Risk Management reports

November, 1996
Volume 23, No. 11


No, I do not propose hunting mosquitoes with a .45, as pleasurable as it might be to obliterate an insect that has just sucked my blood. The connection comes from the recent scare about mosquito-carried Eastern Equine Encephalitis in Rhode Island and southeastern Connecticut. Scientists found mosquitoes contaminated with EEE, a disease that may be 50% fatal to human beings. A furor close to panic ensued. The governors of both states flew to the area, newspapers and other politicians called for immediate action, administrators shortened school days and curtailed sports and planes were sent aloft to spraying breeding grounds. To date, there have been no reports of human infection, much less death, but hundreds of thousands of dollars have been thrown at this presumed problem.

It is a perfect example of misapplied risk management. A scare headline provokes a panic. We feel powerless in the face of a potential killer. We then over-react, wasting time and valuable resources.

During the same week when the EEE situation was reported, I read of at least two people in the area killed by handguns and numerous automobile fatalities. Unfortunately we seem inured to these deaths, while frightened out of our minds by something that hasn't happened.

We probably can't do much about this predictable response. The immediate and the unknown take precedence over more common, if more dangerous, situations. While our resources should probably be directed toward the control of handguns and the reduction of highway carnage, we inevitably misapply them on the appearance of a dramatic headline.

This is an importance lesson for risk managers: what the public fears may drive initial responses that prove to be wrong in light of cold, rational analysis.

. . . ultimately what I am saying is that citizens themselves have to assume . . . responsibility. The leader -- maybe not the hero but the leader -- is necessary but not sufficient to this process.

Senator Bill Bradley, as quoted by Michael Kelly, "A Sense of Where He's Going,"
The New Yorker, March 6, 1995


Nonprofit Risks
In the past, risks facing nonprofit organizations in the US were relatively minor. They had nominal assets, strong public support and, best of all, an immunity from lawsuit (the eleemosynary defense). Today that has changed. Many have substantial assets: both the Ford Foundation and Howard Hughes Medical Institute, two of the largest, have assets over $5 billion. The public has grown skeptical of the operations of nonprofits, particularly when many appear to be primarily enrichment vehicles for their executives. Private donors are more selective in their giving. Immunity from legal liability has almost disappeared.

Recent publicity hasn't helped. The Aramony-United Way scandal, the embezzlement of church funds by financial officers of the Episcopal Church, the Lutheran Church in New England, the United Methodist Board of Global Ministries and the Roman Catholic Diocese of Brooklyn, and the sexual misconduct of leaders from the Catholic Church, Boy Scouts and other youth organizations diminish once untarnished reputations. At Adelphi University in New York, the president is under attack for autocratic behavior and excessive remuneration and the Board is accused of conflicts of interest.

This raises a new set of loss exposures that must be addressed by nonprofit risk managers.

The first, and perhaps most important, is the risk of financial mismanagement. Stronger controls are needed for overseeing those who manage funds. Annual independent audits should be mandatory, whatever the size of the nonprofit. It's not just the risk of embezzlement. Given the reduction in both governmental and private funding, nonprofits are under more pressure to derive maximum benefits from endowments that are already insufficient. This can lead to foolish investment decisions. The Orange County, California, and New Era Foundation disasters were direct results of trying to generate more income from shrinking funds. Boards should be vigilant in overseeing the investment policies of internal and external managers. Conservatism in investment remains the guideline. Potentially higher rewards always are accompanied by higher risk.

The Orange County, California, and New Era Foundation disasters were direct results of trying to generate more income from shrinking funds. Boards should be vigilant in overseeing the investment policies of internal and external managers. Conservatism in investment remains the guideline. Potentially higher rewards always are accompanied by higher risk.

The second new risk is that of increasing governmental regulation and interference. Local tax authorities, themselves under pressure from reduced federal and state outlays, are beginning to attack the tax exemptions of nonprofits. Where nonprofits appear to be in competition with profit-making organizations, strong lobbying from these competitors often allows tax assessors to remove exemptions. State and federal income tax authorities are also looking for income deemed taxable. Environmental, occupational safety & health, and similar regulations are being rigorously enforced against nonprofits. The recent outbreak of church fires resulted in new regulations designed to protect the availability of fire insurance but the unintended consequence will probably be higher rates for all churches. The risk manager should try to anticipate and combat this rising tide of regulation.

A third new risk is that of employment liability: the responsibility of an employer to employees for new and unanticipated loss or injury. General work stress, fair hiring and firing practices, carpel tunnel syndrome, mandates for disabled employees, threats of sexual abuse, molestation and harassment are all new areas of concern. Even the Coast Guard is cracking down. Nonprofits that offer various forms of water activities and who employ persons holding Coast Guard licenses are required, among other things, to provide pre-employment drug testing, training, periodic re-testing, records and reports, all adding to costs.

It never was easy being a nonprofit!

Conservation is only ever a rearguard action, fought from a position of loss. It is ultimately unwinnable, and not least because there are no recorded victories over population increase, nor over the grander strategies of genetic behavior such as the laws of demand, political expediency, sheer truancy and a refusal to relinquish a standard of living once it has been attained.

James Hamilton-Paterson, The Great Deep, Henry Holt & Co.,

New York, 1992


The Warren Report
Issue Number 165 of the Warren Report crossed my desk in September. It was the last one. For over thirteen years I have read the monthly musings, reflections and admonitions of California's David Warren with amusement and delight. His probing of the imperfect world of risk management and insurance always reminded me that we can do better.

For example, I helped develop the first Cost of Risk Survey in 1979 and have continued to study the annual surveys published by Tillinghast-Towers Perrin and the Risk & Insurance Management Society. Early on Dave Warren pointed out in his Report some of the Survey's statistical errors and invalid conclusions, points that admittedly took me too many years to acknowledge. He has consistently tried to unscramble obtuse insurance language and deflate the balloons of pompous legal counsel or self-important risk management consultants!

Each issue was led by a quotation that allowed David to discourse on some aspect of risk management. It's a perfect example of homiletics, the art of delivering a sermon. The last issue's text was from A. A. Milne and Winnie-The-Pooh: "Here is Edward Bear, coming downstairs now, bump, bump, bump, on the back of his head, behind Christopher Robin. It is, as far as he knows, the only way of coming downstairs, but sometimes he feels that there really is another way, if only he could stop bumping for a moment and think of it." From this auspicious beginning,

David segues into a discussion of the evolution of risk management from its insurance antecedents to today's integrated function and to the requisite characteristics of tomorrow's risk manager: a "healthy skepticism," "independent thinking," and a "liberal education." He concludes with five practical suggestions: (1) Subscribe to The New York Times, (2) Get on the Internet, (3) Study finance and statistics, (4) Read Strunk & White's The Elements of Style, and (5) Get an ARM (Associate in Risk Management) and a CPCU (Chartered Property & Casualty Underwriter) designation.

The May 1996 issue's lead was from Colin Powell's My American Journey: "I distrust rigid ideology from any direction." This led to a dissertation on balance and a typically Warren comment: "Ideology focuses the mind, but emphasizes one part of life disproportionately. It can easily lead to fanaticism, which scorns flexibility and tends to the irrational." In everything, David has been rational and flexible.

The Warren Report wasn't all profound commentary. David included a regular column of "What's Funny About Risk Management," to remind us that we should never take this business too seriously. Periodically his "Uncle Pumblechook" (drawn from Dicken's Great Expectations ) pontificated on the meaning of words, the absence of numeracy in too many of us, and the illogic in so much of what we do.

I will miss Uncle Pumbechook, David Warren and his monthly newsletter. I guess I'd best go back to issue No. 1 and begin re-reading them. There is a timeliness to his comments that warrants repetition.

He realized that . . . there was no division between the work of writing and the work of seeing. For no word can be written without first having been seen, and before it finds its way to the page it must first have been part of the body, a physical presence that one has lived with in the same way one lives with one's heart, one's stomach, one's brain. Memory, then, is not so much the past contained within us as proof of our life in the present.

Paul Auster, The Invention of Solitude, Penguin Books,

New York, 1982


Dynamic Financial Analysis
For some time now, I have been watching the progress of different organizations as they attempt to integrate the risk assessment process. Financial institutions, led by Bankers Trust, NatWest, Standard Chartered Bank and QIDC (Australia) appear to be in the lead, primarily because of their traditional focus on major financial risks. Petro-chemical companies seem to be a close second, driven by their environmental risks.

I now know of an insurance company (surprise!) that may be reaching the same plateau. A paper published by Tillinghast-Towers Perrin in September, 1996, describes "An Integrated Dynamic Financial Analysis and Decision Support System For a Property Catastrophe Reinsurer." An actuarially long-winded title, but descriptive. Written by Tillinghast's Stephen P. Lowe and James N. Stanard, Chairman of the Board and CEO of Renaissance Re Holdings Ltd., the paper describes a model developed to integrate the effects (pro and con) of all risks facing a company. It is the framework the company uses for risk management. The authors indicate that "a core strategic premise of the Company has been that an increased level of precision in the measurement and management of risk can be translated into a competitive advantage." (Incidentally, this thesis was also advanced by David Bell and Pascal Onillon, of Harvard Business School, in their paper, "Don't Put Your Competitive Advantage at Risk," in Risk Management Reports, May/June 1992)

"Dynamic financial analysis" requires an on-going and joint effort among technical and operating staff. The conceptual framework outlined by the authors includes three areas:

o Liability: the risk that the cost of settling the insurance liabilities will be greater than expected (also referred to as obligation risk),

o Asset: the risk that the realizable value of assets will be less than anticipated, and

o Business: the general business risks faced by all enterprises (pricing; competition; regulation; crime; disasters).

The risks in these three categories are measured in terms of harm and reward, using modern portfolio theory and a newly-developed framework, "Asset/Liability Efficient Frontier" (ALEF) to assist in better decisions. It uses standard deviation as its primary measure, even though, as the authors acknowledge, this tends to focus only on "the dispersion of the outcomes, without any special recognition of the adverse outcomes." They argue: "While most people equate risk with uncertainty of outcomes, they also equate (it) with the likelihood and severity of adverse outcomes. In the ALEF framework, risk can be any measure of adverse outcomes that management believes is most relevant."

The authors acknowledge that the linkage of catastrophe scenarios to economic (asset) scenarios remains to be developed, an important step toward full integration. Finally, they admit that this is a complex system that will require time and training so that employees can develop the judgment as to how much weight to give to this model and how much to their own experience and intuition. They conclude, "A good sense of how to weigh system results with unmodeled factors is the essence of the amorphous term 'underwriting judgment'."

This is another important step along the road to the "new language of risk" that I called for several years ago.

Copies of this booklet are available from Stephen P. Lowe, Tillinghast-Towers Perrin, 175 Powder Forest Drive, Weatogue, CT 06089. Tel: 860-843-7000 Fax: 860-843-7001

You can learn something about your fellow human beings from what they write in the margin. People have speculated a great deal about Fermat's vanished proof. In a book concerning the never-proven postulate that whereas it is frequently possible to divide the square of a number into the sums of two other squares, this is not possible with powers higher than two. Fermat wrote in the margin: "I've discovered a truly wonderful proof for this argument. Unfortunately, this margin is too narrow to contain it." Peter Hoeg, Smilla's Sense of Snow, Delta Books, New York, 1995

Editor's note: This postulate was finally proven by Andrew Wiles, with the help of Richard Taylor, in 1995. Fermat's proof has never been found.


Swedish Risk Management
Evidence that risk management is a global phenomenon comes from a paper written by Lars Nilsson, the risk manager for Sweden's Kammarkollegiet. This is the "government sector" in Sweden, responsible for some 300 different agencies and 260,000 employees. The paper, delivered to the Fifth Luxembourg Rendez-Vous, on June 4-5, 1996. describes the implementation of the risk management discipline. In 1993 the Swedish Parliament established new guidelines and mandated that "all losses would be borne by the agencies themselves." In July of that year the Swedish National Judicial Board for Public Lands was assigned responsibility for developing a new risk management framework, including general recommendations, support for the agencies, development of a risk financing system, and purchase of common insurance, if needed. The process has already taken three years, described in the Nilsson paper.

Nilsson quickly recognized that it is "not so much the title and role of a position called the risk manager, it is rather the scope and focus of risk management. . . . Risk Management should, in my view, for the future be designed as a top management strategic function, closely related to financial and market perspectives and comprising both 'static' and 'dynamic' risk aspects. They are closely related and should not be treated in different chambers. The tactic(s) and operative measures should be handled further out in the organization, according to the policies and guidelines issued by management."

He makes a strong argument for a different view of risk management: "(it) needs in my opinion a more dynamic image and less of what is too often perceived as boring and obstructive protection measures." I concur: risk has a strong reward as well as the more traditional harm component.

Nilsson also uses a risk management chart to describe the entirety of the function. Like John Boswell's chart for Standard Chartered Bank (see RMR September 1996), it seems to me to be more complex than necessary for good communications, even though it describes the function well.One area where I disagree with Nilsson is his framework for risk management. He suggests that risk analysis, loss prevention and cost of risk reporting are mandatory, while risk financing is optional. In the sense that all losses can be ultimately funded by the government (and the taxpayers), this distinction is perhaps acceptable, but I argue that the financing of risk is a critical ingredient of the entire process. Risk and loss must be paid for, by taxpayers, shareholders, or others. Prudent financing of risk is essential to wise management of resources. Even if commercial insurance is unnecessary, losses can and must be funded. As Nilsson acknowledges in his paper, a credit line from the Swedish National Debt Office is a tacit form of risk financing.

Nilsson's conclusion: the acceptance of risk management in the governmental sector in Sweden has been enhanced by the development of central guidelines and supported by a culture of instruction and assistance to the individual agencies. The key is that the risk management group and its financing component are seen as "partners" by the agencies. Guidance, support and service, not mandates, are what make risk management work in Sweden.

. . . yet although he was in the right mood, costive and solemn, the words would not form themselves into an orderly and harmonious procession. They remained in his hand, swirling in grand but indeterminate shapes; or if they had any concrete existence at all it was in the form of scrappy notes.

Patrick O'Brian, "The Stag at Bay,", in Rendezvous and Other Stories,W. W. Norton, New York, 1994


Risk Management in Sailing?
The subject of our discipline pops up in the most unexpected places. As relief from the trade and economic press, I read Sailing World regularly, and especially Stuart Walker, a regular commentator on racing tactics for over 30 years. In the October 1996 issue, he writes about "risk management," the importance of "being conservative, playing the percentages, acting regularly to reduce the risks of loss, and doing what is most likely correct -- not sometimes, every time." Well said!

He suggest several principles that apply not only to sailboat racing but to other activities. First, " (wind) shifts are more important than anything else." Translated into business, this means that changes, predictable and unpredictable, dominate our world and our responses.

Second, "treat all (wind) shifts as oscillations." Many changes may be impermanent Don't over-react to temporary conditions. Third, "heed the basic rule of thumb -- 'take what you've got when you've got it'." Don't be too greedy. Fourth, "keep to the rhumbline." Stay in the middle of the course. And fifth, "risk management is only effective if applied rigorously and consistently." Amen!

Stuart's rules of risk management are universal. I admit, however, that I am inclined to take a flyer to one side of the course or the other from time to time, just for the thrill of it. As my son and crew attest, it seldom works!