Risk Management Reports

January, 1997
Volume 24, Number 1

Issues for 1997
Each year, as I sit down at the computer to consider critical risk management issues for the forthcoming twelve months, I find recurring themes as well as an ominous disquiet that I could miss something big. Randy Myers quoted Jeffrey Serkes, IBM's vice president and treasurer on this point ("Future Perfect," Treasury & Risk Management, Nov.-Dec. 1996): "Our biggest challenge is going to be something none of us have yet imagined. Some risk will pop up that none of us saw coming."

Last year my issues were counterparty security, the rising tide of debt, use of derivatives, political fragmentation, changes in regulations, environmental liability, employers' liability, violence in the workplace, dependencies on data, and communicating risk assessments and risk responses to stakeholders. Fortunately we saw few surprises. Political incumbents won in Russia and the United States, while a challenger surprised in Israel. The global bull market did peak, but much later than many imagined.

Considering the Serkes admonition, these are my risk management issues for 1997, within the four major risk quadrants: regulatory/political; financial/market; legal liability; and operational.

Regulatory/Political Risks

  • Political Change Major political events take place in 1997 in Hong Kong and Great Britain. First, Hong Kong. This metropolis will be turned over by Britain to China on July 1, and the world awaits the reaction of the octogenarians in Beijing. Will China permit this city-state a modicum of self-government and continuation of its loosely-regulated free enterprise, or will central planning and political authoritarianism crush the spark that has made Hong Kong one of Asia's "Little Tigers?" What happens in China will dictate our economic futures. Its 1.2 billion people make up a market thirsty for new products and economic growth. Hong Kong could be the catalyst for gradual political liberalism and a continuation of China's economic growth. Or it could be the last gasp of Deng's aged cronies to maintain the regressive and controlled military regime that crushed the students in Tiananmen Square, tried to annex the Spratly Islands, played war games off Taiwan, and threatened Disney about a film on Tibet. Military confrontation in Asia is not impossible if China continues this latter course. An alternative is possible political fragmentation of the Chinese landmass into a multitude of contentious, independent and war-lord-led states, similar to the melt-down of the USSR. The problem is that this enormous Panda is capable of chewing up many of its smaller neighbors, just like the panda's voracious appetite for bamboo. The Chinese are capable equally of leading an Asian economic revolution or of allowing the region to slip into political chaos.

    The election of a new government in Great Britain, to take place before mid-year, would normally not constitute a major (pardon the pun) event. But because January 1, 1998 is a key date in the progress toward the European Monetary Union and the establishment of the euro as the common currency in Europe, this election is important. Will Britain join the Union or will the Euroskeptics, primarily within the Conservative Party, keep her out? There is also at play here a larger development: re-defining the role of the nation-state and its sovereignty in a modern global economy. The European Union has the opportunity to prove that a regional compact can provide significant economic benefits while preserving the political identity and special individuality of its composite units.

    Risk managers will be watching these two events closely for future implications.

  • Geriatric Politics. The population aging taking place in most developed countries poses a global economic threat. It must be addressed more responsibly. There is a chance that this process will begin in the US in 1997. Current entitlements, created in a different era to respond to different problems will bankrupt us if not changed. The debate over modifications to Social Security and Medicare may come to a boil this year. We must acknowledge the enormity of our unfunded promises and our inability to keep them. Privatized retirement and health accounts could be one answer. Another will be a later retirement age, probably 70, increased by incremental steps over the next decade. This debate will lead to a discussion of how best to use the resource that is our "retired" population.
We need a social change away from pure "retirement" of fishing, golf, and leisure toward new forms of social and economic participation, consistent with physical and mental capabilities, experience, and interests. John Gardner identified this twenty years ago, suggesting that retirement should not be a cessation of activity, but rather a "repotting" of one's efforts, setting down roots in new soil. This review of geriatric politics will force us to analyze health ethics (when is it both uneconomic and irresponsible to extend life?) and emphasizing savings rather than consumption. There are some interesting challenges to risk managers here! Legal Liability Risks
  • Environmental Liability This has been one of my major risk management concerns since I first wrote about it in 1977. RMR published a monograph on its financial implications in 1988 (July/August, "An Analysis of the Insurance Industry's Exposure to Hazardous Waste Liabilities,", Dan R. Anderson), and it has been on my "issues" list ever since. For many organizations, real or potential environmental liability (clean-up of existing sites; water pollution; air pollution) is the single largest potential cost threat. The public is now aware of the enormity of the problem. Instead of economic over-reaction, trying to undo all that we have done, we should be treating the situation responsibly. Because of cost, some past pollution cannot be remediated. The brunt of the expense should be borne not only by the remaining "responsible parties" we can identify, burdened by "joint and several liability" obligations, but also by the public. After all, we, the public, have been the beneficiaries of many of the low cost products and services that came to us at because of this pollution! The organizational risk manager should be the internal alarm for these potential costs and the advocate for sensible response.

Financial/Market Risks

  • Market Correction. When Alan Greenspan asked two relatively innocuous questions in December about the irrationality of the late (?) bull market, investors worldwide went on a selling spree, proving the significance of his queries. Is the Mighty Bull Market of the Nineties over? History, if nothing else, illustrates the inherent cycles in all human affairs. As corporate profits decline, so will market prices. Interest rates fall and rise, so a modest increase in 1997 should not be surprising, if there is any trace of inflation. The threat of systemic risk to the global banking system seems to have eased, and now even the insurance industry is considering a counterpart to banking's Basle Committee, also to be located in that Swiss city. I suspect that 1997 will see more volatility within financial institutions, credit markets and currencies than in 1996, but within reasonable boundaries.
Operational Risks
  • Business Continuity In the past, insurance risk managers have concerned themselves with "business interruption" and "extra expense" exposures, arranging insurance to assure the continuity of operations. In 1997, they should help their organizations address the much broader issue of business continuity planning, encompassing all forms of risk, and the ripple effects from single and multiple events. The moves in recent years to "just-in-time" inventories, down-sizing of staff, and reliance on data and data systems have led to sharply expanded interdependencies. These interdependencies are incompletely addressed by conventional insurance. Add the critical importance of protecting and preserving reputation and consumer confidence, and it is easy to see that a new methodology of risk assessment and response is necessary. This should be a key risk management effort for 1997.
  • Administration Finally, a continuing issue for this year is the redefinition of risk management within the organization: the shift from a fragmented approach with separate risk management functions doing isolated jobs, to a coordinated and integrated function under the leadership of a "chief risk officer" reporting to the CEO and to the Board. The transition won't be easy and will probably take several years to accomplish. Why not start the process in 1997 by having senior managers read "Against the Gods" (see the last piece in this RMR)?

If "knowledge and uncertainty are the twin principles of modern organization," as suggested by Peter Drucker, then risk managers - those who help organizations address uncertainty more prudently - have a major part to play. Above all, risk managers need to help their organizations prepare for the Serkes risk that "none of us saw coming."

Deep inside I know that trying to figure things out leads to blindness, that the desire to understand has a built-in brutality that erases what you are trying to comprehend. Only experience is sensitive.

Peter Hoeg, Smilla's Sense of Snow, Delta Books,

New York 1995

Lloyd's - The Future?
Last year, the security of insurance institutions was a major issue. Lloyd's was one of them, as it prepared for the difficult transition to the formation of Equitas and the revival of a three hundred year old marketplace. Its "R & R" plan was adopted last fall and now the question is its future. I voiced some continuing doubts about Lloyd's in the October 1996 RMR and received a thoughtful response in December from one of my readers, Peter Maitland, chair of Trafalgar Underwriting Agencies in London. Excerpts from his personal (not corporate) comments are worth sharing:

"Obviously damage has been done to the reputation of Lloyd's over the past few years. That is why Lloyd's is now acting upon the need to work harder than ever before to earn back its reputation and that can only be achieved through performance over time.

The challenge of constructing a new Lloyd's has demonstrated well the level of perseverance and adaptability required to develop beyond the 308 year old market's traditions. But the future of Lloyd's must be seen in a context that extends wider than the difficulties it has managed to overcome. There would have been little value in resolving Lloyd's past problems without the innovation and the determination necessary to reassess how it does business and to seek new business and new markets for the future.

First, at the very centre of Lloyd's future lies the critical importance of underwriting talent. One essential task at Lloyd's is to create the conditions that enable skilled underwriting talent to be nurtured, developed, attracted, rewarded and supported in every way.

The Lloyd's market was once made up of 400 syndicates. Some have fallen by the wayside and some have amalgamated, but the 167 underwriting in 1996 are successful graduates of the school of experience as shown by their 1993 results. . . . Yes, I agree that there should probably be more with degrees and formal qualifications but in the final analysis it is the consistency and quality of underwriting that counts.

Second, and critically important, is Lloyd's capital base. Lloyd's is, without doubt, in a period of transition. (In 1996), seventy per cent of the market's capital (was) provided by traditional, individual members, underwriting with unlimited liability. But corporate membership, introduced nearly three years ago, already accounts for thirty per cent and this proportion is likely to grow. Furthermore, after reconstruction, Lloyd's expects some of its traditional members to convert to a shareholding in corporate vehicles.

The best form of capital structure at Lloyd's, however, is not yet fully determined. Its current corporate members take a variety of forms. Some are spread vehicles, backing many syndicates in much the same way - through on a far greater scale - as traditional members have done in the past. Others are 'dedicated" or committed to supporting particular agents or syndicates. Increasingly, these investors wish to have an interest - maybe a controlling interest - in the managing agents they support.

Meanwhile, Lloyd's is faced with the challenge of managing a reasonable degree of equity among the different categories of capital providers. . . . Provided that can be achieved, Lloyd's will be largely content to see market forces operating: it needs to be responsive to the choices that many individual Names and other investors make. . . .

In order to attract . . . capital, however, a further element needs to be addressed. It has been said by you and many commentators, both inside and outside Lloyd's, that the market needs to reduce costs at all levels. This is one of the drivers towards consolidation among managing agencies and syndicates. There is scope to go much further in reducing costs at syndicate and agency levels. This message applies, too, to the central services at Lloyd's. . . .

Finally, to Equitas. Since the reconstruction plan was launched, (many) independent commentators have expressed their views on its long term viability. What many have overlooked is the work of the Equitas Reserve Group, which conducted the analysis of the 1992 and prior liabilities that have now been reinsured into Equitas. The group undertook the most painstaking and comprehensive reserving exercise in the history of the insurance industry.

Insurance reserving is an inherently uncertain process, a fact recognised by insurance regulators worldwide. In the case of Equitas, the UK Minister of State for Trade and Industry has made clear his view that there is a reasonable prospect that Equitas will be able to meet its liabilities in full as they fall due. That is a sufficient basis on which to have allowed it to proceed.

I believe that there is a positive future and I agree with many of the issues you raised, but there are two additional points:

Firstly, management. This has always been in short supply throughout the whole industry worldwide. Management of underwriting at Lloyd's is attracting more graduates, is meeting the greater demands of corporate capital, recognises the need to reduce costs and improve the ways of doing business, and, above all, accepts that it has a real and enforced accountability to the capital and to Lloyd's. I am not complacently saying that there is not room for improvement but am saying that it is positively moving in the right direction.

Secondly, how does Lloyd's today compare with others? Is underwriting talent better everywhere else? Are expense levels improvable elsewhere? Are other markets as attractive to capital and have all insurers been as thorough with their potential liabilities as Equitas? Whereas Lloyd's may well have been bottom of the class before the launching of Equitas, I think we are doing a whole lot better, are still improving and maybe will soon be nearer the top of the class."

Peter's candid assessment is reassuring but questions remain. Does the recent entry of fresh capital to Lloyd's make sense in the current soft market? Can expenses be reduced to the level necessary to compete with other risk financing alternatives, not just other conventional insurers? Is Lloyd's prepared to deal directly with major corporate buyers? Some of these questions will begin to find answers in 1997.

. . . corporate capital seems to be far less cautious with its money than the unlimited Names . . . in this year's donkey derby. . . . They add capital at exactly the wrong stage of the cycle and could pose a major threat to the CGF (Central Guarantee Fund) in the future and, therefore, to the future of Lloyd's. Have lessons learnt from the excesses of the 1980s really been so quickly and deeply buried in our memories - almost to be forgotten?

"Has Lloyd's Gone Mad? The Return of the Donkey Derby,"

CBSL News - Market Review, Christie Brockbank Shipton Ltd., London, November 1996

"Against the Gods"
I've complained for over twenty years that we don't have a textbook on risk management that is both readable and catholic in its view. Peter Bernstein has just written that book: Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, New York 1996). It joyfully and often lyrically explores the development of the concept of risk as both threat and opportunity. He matches the ideas that have enabled us to measure probability with those who first advanced them, introducing us to familiar and unfamiliar names from the Middle Ages onwards. We know Pascal, Pierre de Fermat, Edward Lloyd, the Bernoullis (Daniel and Jacob), Bayes and Bentham, but we learn, through Bernstein, of the contributions of Pisano (who introduced Arabic numerals), Cardano (who measured probability with dice), John Graunt (who calculated statistical tables), Abraham de Moivre (the "bell" curve and standard deviation), Francis Galton (regression to the mean) and other fascinating characters on whose ideas today's risk management rests. Add to them more familiar names from this century, such as Kenneth Arrow, Frank Knight, John Maynard Keynes, John von Neumann, Oskar Morganstern, Harry Markowitz, and the partners Kahneman and Tversky and Black and Scholes, and Against the Gods comes alive with complex and challenging personalities as well as ideas.

Where once we attributed fortune or misfortune to the whims of gods, we now, through the efforts of those described in this book, "have transformed the perception of risk from chance of loss into opportunity for gain, from FATE and ORIGINAL DESIGN to sophisticated, probability-based forecasts of the future, and from helplessness to choice." Bernstein writes fluidly and coherently. Names and ideas that I vaguely recalled or misunderstood, as a history major, jump to life. I am beginning to understand!

Did you know, for example, that the word "risk" comes from the early Italian word "riscare," meaning "to dare." There's a proactive sense to that translation, implying the choice, not fate, that Bernstein intends. "Hazard" comes from the Arabic word for dice, "al zahr."

"Risk management," Bernstein argues, "guides us over a vast range of decision-making, from allocating wealth to safeguarding public health, from waging war to planning a family, from paying insurance premiums to wearing a seatbelt, from planting corn to marketing cornflakes." His is the complete integrated view of the function, even though, in the last quarter of the book, he focuses on investment risks and the financial market, the areas of his specific expertise.

He maps the development of more and more rigorous quantitative approaches to probabilities and the more recent attempts to understand why "people yield to inconsistencies, myopia, and other forms of distortion throughout the process of decision-making." His story of risk and risk management is one of rationality and human nature, ata one point at odds with each other and at another cooperating, to provide a better understanding of uncertainty and how to deal with it. ". . . Any decision relating to risk involves two distinct yet inseparable elements: the objective facts and a subjective view about the desirability of what is to be gained, or lost, by the decision. Both objective measurement and subjective degrees of belief are essential; neither is sufficient by itself."

"The essence of risk management," Bernstein concludes, "lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us."

This book belongs on every risk manager's bookshelf, to be read and as reference.

Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.

Peter Bernstein, Against the Gods, John Wiley & Sons, Inc.,

New York 1996