ENTERPRISE RISK MANAGEMENT

REALITY CHECK

Executives at Bermuda conference see industry
moving cautiously on a number of fronts, including ERM

By Michael J. Moody, MBA, ARM

Today, primary insurers are rarely risk takers; they have become instead market aggregators that package risks for others. The true risk takers in the insurance community are the reinsurers.

Numerous insurance and risk management conferences occur during the year, each with a specialized focus. However, the Bermuda Insurance Symposium that met in February was unique. It was the first major gathering of senior insurance, reinsurance, financial and risk management executives since the terrorist acts of September 11 and the failure of Enron. Accordingly, many of the industry's best and brightest were in Bermuda to review how the insurance market has changed since these events and what will occur going forward.

Terrorism coverage

The initial session was highlighted by a round table discussion of the current state of the insurance market, as viewed by key insurance company executives. This "sellers panel" made it clear that the lack of action by the federal government to backstop terrorism coverage was a real concern for the industry. It was also a bit of puzzlement to the industry executives, since the federal government had a precedent to move quickly to resolve this matter. Paul Ingrey, chairman and CEO of Arch Reinsurance, Ltd., noted that the government moved quickly to resolve a riot coverage issue that occurred in 1967-68. Federal authorities established a Federal Riot program that provided stop loss protection for insurance carriers. This allowed carriers to continue to offer coverage to consumers while maintaining the integrity of their own reinsurance programs. Within several years, the need for the program disappeared. The key to the success of the riot program was early action by the federal government, but this is not the case today. And luncheon speaker Ellen Seidman, chairperson of the Working Group on Natural Disaster Insurance, provided little encouragement for additional movement by the federal government.

Structural changes

Several speakers throughout the Symposium pointed to structural changes that are occurring within the insurance industry. One of the most profound changes is the difference between primary insurers and reinsurers. Today, primary insurers are rarely risk takers; they have become instead market aggregators that package risks for others. The true risk takers in the insurance community are the reinsurers. This fundamental change has resulted in a mismatch of capital. For the most part, primary insurers are overcapitalized, while reinsurers are undercapitalized in their increasing role of risk takers.

The other significant structural change that has occurred in recent years negates the adage that "Banks do not want to be in the risk business." The fact is they do, and they are. For the most part, they are still limiting their involvement with risk-taking ventures. And while the scopes of the offerings are quite limited (i.e., only risks that can be successfully modeled, and those that can be validated by an outside source), some banks are willing to take risks. Further development into the risk assumption area can be expected, as banks become more comfortable with the risk-taking concept.

Convergence

Based on that notion, one would think that the convergence is moving forward. However, the general feeling of the presenter was that it is not. In the post-9/11, post-Enron era, convergence has slowed to a crawl. There are several reasons for this slowdown. The primary one is a general discomfort with the information that surrounds most capital market deals. In order to maintain a long-term approach, it is critical that all parties to the deal understand the risks involved. Transparency will be the key to successful transactions in the future. Convergence may have slowed but the genie is out of the lamp. Most anticipate that it will be moving forward in the near future.

One example that was shared involved the formation of a special purpose vehicle, known as Redwood. It was structured to cover California earthquake exposures and was oversubscribed when initially written. The reason that this is noteworthy is that it was one of the first catastrophe coverage vehicles to occur subsequent to 9/11. Members of the investor group--which was made up primarily of life insurance companies and mutual funds--each received coupons that provided above-average returns on their investments. The investors clearly were willing to trade the risk of losing both principal and future interest payments for a better-than-average return for a non-correlated security. They appear to be viewing this CAT Bond as a sound instrument for diversification of their portfolio.

Weather-related products

One of the product areas that one would expect to be negatively impacted by the failure of Enron would be weather-related products. Enron was instrumental in developing these products. However, the market's viability has been indicated by its ability to maintain an orderly and liquid market during the time following the bankruptcy. At the time of the Symposium, the market remained robust. In fact, today, there is considerable interest in weather-related products.

These products were originally developed to assist the energy industry in coping with deregulation. The industry soon found that it could no longer pass along revenue shortfalls that were incurred as a result of weather-related situations (e.g., warmer than normal winters) to their customers. Accordingly, they needed to find protection from abnormal weather conditions. As a result, many utilities are including weather-related products in their risk management programs. Additionally, other industry groups are now seeing the value of such products, and several panelists provided insight into this expanding market.

* AEGIS--This large gas industry captive has begun to offer weather products as a value-added service to its insureds.

* Cargill--This major distri-butor of agriculture products is working to develop a user group for weather products.

* ElementRe--This subsidiary of XL has developed a weather insurance policy in order to overcome the general consumer's resistance to derivative products, post-Enron. The policy is an insurance cover in every sense of the word, and as such, allows the insured to take a deduction for premiums paid and have the same accounting treatment as any other premiums paid by the insured. Rather than purchase traditional reinsurance, ElementRe is purchasing weather derivatives to transfer the risk.

Alternative risk transfer

Captive insurance companies are one of the traditional hard market alternatives, and the current hard market already has stimulated additional captive formations. Over the past six months, most captive domiciles have seen accelerated growth in captive formations. Captives certainly represent a viable approach to the hardening market, particularly when the advantages provided by recent changes in the tax laws are taken into consideration. Despite this, captives face a number of challenges. Chief among these challenges is locating a fronting carrier. Fronting carriers are required in order to write regulated lines of coverage such as workers compensation or auto liability, and their availability at this point, is quite limited. Captives continue to offer corporations a viable option. However, care must be taken in the development stage to make certain that all aspects are considered. Regardless, many believe that the captive growth will continue at high levels.

Communications concerns

One of the topics that continued to arise throughout the two-and-a-half day event was communications, or more correctly, lack of communications. Most speakers (both buyers and sellers) agreed that there is little in the way of true partnering going on in the industry today, and the primary reason is lack of communications between buyer and seller. At a time when risk management is once again center stage at the board level of many corporations, the industry (buyer and sellers) needs to marshal its forces to resolve the fundamental breakdown in communication. The buyers have difficulty in explaining to their management the volatility of the insurance marketplace and, for the most part, sellers have been unable to articulate the reasons for the broad swings. As one of the risk management panelists noted, it is difficult to deal with the fact that insurance is one of their company's most volatile risk management costs. And while some underwriters are quick to point out the cyclical nature of the insurance business, panelist Stacey Regan, deputy treasurer at General Electric Co., asked a question that was on many participants' minds: "Why does the market have to be cyclical?"

Many of the buyers who spoke on the panels believed that today is a golden opportunity to solve many of the underlying problems that have plagued the industry for years, and do so on a joint or cooperative basis. However, as Chris Duncan, chief risk officer for Delta Airlines, pointed out, buyers are left, out of desperation, to find their own solutions. Such was the case with the airline industry being forced to form its own risk retention group. Instead of a cooperative approach to innovative solutions, most insurers are offering terms and conditions that few buyers can live with. Many of the "buyers" felt that the insurance industry needs to become customer-focused if it expects to be a long-term player in the risk management solutions of the future.

Enterprise risk management

Enterprise risk management (ERM) appears to have taken a temporary back seat to the more immediate problems of the hard market. As insurers move back to core competencies, they are more reluctant to work with innovative concepts. However, those carriers that have been involved with ERM solutions will soon move back to this market because their insureds' boards of directors will demand it. As so many of the Symposium's presenters noted, the time is right to make significant strides in solving some of the industry's long-standing problems, and ERM could provide assistance in this area. *

The author

Michael J. Moody, ARM, is managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that was established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote
the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.