tax money.

o Derivatives Barings, Daiwa, and the pending Bankers Trust/Proctor & Gamble suits will all create more discussion and probably more (unneeded) regulation about derivative and other investment risks. Already the Basle Committee is looking at new capital standards for the market risks of banks, and the Federal Reserve Bank of the US suggests that banks "pre-commit" necessary capital to cover trading losses. What controls are useful, not unnecessarily restrictive, and how do organizational risk managers measure the strengths and weaknesses of their investment counterparties? Beware of more losses and more changes in regulations.

Political/Regulatory

o Political Fragmentation This remains a global movement, although the signals are mixed. Quebec (narrowly) and Bermuda (by a wider margin) elected to remain within their national structures, even as Bosnia is split and the Palestine-Israel separation gingerly moves ahead. In both South Africa and Northern Ireland, peace seems to be gaining the upper hand. Nonetheless, look to further signs of fragmentation or at least devolution of political power to smaller units, especially in the US. Fragmentation always creates increased risks of political and regulatory change.

o Regulations Regulatory uncertainty will persist for the next few years, in areas like the environment, safety, and public notice of risks. Regulation will also be in a particular flux for insurance and reinsurance companies. The National Association of Insurance Commissioners (NAIC) in the US persists in fighting a delaying action against the inevitability of some form of Federal regulation, especially for solvency. Banks continue to try to breach walls preventing them from selling and underwriting insurance, as their counterparts in Europe have done successfully. The UK soon may permit its insurers to create tax deferred "equalization reserves" to help fund for catastrophes, a right not permitted US companies. Overall, at least in the developed countries, insurance regulation is moving inexorably from "substantive insurance supervision (strict licensing requirements and rigid price and product regulation) . . . to a more demanding form of financial supervision (solvency provisions)" (in the words of Swiss Re's Sigma, 3/95). Yet until this "re-regulation" is completed, buyers will find market turmoil.

Legal Liability

o Environmental Liability This continues to be the issue of the decade. From the known and escalating costs of site remediation, under the Superfund Act, to the potential for new sudden or gradual pollution events, organizations need continuous risk assessments and financial contingency plans. Conventional insurance isn't a realistic option, despite the success of some companies in winning suits against past insurers. Environmental claims have already crippled Lloyd's and driven several carriers into mergers. Estimates vary but the cost to insurers for past claims will likely reach $132 billion over the next 25 years (A. M. Best & Co.). Will Superfund drop its "joint and several" liability requirement? If so the costs could moderate but the overall social effect will remain: we are trying to hold a narrow group of organizations (corporate polluters, banks, insurers) responsible for the excesses of the past even when all of us who have benefited should agree to share the costs.

Another issue is the growing concept of "environmental sovereignty." This is an idea "that says that my home, my space, isn't limited to my borders on a map. It includes the air I breathe, the water off my shore and the whole extended food chain upon which I rely. Environmental sovereignty is not confined either by conventional borders or by conventional time." (Thomas Friedman, in "The Bomb and the Boomerang," The New York Times, August 27, 1995) In other words, if you foul my air or contaminate my water, even though that pollution may begin hundreds or thousands of miles away, I may have a right of action against you. If this idea persists, and it was certainly evident in the global public outcry against the renewed French underground nuclear tests, it could mean even more difficulty and costs for alleged polluters.

That we have fouled our planet is unquestioned. The problem is whether we tackle the solution together or try to attach blame and responsibility to individual organizations.

o Employment Liability New areas of real and potential liability are being created in the US in the workplace. Employers are now held accountable for sexual harassment, improper ergonomics, unfair access for the disabled, and almost any form of "stress" that could conceivably result from work. Risk controls standards are constantly escalating as well. This is an area where the risk manager can riase corporate awareness.

Operational Risks

o Crime in the Workplace Despite increasing emphasis on security, more crime is taking place at work. Whether it be terrorists (Oklahoma City), disenchanted protesters (New York, December 1995) or deranged or unhappy employees, it seems that office or factory violence is increasing. Some of it may be of the copycat variety. Homicide at work is the largest cause of death for women and the second largest for men in the US: some 1,063 homicides and 100,000 incidents were reported in 1993 (see Sandra Kelley's article on this subject in the October 1995 issue of Risk Management). Part of the problem is the rapid increase in urban crime worldwide, from Rio de Janeiro to Johannesburg, from Moscow to Los Angeles. A more heavily armed populace, especially in the paranoid US, coupled with global extremist groups, argues that this problem will escalate. Drugs, over- crowding and reduced economic opportunities result in murder, extortion, assault and car hijackings. Risk managers, working with human resource personnel, should take more aggressive action.

o Catastrophes The incidence of natural hazard catastrophes has risen dramatically. In the US 16 of the 20 largest catastrophes have occurred within the past six years. Worldwide, insured catastrophes accounted for about 0.2 %o of gross domestic product (GDP) from 1970 through 1988. The cost doubled to 0.4%o of GDP since then, according to Swiss Re. Recognizing that in most cases the costs of catastrophes are only modestly covered by insurance, and that the insurance market is financially unprepared for real catastrophes, the organizational risk manager is forced to develop both contingency plans and alternative forms of financing. Traditional insurance and reinsurance cover is inadequate in major markets, leaving organizations and individuals to depend on their own resources and those of States. Relief may be in sight, however, with the move toward granting insurers the use of tax-deferred "equalization reserves," at least in some European countries.

o Data Risk As "information" replaces capital as a critical segment of our economy, we face increasing risk of those data being unavailable when needed. In 1996 many organizations will face, and perhaps solve, the "year 2000 problem." Systems could be shut down because of an inability to convert to the date "01/01/00." There is even a World Wide Web site devoted to this potential glitch: http://www.year2000.com. Protecting data from loss, improper modification, or misuse will be continue as a major risk management problem.

Communications

Amid all these issues is one over-riding concern: how to communicate the enormities of risk and the cost of their responses. Risk managers need to translate the potential effects of risks and the costs to contain it not only to senior managers and operating staff, but also to all the stakeholders of a organization (customers, suppliers, the public). The US Congress now requires risk/benefit analyses for all governmental regulations. In UK the Cadbury Committee Report requires risk assessments for Board members. In Australia and New Zealand, new "risk management standards" have been adopted for both private and public sectors. How is "risk" to be defined within an organization? Can a single strategic risk management response be developed to address all forms of risk, or must risks continue to be segregated into their old compartments where skilled tacticians (hedgers; insurance buyers; safety specialists; etc.) seldom talk with one another? How can we explain "risks" coherently to employees, shareholders, customers, suppliers, and communities without unnecessarily arousing fears? Will their ingrained perceptions of risk overwhelm the opinions of experts? Can traditional service providers (investment brokers, bankers, accountants, insurance brokers, consultants) help bridge this communications gap or will they persist in flogging their narrow areas of skill and interest?

Fortunately, those risk managers interested in more intelligent communications with their larger audience have some innovative resources available. One risk manager, Richard Lowther of Brown & Williamson Tobacco, has a home page on the World Wide Web. His "Risklist" is a catholic compendium of research tools, drawn from his peregrinations through the Internet and his broad view of risk management. His sub-heads include Risk Resources (and the means of subscribing to RiskNet - see the April 1995 issue of RMR), Risk Financing, Disaster Recovery/Contingency Planning, Sources of Legal and Regulatory Risk, and Other Sources. You can reach Richard Lowther at rlowther@iglou.com and his RiskList at http://pages.prodigy.com/KY/rlowther/risklist.html.

The Internet's discussion groups and the World Wide Web give a risk manager unique resources to improve communications.

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Maybe it's time to give up the notion of human beings as intruders, tramplers, and destroyers. We are all of these, there's no doubt about it, but they are not all we are. And yet the same mind-set that interprets human history as little more than a string of increasingly lurid ecological crimes also insists that our species represents the last, best hope of "saving" the planet. Is it any wonder that the future looks bleak?

Here we have the essential Puritan outlook disguised as science - human beings, the sinners, occupy center stage, and cannot move a muscle without risking the direst consequences in a cosmic drama. . . .One false step - and our ancestors, as we know, have taken almost nothing but false steps - and our dwelling place may be mutilated beyond redemption. . . . Somehow an agreement has been reached to exclude whatever is human from the sum of biodiversity.

. . . when homo sapiens came on the scene . . . this creature released organic change from its age-old dependence on genetic recombination and harnessed it to new energies - culture, symbolic language, and imagination. As is becoming more and more evident, nothing has been the same since.

Thomas Palmer, "The Case for Human Beings," in The Best

American Essays, 1993, Ticknor & Fields, New York 1993

The Psychology of Commissions

What is it about a "commission" that erodes one's confidence in a "professional?" In November I met an articulate and intelligent insurance agent at a Washington conference for nonprofit organizations. I had earlier suggested from the podium that a fee basis of remuneration is the most professional payment mechanism, if not now, then in the near future. He acknowledged that his commissions barely covered his costs for many of his nonprofit customers but he argued that they could not afford to pay additional fees.

My response was that the amount of remuneration is less important than the form. If he wished to continue his essentially pro-bono work, he could charge a fee commensurate with the current low commissions, and, in doing so, at least save the state premium tax on commissions. The point is one of the relationship between "advisor" and "client." A commission creates a "buyer-seller," a fee a "advisor-client" relationship. This applies to any person who wishes to be treated as an advisor, not a seller, be it in banking, insurance, investments, etc.

It's basic psychology. Would you trust the advice of a physician who represented six or seven drug companies and whose remuneration was based on commissions on drugs prescribed? Even though the doctor told you he only advised the best course of action, wouldn't you have some suspicions?

This thinking applies to those who purport to advise objectively about risk management and risk financing. They must subscribe to a broader mission than selling products or services (to a risk management equivalent of the Hippocratic Oath) and use a method of remuneration that reduces to a minimum any suspicion of selling.

Risk management is a form of medicine: it's best prescribed by physicians, not drug salesmen.

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Lobbies exist to behave swinishly on behalf of people too delicate to behave swinishly for themselves. . . . most lobbies are too worldly to whine when someone notices their snouts in the trough lapping up the slops.

Russell Baker, "Snouts in the Slops,", The New York

Times, October 21, 1995

Sleeping Policemen

Once upon a time, a chief executive was driving down an English road to visit his new plant. His risk manager was navigating. Suddenly the driver spied a sign: "Sleeping Policeman Ahead." The risk manager said nothing. The executive, a native of New York City, laughed, and said, "That's what they all do in New York, only they call in 'cooping,'" and accelerated. Shortly thereafter their car hit a speed bump and tore out its transmission, leaving them both stranded. The risk manager walked home without a job.

The moral of this short fable: a risk manager should be able to recognize, read, understand, and report warning signs, in any language, to senior management. Failure to do so will properly result in dismissal.

This was brought to mind by a recent interchange on the Internet regarding the amusing nomenclature for speed bumps used in some English-speaking countries. We knew them in West Sussex as "dead policemen."

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A physician can bury his mistakes, but the architect can only advise his clients to plant vines.

Frank Lloyd Wright, as quoted in Chuck Crandall and

Barbara Crandall, Flowering, Fruiting & Foliage Vines,

Sterling publishing, New York 1995

"Robust"

What is it with this word, "robust," popping up fad-like in all forms of usage? Actuaries now refer to their "robust" numbers. President Clinton refers to "robust rules of engagement" for Bosnian troops. Advertisements refer to "robust" clothing. "Full of health and strength, vigorous", says my American Heritage Dictionary in definition, "powerfully built, sturdy, suited to physical strength or endurance." Yet there is also a secondary definition: "rough or crude; boisterous." I wonder if that is what the actuaries or the President intended? H. W. Fowler (Modern English Usage) notes that the prevailing 17th century usage was "robustious" with an emphasis on the "rough" or "crude" meaning. Is this a robust attempt at humor?

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Over the years she had come to depend on misfortune of all kinds. It imparted form and unity to the days and weeks and gave her a consistent set of expectations and a sense of security. So long as all was wrong with the world, Bangor was content.

Howard Frank Mosher, Where the River Flows North,

Penguin Books, New York, 1985

The Value of Insurance

My perambulations through the Internet pulled out a recent gem from consultant Paul Roller, with Roller & Associates in Tucson, Arizona. Commenting on the societal value of insurance, he cited a former student of his who argued that most insurance companies missed the opportunity of emphasizing the "good neighbor" element in the purchase of coverage. "I am a good neighbor because when my neighbor suffers a loss, I've contributed to a pool (insurance) that will help my neighbor to rebuild. My neighbor cares enough about me to do the same. Our insurance carrier helps us all by acting as the conduit to fulfill this important function."

This is the very heart of insurance as it was originally intended: the sharing of risk through a mutual facility. The oldest existing insurer in the US, the Philadelphia Contributionship, was formed in 1752 on exactly these principles, with Benjamin Franklin as one of its founders. That it still operates successfully in Pennsylvania attests to the power of this idea. As Paul Roller concluded in his message, "If only the industry could capture the sense of pride insurance people feel when a catastrophe strikes and this 'mechanism' we call insurance is there and working when everything else is not."

Here's a resolution for 1996: restore this pride in the institution.

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Sound unrelated to concept is nothing but noise.

Anthony Burgess, A Mouthful of Air, William

Morrow & Co., New York 1992