Risk Management Reports

October, 1997
Volume 24, No. 10

Load of Breezes
Earlier this year, at the request of Bill Adelson, the editor of Focus, the customer magazine for Zurich Insurance, I wrote a short summary of my ideas about the state of the risk mananagement discipline. I am reprinting it, with the permission of Zurich. Those interested in the full issue, Number 21, Summer 1997, entitled "Total Risk Solutions," can obtain a copy from Zurich Group, Mythenquai 2, P.O. Box, CH-8022, Zurich, Switzerland.

How hot the pedlar, panting with his pack
Of fans - a load of breezes on his back!

Kako, in A Net of Fireflies, translated by
Harold Stewart, Charles E. Tuttle Co.,
Rutland, VT 1960

Contradictions and ironies confuse and delight our modern world just as they did the Japanese poet over a century ago. Can today's corporation, laden with the uncertainties of the global economy, find relief within these risks themselves? This is the question facing strategic risk management. 

Instead of looking at risk negatively, as a chance that some future event may cause harm, some organizations are beginning to recognize that risk includes inherent opportunity. Future success depends on both taking advantage of the benefits and reducing the harms from risk. The relationship between gain and loss depends on how well the risk is managed. An example: I traveled from London to Paris several months ago on the Eurostar. An electrical failure stopped us at the mouth of the Chunnel, delaying our arrival in Paris by 45 minutes. Not only did the train operators keep the passengers fully informed about the delay, but they offered a free one-way ticket to compensate for the inconvenience. Here is a perfect example of transforming misfortune into opportunity. The railroad took advantage of the "fans" on its back and created goodwill where it first appeared to have lost it.

Too often today, risks remain contained and managed within separate compartments. A financial officer manages currency hedges and interest rate swaps. Credit managers review supplier and customer balance sheets. Legal staff supervise political risks and regulatory compliance. Engineers oversee environmental, safety, and health issues for personnel and neighbors. Insurance managers organize operational and legal liability risk financing. Highly specialized, with arcane skills and jargon, these specialists in their isolated castles generally miss opportunities and risk inter-relationships as they over-focus on potential negative outcomes. Risks remain discrete, but most are connected and present numerous inherent opportunities. They must be viewed in a more holistic fashion.

This view demands new risk assessment tools. They will define risk correlations and inter-dependencies so that organizational responses are more strategic and efficient. While financial/market, regulatory/political, legal liability and operational risks may require separate specialists for tactical day-to-day management, someone must provide a strategic overview of both opportunities and harm. Someone must "balance risk," using the words of Bankers Trust's Charles Sanford. Strategic, or holistic, or integrated, risk management, becomes today's answer: the new way of dealing with uncertainty.

This new philosophy for management calls for a commensurate change in both the attitudes and the organizational structure of external risk management service providers. The problem is that too few have the vision to discard outmoded approaches and search for new solutions. Unfortunately, one service provider, the insurance industry, appears to be reacting more like a slug than a gazelle. It is rapidly diminishing in importance.

New communications tools are radically changing old relationships. Electronic transmission of information and global access to data mean that intermediaries may not be essential in the arrangement and purchase of insurance. Underwriting information moves electronically to underwriters, and quotations, policy wording and financial data flow back, quickly, accurately and without the intervention of insurance agents and brokers. Intermediaries are outmoded. Today's managers need seasoned advisors who are not connected to the financing transaction.

All forms of advisors to the risk management process will see their traditional turf disappear. Accountants, brokers, consultants, lawyers, and engineers are essentially purveyors of information. With the Internet and the World Wide Web as a resource, will these services and skills be required? One US risk manager now creates special project teams drawing proven individuals from different outside organizations, rather than dealing with a single firm. The team is linked through a dedicated Internet group, increasing mutual communication and efficiency. The Internet today does what a corporate group did yesterday. It creates and manages a highly skilled network.

It's ironic to see the current rush to merge insurance broking houses into larger monoliths, still chained to the commission system, when clients are dispensing with their services and moving to smaller, more flexible, fee-based advisors, called upon only when required. New technology accommodates this approach.

Risk management is now a Board issue, as a result of the Cadbury Committee and Dey Committee recommendations in the UK and Canada, and the new Risk Management Standard in Australia and New Zealand.

The new risk view is no longer local or regional, but global. All risks now come under the purview of senior management, even as specialists continue to direct their attention to their respective risks. Internal and external multi-disciplinary "teams" are created to deal with the most current risk situations, incorporating solutions within new, flexible contingency plans. Knowledge of risks and the organization's responses to them are communicated to all stakeholders, acknowledging their different interests: shareholders, employees, customers, suppliers, regulators, communities in which the organization operates, and the public. The risk management team, no longer subservient to finance, legal affairs or administration, acts as an independent staff function networking with other staff and line responsibilities.

Risk financing is also becoming more holistic and strategic. The new approach assumes that all risks are somehow fundable, using the total resources of the organization. This makes much less important the conventional insurance and reinsurance industry. Traditional underwriting calls for an actuarial base of losses, spread of risk, homogeneity, randomness and the operation of the law of large numbers. Yet when the insurance industry applies these rules, it finds itself competing to finance the same risks that most large corporations can easily self-fund. The industry may be relatively efficient in funding losses less than US$10 million, but interest, acumen, and financial security diminish rapidly for risks in excess of that figure. The insurance industry also saddles its policies with numerous exclusions and offers limits of protection that are often dwarfed by its customers' exposure requirements. When limits of over $2 billion plus are needed, the industry often offers only $100 million. Its global surplus is only 14% of the market capitalization of the world's 50 largest companies and less than 3% of the assets of the world's 50 largest banks. Is the industry slipping into financial insignificance when compared to the needs of its customers and other financial institutions?

The transformation of risk financing is the freshest "breeze." Over the past quarter century managers responsible for risk financing have steadily moved away from conventional insurance toward increased self-funding, internal reserves, captive insurers, pools and innovative use of credit and capital markets. They carry their own solutions on their backs. The insurance industry, somewhat pejoratively, calls this the "Alternative Market." In fact, it is now the "primary market." Insurance has become the "alternative." Recent analyses in the US and EU show that these "primary" mechanisms account for 30% to 40% of all risk financing, but these studies are limited to those risks defined as conventionally "insurable." Add to those numbers the financial/market, regulatory/political, and public forms of risk financing, and it is easy to see that insurance plays a minor role - probably less than 10% of total organizational strategic risk financing.

The key idea behind new strategic risk financing is that risk is shared, not transferred. Unfortunately insurance has often given (and been sold as) the illusion that someone else has accepted the problem. No matter how completely we try to fund risk, hidden and intangible costs remain. Our risk remains our responsibility. The new form of risk financing recognizes this and constructs a program to protect not only the balance sheet, but also the reputation of the organization. Recovery of business interruption or physical damage insurance does little to save a company if its reputation is destroyed. This naturally leads to much higher retention levels, as managers recognize that internal funding is both less expensive (given the high overhead costs of insurance) and a greater stimulant to rigorous risk control. Risk financing relationships today are being built on composite arrangements incorporating internal funding, captives, pools, credit, capital markets and, where cost-effective, insurance. These plans require longer-term relationships, ranging from five to ten years, building on the idea of partnership over time rather than on the more volatile annual re-negotiation of protection. Long-term plans permit risk managers to devote more time to risk assessment, risk communication, and risk control, where the payoffs are larger.

One unresolved problem is catastrophe. When larger trans-national organizations face risks where losses could easily exceed US$2 billion, they find an insurance market too thinly capitalized and too fragmented to provide the high levels of protection needed. Risk managers want financial partners that can take, on a net basis, as much or more risk than they themselves accept. How many insurers or reinsurers today can take, net, up to and over US$100 million, a not-uncommon retention for larger corporations? As before, the possible solutions may be carried on their own backs. Greater post-loss "pooling" arrangements with other large organizations, supported in part by insurance and by local, regional, and global disaster funding, may provide the necessary solution and financial security. More private stimulation of public-private consortia for major catastrophes, man-made or natural, could resolve the problem..

The strategic risk management idea is born of the recognition that we carry on our own backs the solutions to our problems. Just pull down a fan.

Of course, all of this may be simply one person's biased surmise! As another Japanese poet, Koyo, wrote:

Autumn night on the river, with a moon;
My neighbor's flute is playing, out of tune!

The problem with management theories is that while they often make unassailable sense on paper, each company or situation is different, requiring a distinctive solutions that is best devised by smart employees who are allowed to think for themselves.

Scott Adams, as quoted by Adam Bryant, in "Managing Dilbert, Inc.," New York Times, September 7, 1997

Risk Manager of the Year
Have you noticed the proliferation of so-called "risk manager of the year" awards? First North America, then Australia and New Zealand, and now Europe. Do they really recognize meritorious achievement, as most claim, or are they simply advertising ploys for their sponsors? I've now served as a judge for the Business Insurance Awards in North America (once), for the Alexander Hamilton Awards for Excellence in Treasury Management of Treasury & Risk Management Magazine (twice), and for the new 1997 European Risk Management Awards, sponsored by International Risk Management magazine. The latter two awards have individual corporate sponsors, which pay for the privilege (CIGNA, AIG, etc.). Similar awards are made by the Australian and New Zealand RIMS group and now by Asia Insurance Review and The Review, for the Asian insurance industry. The Asian awards feature a full panoply of insurer and reinsurer sponsors: Eagle Star, Commercial Union, CNA Re, American Re, Allianz, Swiss Re and AIG, plus Reuters.

In each set of judging, I've been surprised by the limited number of entries, the difficulty of persuading notably successful organizations to prepare entries and the absence of certain individuals and firms that I know have actually made major achievements. Too often the nominations seem to be driven by service providers anxious to curry favor with prize clients or trying to take credit themselves for financing programs. If awards are regularly given to good, but not great, programs, doesn't some cynicism creep in?

The awards this year include the Business Insurance winners, announced in the spring on the occasion of the annual RIMS Conference, the European honors made on October 2 in London, the Asia awards on October 6 in Singapore, the Hamilton Awards, on October 9 in Chicago and the Australian/New Zealand awards in November. Each group has different standards, with little or no coordination. Is it time for an independent organization to sponsor these awards and establish some global benchmarks, perhaps in conjunction with a major publication? The Alexander Hamilton Excellence in Treasury awards are offered jointly with the US-based National Association of Corporate Treasurers. The Australasian awards are made jointly with ARIMA. I understand that Business Insurance approached RIMS when it first considered the north American awards, but RIMS declines to participate.

Another question: is there that much "excellence" globally to warrant so many awards? Is there a natural dilution that diminishes each award? Even if we were to find an organization to promote the idea of "global excellence," with global winners drawn from the ranks of regional awards, could we persuade organizations and individuals to apply. Are we dealing with i