A Precarious Balance

Despite tremendous losses resulting from the 2005 hurricane season, and a subsequent reduction in capacity, the insurance market retained a profit and appears to have leveled into a surprising state of stability. Logic dictates the apparent cessation of the familiar ebb-and-flow from soft to hard insurance cycles would mollify risk managers; in fact, this leveling has translated into precarious times for risk managers, as they attempt to balance their organizations’ risks in 2006.

Perry Brazeau, senior vice president, Canada division manager of FM Global, says risk managers are finding the current insurance market fragile because of “uncertainty on the horizon that’s not been brought forward.” Hurricanes, pandemics, and terrorism are a few of the hot button issues plaguing the current risk environment, he says. Although these potentially disastrous catastrophic events are known, accepted and insurable risks, the trend toward increasing frequency and severity in storm activity and the unforeseen and uncontrollable repercussions of pandemic and terrorism make it difficult to quantify and measure their risk.

According to Michael Cherkasky, president and CEO of Marsh & McLennan Companies, Inc., risk managers need to assess and balance their risks differently in today’s changing risk landscape. “The world is riskier now than it’s ever been,” Cherkasky says. “We’re seeing the greatest risk the world’s seen in the last 25 years.”

Only when these threats become realized will risk managers be able to understand and measure the potential damage each may cause to Canadian organizations. And yet, without evidence of such threats occurring, risk managers may find it difficult to sell the idea of potentially costly and apparently nonessential risk coverage expenses to their CFOs and board directors.

John Welch, risk and insurance manager for the University of British Columbia, says things in the insurance market can change in almost a moment’s notice. “The market reacts to things other than the bottom line,” he observes. “Whether it’s fear of the unknown, or fear of what’s going to happen, you know markets are reacting to emotions.”

This is glaringly obvious in the area of natural catastrophes. In this area, according to Cherkasky, fear and an increasingly pessimistic outlook on storm frequency and severity is causing a significant drop in capacity, which is subsequently turning natural catastrophes into a precarious risk to cover.

WHERE WEATHER’S AT

Natural catastrophes are posing an increasingly severe risk to businesses, according to John Chippindale, managing principal and president of Integro Canada. Chippindale says the scientific and insurance communities are expecting the fall of 2006 to be the worst hurricane season ever. This, he adds, will “really question the structure of the risk management system.”

If the hurricanes making landfall in 2006 are as bad as the 2005 storms, “there will be a shrinking of cat coverage,” Joe Restoule, senior risk consultant for Nova Chemicals Corp., predicts. As a result, capital will exit the market, initiating a definite decrease in capacity. Or, as Brazeau puts it: “Cat capacity may completely dry up.”

But what does this mean for risk managers?

“Less capacity means less choice,” Restoule explains. “This means there will be less players willing to offer the products and services that risk managers might need in the face of potential risks.” The real questions, according to Restoule, are:

(1) Will more capacity enter the market? And

(2) Will there be a need for more capacity? For example, Restoule asks: “What will the 2006 hurricane season bring, if it brings anything?”

Thus far, the 2006 storm season seems somewhat muted. Nevertheless, there is an emerging and recognizable trend toward increasingly severe and frequent storm exposures, which, despite premium rate fluctuations, is driving the capacity reduction and feeding the uncertainty.

“We just came out of a very hard cycle, plus a disastrous run of hurricane losses that we know are going to affect the market somehow,” Welch notes. “However, that really hasn’t happened yet. Now we’re racing into another storm season and, if there are more mega-losses, perhaps that will change the market somehow.”

Therein lies the problem, according to Cherkasky. He says changes to insurance are in and of themselves a risk. Changes to storm exposures and models, for example, regardless of where the storm losses occur, will hit the market on a global level, he predicts. In order to absorb and mitigate the trend toward increasing severity, the industry as a whole must be willing and able to quantify the risk, Cherkasky adds. This means the industry must become more comfortable using the new, modified cat models.

Even if risk managers are able to quantify the changing landscape of storm risk, they must investigate alternative ways to mitigate their risks, Brazeau says. “Trying to buy cat coverage is going to be difficult for risk managers [if they] are only looking at traditional risk transfer options, because there is going to be less capacity available,” Brazeau says. “There’s no question that deductibles of self-insured retentions are going to be much higher than anybody’s experienced for some time.”

Captives represent an “excellent” risk-financing tool that can be used to access the reinsurance market, Restoule says. They also absorb financial risk within their own portfolios. In the current market, alternative risk transfer tools such as captives can help reduce the potential that organizations will be forced to absorb financial hardship resulting from traditional spread of risk. This can result in what Chippindale calls “unfair practice.”

“Is it fair for businesses that don’t have those (hurricane) risks to have to share in the losses of those that do?… Do you spread the risk out against organizations that don’t have those kind of exposures?” Chippindale asks. “All of this concentration of catastrophic risk and actual cat losses can render companies non-continuous.”

Pandemic and terrorism risks may also call into question the continuity of a company.

SETTING A PRECEDENT

Currently, it is uncertain how severely a pandemic or terrorist attack on Canadian soil could damage homeland businesses. That’s because there hasn’t been a localized event that would spark enough fear to emphasize such covers, risk managers say.

Chippindale says he does not believe the insurance industry has “done a good job creating an imperative for organizations to invest in their own risk prevention.” Welch explains the phenomenon by saying “maybe we’re being nave in Canada about the threat of terrorism.” Welch adds the United States had a similarly lackadaisical attitude about the threat of terrorism prior to 9/11.

Only recently in Canada have inklings of terrorist activity become a publicized reality, Welch observes. “We just saw an example in Toronto that terrorism is a potential threat to Canada,” he says. “But Canadians don’t have the mindset that terror is a real risk unless their companies have financial or physical interest in the U.S. It would take a terror event happening on home soil before terrorism would pop up on the Canadian risk radar.”

However, risk managers are increasingly recognizing the potential risk that error may pose in today’s changing environment. Terrorism coverage, according to Restoule, is currently available and generally affordable to Canadian risk managers should they choose to invest in the mitigation of such a risk. The hurdle many risk managers face, however, is to convince organizations, CFOs and/or board directors that terrorism is a real risk exposure that necessitates coverage and for which there should be a budget.

“In the Canadian landscape, we have never felt there was a need to put a terrorism facility in place,” Restoule says. “Given what happened in Toronto in the last quarter, it may be that CEOs and CFOs will have a change of heart. It
might be something that risk managers want to push more aggressively.”

Pandemic risk coverage poses a different difficulty for risk managers. Heightened media coverage of the recent outbreak of Avian Flu (H5N1) has established pandemics as a real, publicly recognized threat. However, underwriting a pandemic risk policy may be neither a simple nor effective task. “In [the underwriting of] pandemic risk, organizations do not ultimately call the shots,” Welch says. “It really goes back to provincial health authority in terms of how a pandemic is handled.”

Welch believes current discussions within the risk management community about pandemic preparedness and mitigation overlook the issue that an outside organization ultimately controls how a pandemic outbreak would be handled. As a result, managing the risk of pandemic is another arena of uncertainty. Again, risk managers will only gain insight into a pandemic event when one occurs; by that point, it is too late to react successfully. In light of this uncertainty, Welch says risk managers are mitigating their pandemic risk through internal preparation programs.

Business continuity planning is emerging as an integral tool that risk managers are using to mitigate risk in the face of a pandemic outbreak. Karen Barkley, chief operations officer of ACE INA Insurance, notes a business cannot operate without its employees, and this creates pandemic risk exposure. “(Pandemic risk) may or may not have a direct effect on the bottom line of the actual insurance … but it will have an effect on everyone’s ability to do business,” she says.

ACTIVATING ERM

In preparing for the precariousness of today’s risk landscape, risk managers must take a more holistic approach, Cherkasky says. “If you’re just looking at slices of risk, then you’re really not being prepared,” he says. “At some point, every business has a crisis, regardless of whether it’s a storm, earthquake, epidemic or pandemic.”

Shawn Doherty, vice president, actuary ACE INA Insurance, says the risk manager’s role involves more than just acting as a simple insurance buyer. He says the contemporary risk manager needs to have an understanding of the broader range of risks facing enterprises, including strategic and tactical responses that deal with this wider realm of risks.

“Risk mitigation and transfer responses are moving away from consideration of only traditional insurance-type products, to include other financial instruments such as hedges, derivatives and loss-control activities,” Doherty says. “Insurance may not always be the best mitigation/transfer tool available.”

Enterprise risk management (ERM) is another means to assess and mitigate risk. ERM not only allows risk managers to asses risk, but also to quantify it. This puts control back into the risk mitigation process, because it creates fixes values in an otherwise ambiguous, precarious risk environment, according to Cherkasky. Chippindale agrees organizations should manage risks by taking the broader approach of ERM more seriously. “Risk managers have to serve their masters – their own shareholders,” Doherty adds. “To do so, they must understand their company’s risks, and prepare cost and benefit analyses to present to their shareholder representatives [i.e. board members].”

In order to understand their insurable risks, risk managers must be proactive in maintaining their claims history from a ground-up, claims perspective, Doherty maintains. He says they must also keep records of measures of exposure to perils that generate losses.

“With this information, they can work with their broker and insurers to identify cost-effective loss control strategies,” Doherty says. “In the longer term, this process will help them (risk managers) to develop internal models not just with respect to traditional ‘insurable’ perils, but also in building models of other operational risks.”

Today’s risk managers are taking a proactive approach and developing analytical, internal risk identification programs. The result is a new way to control risk transfer structure at all levels while maintaining corporate advocacy.