Risk Management Reports June 1996

Volume 23, Number 6

Internet News

The eruption of electronic media is far more dramatic than most of us realize. Following the global fall-out is fascinating. Just a year ago (RMR, April 1995) I tentatively joined the Internet and my first risk management discussion group. Today I'm an active participant on RiskNet, a moderated global discussion group of some 1500 professionals and I surf through numerous home pages on the World Wide Web seeking new ideas. More fall-out: since I'm a believer in the idea of free-flow of information, I've decided to put Risk Management Reports on line. Beginning with this issue, a full-text version of RMR will be available through InfoRisk (http://www.riskinfo.com). RMR joins two other risk management publications there, Practical Risk Management and The Warren Report. RiskInfo hopes to host other risk management publications so that it can be an extensive knowledge base for both practitioners and theoreticians. Allen Munroe, its President and founder, also plans a Risk Forum of moderated discussion groups to address topics of current importance.

A canvass ofRMR's readers indicates that most prefer reading this publication in print copy. It's certainly easier to stuff a copy in a briefcase for travel or to read before the evening news. Some of us older types may never convert entirely to this new medium, as much as we acknowledge the inevitability of its future. The younger generation, however, is rushing toward storing and retrieving all information within portable PCs. As publisher, I want to enable this growing minority to find RMR on line.

RMR will continue to be available in individual print subscriptions at US$ 96 per year for North America and US$ 108 elsewhere in the world, with discounts for group subscriptions. We're still experimenting with the electronic version: the initial offer is US$ 25 per year, strictly on a voluntary basis, for an annual subscription. Is this wishful thinking on the part of a naive editor? Perhaps, but I will try the voluntary pledge approach, similar to that with which public radio and television are supported in the United States.

Check Risk Management Reports out on RiskInfo and let me know what you think. I want RMR be be your risk management mentor (see below)!

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Can we imagine universities without lectures? Will we one day notice that the extended monologue is a form of discourse now practiced most often by professors and madmen? . . . . The real roles of the professor in an information-rich world will be not to provide information but to guide and encourage students wading through deep waters of the information flood. Professors in this environment will thrive as mentors.

James J. O'Donnell, "The Digital Challenge," Wilson

Quarterly, Winter 1996

Risk Management in UK

While in England in March, I had the chance to talk with representatives from two major banks, both of which are distinctly innovative in their approach to the management of risks. How they administer the function is worth reviewing.

The 1995 videotape explaining the scope of risk management at London-headquartered Standard Chartered Bank, a global financial institution, is introduced by Graham Trapnell, its Group Head, Passive Risk Management, an oxymoron if there ever was one. Risk management in this bank is active, coordinated, and critically important to the future, according to its Chief Executive, Malcolm Williamson, who concludes the tape. It's a graphic example of the new form of integrated risk management, trying to tear down the "castles" that segregated different risk responses in the past (see RMR, May 1996).

While Standard Chartered Bank as yet does not have a single risk management policy statement approved by its Board, something that I recommend, the Board's Audit and Risk Committee does review all the work of the staff addressing the bank's risks. Perhaps a policy is unnecessary if the work is done! Three other Board committees also review and monitor risk issues, the Credit Risk, Country Risk Review and Asset and Liability Committees.

The reporting relationships vary but they seem to work. Legal and Compliance teams report to the Chairman through the Group Secretary. Group Audit and Security report to the Chairman and to the Board, using a risk profile system developed jointly with Price Waterhouse called SCREAM (Standard Chartered Risk Evaluation and Assessment Model). Like the other risk management teams, Audit and Security have moved from a regional to a functional focus, using ISO 9000 certification and twelve regional audit offices around the world. Credit Risk, Market Risk, Operational Risk and Passive Risk all report to the Group Executive Director Finance and Risk, who in turn reports to the Chairman. Credit risk is defined as "the risk that a borrower will be unable to meet its obligations." This team includes both country and environmental risks. Market risk is defined as "the risk of loss arising from a change in the market level of interest and exchange rates, securities, equity, commodity and bullion prices and their volatilities." It uses VAR (value at risk) along with concentration, notional principal and liquidity limits that, if exceeded, are reported immediately to London. Operational risk is defined as "the risk of loss arising from a failure to control properly all aspects of the documentation, processing, settlement of, and accounting for transactions." Passive risk is defined as "the risks to which the Group is subject in the conduct of its business and which have the potential to cause loss, but which cannot be a source of income generation." Graham Trapnell's six person Passive Risk Management team has developed a "risk map" to show the reputation, legal and financial costs of human, political, environmental, technological and economic perils for which the Bank has developed its control responses. The term "passive" was adopted since the more preferable "operational" had already been taken by the units responsible for transaction risks.

Coordination among these teams, while informal and ad hoc, is active and mutually supportive. It is the key to the success of the overall program.

Standard Chartered has no single, formal definition of "risk," but it certainly recognizes and deals with both its tactical and strategic implications. It began in 1993 a four year project on risk management, hoping to create a complete cultural change toward risk and its response. It seems to be working.

Where Standard Chartered uses informal coordination, its London competitor NatWest Group uses a more formal internal structure. In NatWest the Group Risk Management Unit (trading, systemic, reputational and cross-sector risks), the Group Operational Risk and Insurance unit (physical and other insurable risks; contingency planning, insurance), the Credit Risk Review unit (all credit risk functions), and Credit Policy & Portfolio Management (global limits, lending concentrations, environmental risks) all report to the Deputy Group Chief Executive (the bank's number two officer). He in turn chairs the Group Risk Policy Committee, made up largely of main board directors, that meets monthly. The business of the committee is strictly risk management.

NatWest, in contrast to Standard Chartered, uses the term "operational" risk to mean "any non-banking risk." Each business unit prepares an annual "risk profile" that is composed of risk category, priority, risk description, probability of occurrence, financial impact, impact description, tolerance level, earliest date the risk could occur, dependencies, countermeasures in place and planned, assigned responsibilities, and review of previously agreed-upon actions. Like Standard Chartered, NatWest has no common "report" but uses the common reporting route. It is currently working on testing contingency plans, developing executive risk management training (with the support of academic consultants) , and building a model for sharing techniques for identifying risk and control mechanisms in business alliances.

These two leading UK institutions are developing a more coordinated approach to the management of all of their risks. Their somewhat different approaches simply indicate the importance for risk management to be adapted to the unique characteristics of each organization and the inclinations of its people.

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Life, for the biologists, is an uphill or retrograde process - it adds order and complexity to environments whose overall tendency is toward diffusion and disorder.

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

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

Conference Contrasts

This year I traveled to two major risk management conferences, one in Nottingham, England and the other in Toronto, Canada. They were complete contrasts in size and sophistication, yet each was successful in its own way.

The Association of Insurance and Risk Managers (it still keeps its old acronym AIRMIC) held its 26th annual conference in late March at the East Midlands Conference Centre at the University of Nottingham. Built on the theme, "Partnerships - Mirage or Reality," the two day session attracted about 350, all of whom could join in the several plenary sessions. We were housed in University dormitory rooms, modest and inexpensive, and fed breakfasts and lunches (surprisingly tasty!) at the University dining room. The exhibit hall was modest and there were no intrusive hospitality suites. The breakout sessions were all at the Centre, offering an opportunity to meet and talk with participants there, in the hallways and outside the Centre, although the uncommonly cool weather meant restricted that locale to the cellular phone and nicotine addicts. Speakers argued for and against the desirability of partnerships in risk management, warned of the effects of climate change, and forecast increasing violence in the workplace. The size of this meeting and its university venue stimulated an intellectual approach to the topics, one that I thoroughly enjoyed.

The 34th annual conference of North America's Risk & Insurance Management Society was, in contrast, a mob scene. More than 8,900 registrants, exhibitors and speakers almost overwhelmed the city of Toronto and its Convention Centre in late April. The consistently inclement weather spelled doom for solar-celled calculators, and it was an equally grim week for Canadian ice hockey fans. Canada's risk and insurance management all stars were crushed by their US counterparts despite some 60 saves by Montreal's Steve Patenaude, the the Spencer Foundation game and all of the Canadian entries in the National Hockey League's Stanley Cup playoffs lost to US teams. They may have to move the Hockey Hall of Fame from Toronto to New York! The exhibition hall and its booths were, as usual, enormous and lavish: it took me a full two days to trudge the entire acreage. I found, to my surprise, that the exhibition area was the most convenient place to meet and talk. I had innumerable chance encounters with friends. In one serendipitous meeting, I had just mentioned the name of an insurance executive to two friends when he appeared and joined our conversation. Toronto is also a compact venue: almost every hotel and evening entertainment (opera house; baseball stadium; symphony hall, Maple Leaf Gardens; Hockey Hall of Fame) was within reasonable walking distance of the convention center. I found the sessions well-run, intellectually challenging and well attended, perhaps because of the weather.

A personal high point was Wednesday morning's annual get-together of members and guests of San Francisco's Risk Management Forum. An off-the-record round-table discussion of several current risk management topics, it is noted for the candor and good humor of its participants. At last year's session I ventured several prognostications (see RMR June 1995) for one, five and ten years out. My one year forecast, that many more risk managers would join the Internet, was correct. This year's one year forecast: the Names at Lloyd's will turn down the proposed Reconstruction and Renewal Plan, when they vote later this summer. My five year forecasts: a major insurance brokerage firm will sell it general brokerage operations to a competitor or to an insurer, and at least two consulting arms of accounting firms will jump to the top of the league tables in risk management consulting. Ten years? At my age I avoid long-term forecasts, just as the late George Burns recommended that older paople avoid buying green bananas.

I must admit that, while I much prefer a smaller conference, on the lines of the AIRMIC session in Nottingham, I enjoyed Toronto and look forward to next year's extravaganza in Atlanta.

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Many physicists believe that the singularity inside a black hole represents the end of space and time, and that any matter that encounters it will be completely obliterated. If this is the case, then even the atoms . . . will vanish into the singularity , in a nanosecond of ultra spaghettification.

Paul Davies, The Last Three Minutes, Basic Books,

New York 1994

Banks and Insurers

I have been increasingly pessimistic about the overall financial condition of many commercial property and casualty (non-life) insurance companies, especially in the United States, and have suggested that those seeking secure risk financing should look at the capital markets and banks. Buyers are doing this, and several insurers and banks have linked to offer combined services.

Myron Picoult, of First Manhattan Co., confirms my concerns about US insurers: "We are skeptical of the reserve moves by many insurers. Our view is based on history, some evidence that retentions are being increased, and the potential of looming potholes for some reinsurance recoverables." (Business Insurance, March 11, 1996) And: "Most companies are bloated and inefficient, as exemplified by their expense ratios. With few exceptions, 30%-plus expense ratios put an insurer into non-competitive territory. Cutting from within is not impossible, but it is difficult, given the fiefdom mentality that pervades most operations." (Business Insurance, April 15, 1996)

I have argued that insurance consumers needed fresh competition (see RMR September/October 1983, and the September and October issues from 1995). As Picoult observed, the Neanderthal habits and "fiefdom mentality" of many conventional insurers are difficult to change. Fresh competition from financial institutions experienced in segmented marketing (the banks) will help. In the US, however, ancient regulations and the strident lobbying of insurance interests have prevented this from occurring.

In March of this year, however, the US Supreme Court unanimously ruled in favor of Barnett Banks, Inc., of Florida, allowing a Federal statute that permits the Bank to sell insurance from branches in communities of less than 5,000 inhabitants to take precedence over state law prohibiting such activity. The inevitable and the desirable has finally occurred.

Just as I see some long-awaited progress in competition and new ideas, along come warnings about the banking system! The UK's Centre for the Study of Financial Innovation published a survey in which bankers express serious concern about "over-capacity and thin margins" that force them to act imprudently in order to hold market share. The Economist has also published a lengthy survey of international banking (April 27, 1996 - "The Domino Effect") that warns of the possibility of a "systemic" global banking shut-down: " . . . banks are taking greater risks than they used to. . . . they earn a larger proportion of their income from the volatile trading business."

Banks are larger. Many have fatter capital cushions and more sophisticated risk management systems (see my earlier NatWest and Standard Chartered Bank article in this issue) that increase and improve internal controls. Deregulation has given them more profit opportunities. Yet,The Economist argues, "although the threat of a systemic crisis has probably diminished, the damage that one could do if it did happen has increased exponentially." One problem is the presence of governmental safety nets for depositors. These deposit insurance arrangements could, under the wrong set of circumstances, actually encourage managers of banks nearing the precipice to take even more risks in the hope of salvaging their operation (called "gambling for resurrection"). The savings and loan debacle in the US is an example of similar unintended consequences arising from the theoretically sound idea of deposit insurance.

The Economist solution: a more realistic view of the limitations of regulation, heavier penalties on those who cause banks to fail, more "co-insurance" in deposit insurance, or restricting full deposit insurance to "tightly supervised banks that would be allowed to invest only in safe, highly liquid assets, such as government bonds." This latter idea, called "narrow banking," would put more responsibility on depositors to choose their banks carefully, increase the market for private depositor's insurance, and reduce the risk of systemic failure. The existence of an international watchdog, the Basle Committee, also serves to mitigate systemic risk.

Those responsible for risk financing should read this important Economist article by Martin Giles.

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The historian, by contrast, cannot rely on intuition or mental speed. History is an art not only of imagination but also of accumulation - of languages, reading, travel, perspective.

David Remnick, "The Devil Problem," The New Yorker,

April 1, 1995

"The Best of the Best"

Last year, the Cambridge, Massachusetts-based management consulting firm of Arthur D. Little (ADL) sponsored a risk management colloquium last to allow senior executives from eight organizations to share ideas about environmental, safety and health risk management. Participating organizations included Union Carbide, ICI Americas, Rohm & Haas, Olin, BP Exploration, W. R. Grace, NOVA and Monsanto. Ladd Greeno of ADL summarized the session with five key suggestions:

(1) A sense of ownership of the process is critical;

(2) Strong team relationships are essential;

(3) Build on previous improvements: don't relax;

(4) Establish a clear vision of risk management goals;

(5) Measure and communicate risk management successes.

A copy of this exceptional booklet is available from Patricia A. Mahon, Arthur D. Little, Inc., Acorn Park, Cambridge, MA 02140-2390, USA. Tel: 617-498-5777.

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Let's look at the face of tragedy. Let's see its creases,

its aquiline profile, its masculine jawbone. Let's hear its rhesus

contralto with its diabolic rises:

the aria of effect beats cause's wheezes.

How are you, tragedy? We haven't seen you lately.

Hello, the medal's flip side gone lazy.

Let's examine your aspects, lady.

Joseph Brodsky, from "Portrait of Tragedy," The New

Yorker, February 12, 1996