Shouldn't those who practice risk management devote the bulk of
their attention to those risks that are truly material to their
organizations? If we agree on this, why do so many persist in
The fundamental problem facing risk managers who are involved in insurance matters is that they over-focus on relatively mundane problems. They manage minuscule risks - slip and fall lawsuits; auto accidents; loss of personal computers; workers' compensation accidents; etc. - overlooking more serious risks. They seem to relish the management of claims, not the management of risk. Why do they choose the relatively trivial? The answer is easy: insurance. These claims are conventionally covered by property and liability insurance and insurance dominates the picture. Insurance underwriters prefer to underwrite the predictable and the recurring, avoiding the potentially massive and less predictable. They can generate handsome profits (if not underwriting profits, then investment income) on these losses without risking big hits. Yet these are the very same losses that most organizations themselves can easily afford to fund internally. If a risk management program is anchored in insurance, these minor risks prevail, leaving no time to study major risks.
Look at the annual RIMS/Tillinghast Cost of Risk Survey numbers: the total cost of insurable risks is well under 1% of revenues for most organizations. Why bother with insurance? Why not dispense with the high time requirements of annual insurance renewals, bid reviews, policy evaluations, claims filings and followups, and the need to work through an outmoded system of intermediaries?
I agree that smaller risks, losses, and claims need management, but shouldn't they be the responsibility of local operating managers who control them in the first place? Corporate risk managers can provide some counsel and advice but should not become mired in tactical details.
If those who call themselves "risk managers" want to
provide significant service to their organizations, they should
look first at all risks, whether operational, liability,
regulatory/political, or financial/market, and begin with those
most influencing finances and reputation.
The old insurance risk management function was organized along the lines of insurance: property; crime; marine; liability; workers' compensation. The new strategic risk management function will be organized along process lines: risk assessment; risk control; risk financing; communications.
I am the first to admit that it is often difficult to identify a "major" risk. This past summer a perfect example occurred in Maine. The DeCoster Egg Farms, a conglomerate that supplies a large percentage of fresh brown eggs to New England supermarkets, was hit with $3.6 million in fines from the Occupational Safety & Health Administration for deplorable working and living conditions at its Turner, Maine farm. Each citation in and of itself might have been considered minor, and even the fine, while large, might have been the end of the affair if the owner has responded immediately with a "mea culpa" and a promise to rectify the situation. The response, however, was otherwise. Press attention followed, along with public pressure and a boycott by many of New England's major supermarkets and retail chains, stores that account for almost 20% of the farm's sales. The ensuing financial effects and damage to reputation have forced a much more costly response, and the boycotts will probably continue until independent assessors confirm promised changes.
As risk managers look to the more significant risks, they should be aware of the potential ripple effects from smaller events, especially those that affect reputation. If they continue to "micromanage minutiae" they may overlook the sequence of events that shook DeCoster, just as they are likely to overlook a Leeson (Barings) or a Citron (Orange County) manipulating investments. The risk manager must take a broader, more strategic view of risk.
Here I wanted to show the ungrained freedom of life, its very
verisimilitude contiguous with unprobability.
Boris Pasternak, "Interpretation," The New Yorker,
June 24/July 1, 1996
|A Review of Summer Reading|
Summer traditionally is a time to settle in with reading material assiduously collected but unread during the winter months. The monograph that is just a bit too long. The book started on the airplane that caused deep sleep after the first two pages. The academic treatise requiring a dictionary to decipher its title. As the old saying goes, summer good and summer not so good! I'm deliberately not mentioning the not-so-good to focus on four pieces that most risk managers will find worthwhile. Note I didn't say "enjoy." Too much of business reading remains turgid and dry. These four are at least a level above the ordinary.
o The New Religion of Risk Management, Peter L. Bernstein (Harvard Business Review, March-April 1996) This is well-written. Bernstein begins with a brief history of the mathematics of probability in risk management, from de Mere, Pascal, Pacioli, Fermat (he of the Last Theorem), Bayes, Bernoulli to Galton and Markowitz, a history that broke society free from the religious superstition that preceded the Renaissance. This work has led, however, to today's almost religious reliance on numbers. We can now take more risk because of our knowledge of probabilities, possibly permitting greater social progress, but, Bernstein argues, "nothing good comes for free. . . .The mathematically-driven devices of modernism contain the seeds of a dehumanizing technology that offsets the positive features of risk management. Our lives teem with numbers, but numbers are only tools; they have no soul."
Bernstein sees three dangers in this "new religion of risk management." The first is the exposure to discontinuity. Life, he says, is "messy." Calamities are not unpredictable; they are now simply unthinkable. Interest rates stay steady for 150 years and then rocket to over 20%. Serious windstorms occur in Europe for the first time in hundreds of years. Discontinuities disrupt statistical prediction. The second danger is the "arrogance of quantifying the unquantifiable." The trap is that "past data from real life are untrustworthy because they compose a sequence rather than the set of independent observations that the laws of probability require." He goes on, "It is hubris to believe that we can put reliable and stable numbers on the impact of a politician's power, on the probability of a takeover boom . . . or on subjective factors utility and risk aversion."
And third, "the science of risk management is capable of creating new risks even as it brings old risks under control." The unintended consequences of our actions could dwarf what we attempt to contain.
Has "risk management" become the "replacement for the snake dances, the bloodlettings, the genuflections, and the visits to the oracles and witches that characterized risk management and decision making in days of yore?" Read Bernstein's challenge even if you read nothing else.
o Comparing Environmental Risks, J. Clarence (Terry) Davies, editor (Resources for the Future, Washington, 1996) This set of essays by Terry Davies, the director of the Center for Risk Management, in Washington (see RMR March 1995), looks at the development of comparative risk analysis (CRA)and how it affects public decisions on the environment. Although his is distinctly a public policy view, it should be read by other risk managers, including financial and insurance. Davies addresses risks, their responses, and the consequences of both inaction and the responses themselves. He stresses understanding the public's perception of risk and the effect of changing societal values. The ultimate goal is the best allocation of relatively scarce resources. CRA today is at the center of Congressional environmental and political debates and will likely remain there in the next few years.
An article by Richard Minard describes the comparative risk analyses recently undertaken by states such as Washington, Colorado, Vermont, Pennsylvania, Louisiana and Michigan. To him, "the strength of the comparative risk process appears to be its capacity to frame important public policy questions and to engage people in a productive attempt to answer them. Its weakness is that so many of the answers are uncertain or unwelcome or both." Other articles describe the work of the 104th Congress and suggest options for the Executive Office.
John Graham, the director of Harvard's Center for Risk Analysis, makes a cogent observation about how easily resources can be misapplied: "We suspect that resources are disproportionately allocated to preventing disasters because of public aversion to any concentrated loss of life, the newsworthiness of such events, and the desire of officials to avoid being held to blame when disasters occur." Look at the responses to this year's ValuJet and TWA disasters to see the truth of his words.
The final chapter outlines the attributes of a logical system
of risk analysis, even as it cautions that, all too often, "risk
management priorities are set through somewhat chaotic social
and political processes." These same "chaotic"
conditions often exist within corporations and public entities!
o The Convergence of the Financial and Insurance Markets. Mike Hanley, editor (International Risk Management, 1996) Generally a series of "sponsored" articles becomes an extended sales pitch. I admit a certain skepticism with sponsor names plastered on the cover: a reinsurer, bank, insurance broker, accountant, lawyer and consultant. Yet the product is worth reading. As the editor explains, " . . . distinctions between different forms of risk are becoming increasingly irrelevant" and what is evolving is a "continuum of risk-financing alternatives." The articles describe the new capital markets, some of their benefits (greater predictability; reduced distribution costs; price advantages; new investor base; price transparency), and the growing conclusion that many loss exposures "dwarf" the capital base of the insurance industry.
A former practicing risk manager, Clive Thursby, cautions, however, that "bold talk about treating risk as risk, irrespective of its traditional categorization, makes for good journalistic copy. So does the idea of managing risk in a coherent and coordinated way by accessing financial and insurance facilities as though they were part of a seamless market. But in practice, matters are seldom so simple." Agreed. Insurance derivatives, for both insurers and corporations, are in their infancy, but the sheer size of the capital markets and the apparent inability of the insurance market to meet ever rising requirements dictate that new forms of risk financing must be considered. Even though this monograph over-focuses on financing, to the exclusion of assessment and control, it is valuable reading.
o Systemic Risk Facing the World's Financial Institutions, by George Littlejohn and Adrian Fry, (The Financial Times, 1996). The authors address the global problems of foreign exchange (FX) trading, admittedly a narrow subject, but pertinent in light of recent disasters. Daily turnover was US$ 1.23 trillion in April of 1995 and may well exceed that number by one or two multiples if trades are counted differently. The authors surveyed 80 of the world's largest banks and conclude that the FX settlement exposure is a multi-day phenomenon and that individual banks may have exposures to single counterparties that "could easily exceed a bank's capital."
They reach four conclusions:
o "The FX settlement exposure can stretch over several days."
o "The amount at risk to a single counterparty could easily exceed a bank's capital."
o Exposures can be reduced through "improving back office payments processing, correspondent banking arrangements, obligation netting capabilities and risk management controls."
o "Multi-currency settlement mechanisms and bilateral and multilateral obligation netting arrangements" can reduce exposures.
Will a domino effect systemic disaster occur? The authors review recent cases (ranging from Sumitomo, Barings and Daiwa to the fall of the Mexican peso) and the responses of the global financial community. Their conclusion: guarded optimism. Their worst case scenario: simultaneous earthquakes hitting Tokyo and San Francisco!
One of the most valuable parts of this monograph is the description of recent financial risk management methodologies, from "RiskMetrics" of J. P. Morgan, the "Shareholder Value at Risk Methodology" (SVARM), and "Counterparty Risk Methodology" to the work of Bankers Trust (RAROC) and covariance, historical simulation and stress testing. At the end, the authors return to the shaky Japanese situation as the possible cause of any systemic breakdown.
In all of these publications, risk management remains a fragmented discipline, even as individual elements surface for attention. Each author looking at the discipline operates from a narrow perspective, yet their joint conclusions made for some stimulating summer reading.
I think if most people were honest, they would admit that imaginary
experiences are more real than actual ones. It is like the smell
of coffee - the thing itself is never so good, it is always a
A. S. Byatt, The Babel Tower, Random House, New York 1996
|A Microsoft View|
Insurance regulation and the security of the Internet were two of the subjects addressed by Bill Hartnett, the Worldwide Insurance Industry manager of Microsoft, at August's Vermont Captive Insurance Association Conference in Burlington.
"The insurance industry," said Hartnett, "is a perfect Second Wave institution" (referring to Alvin Toffler's descriptive term). It over-emphasizes its offices, bricks and mortar, employees and an agency delivery system. It under-focuses on information and how to "deliver value, security and convenience" at the lowest cost. In addition, it is dominated (perhaps willingly) in the United States by an outmoded state regulatory system and archaic taxation. Hartnett suggested that what we need is not a shift to a Federal system but to a global means of solvency regulation, given the trans-national nature of today's trade and business. I agree. We must find a way to leapfrog from the unnecessarily restrictive state system, over the federal government, to regional or global plans. Europe is already moving in that direction and it is time the US followed.
Hartnett also sees the concern about security of credit card numbers
and other data on the Internet as being misplaced. The "FUD"
factor (fear, uncertainty, and dread) is being fed by scare articles
in the press. It does not reflect the progress that has been
made in SET, or Secure Electronic Transactions. No matter what
systems are developed, Hartnett argues, some sophisticated hackers
will be able to compromise them. The ultimate security then probably
rests on the sheer volume of data on the system, increasing geometrically
each year. Hartnett concludes that, today, using a credit card
number on the Internet is probably more secure than relaying it
over the telephone or using it casually in restaurants and stores.
Coming from Microsoft these are challenging observations.
(The third wish) would be that he not die without adding some
artful trinket or two, however small, to the general treasury
of civilized delights, to which no keys were needed beyond goodwill,
attention, and a moderately cultivated sensibility: he meant
the treasury of art; which if it could not redeem the barbarities
of history or spare us the horrors of living and dying, at least
sustained, refreshed, expanded, ennobled, and enriched our spirits
along the painful way.
John Barth, Chimera, Random House, New York 1972
|Lloyd's - A Reprise|
Some months ago, I predicted, gloomily, that the Names at Lloyd's would reject the Reconstruction and Renewal Plan proposed by Chairman David Rowland and his team.
I was wrong. The R&R plan has been overwhelmingly approved and the legal challenges overcome. Much of the credit must go to Mr. Rowland for his energy and persistence over the past difficult years, and especially for his honesty and willingness to disclose in full the problems.
Where will Lloyd's go from here? It remains a key player in the marine and aviation insurance markets but can it regain the confidence of many corporate insurance buyers severely disillusioned by the shenanigans, outright criminal behavior and volatility during the past twenty years?
I continue to have concerns. First is underwriting talent. Lloyd's used to be known for its underwriting acumen. Given the recent unsavory history, how many of the new breed of risk management-trained university and post-graduate students will be drawn to Lime Street? Recruiting could be difficult.
Second is the problem of reducing expenses. Can the archaic access system to Lloyd's be streamlined, or is it so ingrained that the system cannot rid itself of its inherent inefficiencies? Again, despite studies, promises and plans, I have yet to see the sort of dramatic expense reduction necessary to assure a future role for this market. It's not only reaching the 20% region: to be competitive in the 21st century, a risk financing market must reach for an expense load well less than 10%.
Third is the continuing problem of capital. The recent mergers
taking place in the reinsurance business indicate that enormous
capital bases are required to play in the new risk financing arena.
Will US$ 12 billion be enough? With much of the capacity moving
to limited liability (corporate capacity now constitutes 30% of
the market), and with the continuing anomaly of re-capitalization
every year (individual and corporate Names have the right to withdraw
from future underwriting each year), what will prevent a massive
exodus if results turn sour again? How persistent will this new
Finally, Equitas remains a Damocles Sword overhanging the entire market. Its advocates tell us that its reserves should be sufficient to meet all possible claims, but is this true? Scott R. Adams, the general counsel for risk management at Dow Corning, calls Equitas "a giant international shell game" (New York Times, August 22, 1996). Is Equitas a black hole, that will suck in past Names who assumed finality or a bright star that will actually return to its owners some dividends? The optimists believe that the fixed sums in Equitas may stimulate many claimants to settle earlier and for less, to avoid any possibility of being left in the cold. The pessimists continue to have "nagging doubts about its life expectancy" (World Insurance Report, July 26, 1996).
Faith and hard work have brought Lloyd's back from the brink. Perhaps the Rowland magic will work again to carry it successfully and profitably into the next century and its 400th year.
Words. They haunt him night and day, through his rewrite sessions
. . , through breakfast, tea and dinner, words masticated over
plaice and fowl, lucubrated at the hour of the wolf, pried from
the recesses of his memory like bits of hardened molding . . .
words that fight one another like instruments out of tune, arrhythmic,
cacophonic, words that snarl sentences and tangle thoughts until
be flings the pen down in rage and despair. He never imagined
the book would be such drudgery.
T. Coraghessan Boyle, Water Music