Risk Management Outlook 2006: Calm Within the Storm

Affected but unfazed by record-breaking losses that the recent hurricane season has imposed on the insurance industry, risk managers are welcoming what appears to be a return to more stable market conditions.

Hurricanes Katrina, Wilma and Rita may have dealt the industry a heavy blow, but risk managers observe the market appears to have absorbed the losses avoiding a return to the hard pricing the industry experienced between 2001 and 2004, when a trend toward softening began. This moderating effect, they say, is the result of a strong foundation of financial reserves – a byproduct of the hard market – that helped overcome the losses. Risk managers cite good underwriting and a strong performance in the equity markets as the reason why renewals in “non-problematic” lines – i.e. those not affected by climatic risk – are continuing to come out flat, despite the catastrophic conditions.

“It is amazing that, given the severity of wind losses in 2005, in general terms, the market has been able to sustain itself without a dramatic shift in capacity and pricing,” John Johnstone, executive vice president and national director risk management at Aon Canada, says. However, he expresses concern that these favorable conditions may not last. “There is a strong school of thought that says we are in the middle of accelerating climatic change; as such, the challenge of facing change is still ahead of us.”

So although risk managers are reveling in the return to pricing rigidity, they have yet to don their party hats. In fact, within both the risk management and brokerage communities, there is mounting uncertainty about how to approach weather and terrorism risks, claims settlement behavior, and the familiar issue of contract certainty (which refers to timely document delivery and policy wording).

CHALLENGE OF CHANGE

Risk managers and the industry at large recognize the concerns of changing catastrophic exposure risks. They acknowledge reservations regarding the future of insurance capacity.

Certain sectors – specifically, energy companies with exposures in the Gulf of Mexico or coastal North America – currently face serious challenges accessing competitively priced premiums. Although premium increase concerns are currently restricted to select industries with higher cat exposures, Johnstone warns the upcoming year may prove challenging in lieu of the anticipated trend toward climatic change.

“What 2006 has in store, in terms of catastrophic losses, has yet to manifest,” Johnstone says. “If we do in fact see a repeat of the very severe climatic losses that characterized 2005, then the marketplace could move into a period in which corporations may again have difficulty accessing adequate capacity at reasonable premium rates.

All indicators suggest 2006 will be a “weather year,” which is of concern to Susan Meltzer, assistant vice president, insurance and risk management at Sun Life Financial. Moving forward, Meltzer says risk managers might discover that the insurance industry may no longer be the best risk transfer mechanism for windstorm. “We have to develop more of a strategy for transferring risks in response to catastrophes, by understanding what all of the repercussions to our organizations are, and work towards covering all potential risks and ensure that our companies are prepared for the events,” Meltzer explains.

Weather-related risks do not only affect a client’s direct losses. The overall market will also be influenced: prices typically increase after severe losses, and a cyclical return to hard market conditions often results.

In preparation for the challenge of climatic change, one of the integral core risk manager competencies is being cognizant and clear about the contingent threats resulting from weather loss, Johnstone says. “Even if an organization isn’t directly threatened – because it is not involved in geographically high-risk zones – it may face contingent threats due to damage to customers or suppliers that may significantly impact the balance sheet,” he says.

Catastrophic risk is currently at bay, risk managers say, and today’s market is in a state of general stability. Most insurers that haven’t been hit badly by catastrophe exposures are reporting strong profitability in 2005, they note. “The market has built in the ability to take on cat risk and climate risk and it’s getting accustomed to this, so that overall these risks haven’t had and won’t have a huge impact on the marketplace,” Marsh Canada Ltd. president and CEO Alan Garner says.

In addition, a flood of continued new capacity has recently entered the market – including an enhanced return on equity, which has increased competition and therefore caused pricing declines. Insurers that want to sustain their market share are providing discounted renewal quotes, according to Brian Hammond, director of risk management and insurance at the Business Development Bank of Canada. “Insurers who traditionally charged higher premiums seem to be changing their tune,” he says. “They are coming back into the playing field offering some interesting terms and conditions that can no longer be ignored. Now they want access to some of the run-of-the-mill ‘good’ business that is traditionally written in order to retain their book and increase their market share.”

Garner agrees: “The amount of capacity out there is huge; as such, we don’t expect huge problems in terms of access to capacity or pricing over this year.”

The recent renewal season, he adds, validates the current strength of the marketplace. For the most part, primary insurance policies have been renewed without much fluctuation in pricing. Garner believes this trend toward steadfast pricing is ‘”relatively durable.”

Capacity for terrorism risk has also returned to a degree of stability. On Dec. 22, 2005, U.S. President George Bush extended the Terrorism Risk Insurance Act (TRIA) program, with certain modifications, by two years until Dec. 31, 2007. Key TRIA provisions going forward include:

* The inclusion of all lines covered in the original TRIA program, except for commercial auto, professional liability, surety, burglary and theft, and farmowner’s multi-peril.

* A 17.5% deductible in 2006 and a 20% deductible in 2007.

* A US$50-million trigger in 2006 and a US$100-million trigger in 2007.

The Risk and Insurance Management Society (RIMS) says terrorism insurance is intended to “guard against economic dislocation caused by the unavailability or extraordinary expense of terrorism insurance … and to provide the insurance industry with a transition period to develop the capacity to provide terrorism insurance without government involvement.” RIMS adds the future of terrorism insurance will be developed by a presidential working group seeking “a long-term solution to insuring against terrorism.” Michael Liebowitz, director of risk management and safety officer for Bridgeport Hospital & Healthcare System Inc., says RIMS has offered its expertise to the TRIA Working Group on Financial Markets in the analysis on the state of the terrorism insurance market. In addition, RIMS has requested that President Bush select a RIMS member to become a policyholder representative consulting with the presidential body. “We have to begin working on and getting prepared for the next stage of TRIA,” Liebowitz, the incoming president of RIMS, says. “Otherwise, it’s just going to come back and haunt us when it expires in just two years.”

Terrorism risk appears to be of lesser concern to some Canadian-based organizations. TRIA, for example, is very low on Meltzer’s risk radar. She explains that her organization – a major commercial lender – requires terrorism coverage only on properties where such policies are obvious and expected. “There is no driving commercial reason for people to buy terrorism cover unless they are considered to be in a trophy building or a power plant,” Meltzer says. “Canadian commercial lenders are not generally
overreacting.”

Although Canada has not been directly exposed to significant, homeland terrorism loss, the continuing viability of TRIA may still be of high consequence for Canadian corporations with global exposures. “Terrorism is an everyday present global threat that will affect the global insurance marketplace regardless of where the terror is felt,” Johnstone explains. “Canadian risk managers have to be just as concerned with terrorism, as the risk managers located in the highest risk areas are.”

CONTRACT CERTAINTY

The risk management community’s Achilles’ heel – and a source of mounting concern within the community – is the issue of contract certainty. Attaining a perfect policy is a hurdle most risk managers expect to face (and a goal they hope to achieve), but the all-too-common inability to receive their contracts within the generally accepted 30-day period should be overcome, risk managers say.

Garner believes policies can be delivered in a timely manner if insurers and brokers begin to use better technological resources to get policies out more efficiently. “A cohesive effort between insurers and brokers is needed if we are to begin delivering policies in a more timely manner, and this certainly seems to be starting to take place,” Garner says.

Delays occur at the underwriting end of the spectrum, according to Johnstone, who refers to the historical difficulty risk managers have encountered when attempting to obtain policy documentation on London placements. “Currently, London is very aware of this and is taking the necessary strides to address the issue,” Johnstone says. “So even documentation from one of the most difficult areas is now moving towards more timely and accurate issuance of contracts.”

There is general agreement that, moving forward, all participants in the policy process must adhere to principles that will expedite the delivery of policy documentation. Liebowitz says the risk management community in particular has to pull together and establish a general expectation prior to the renewal season, dictating that the policy must be in hand before risk managers are expected to pay the premium.

Unfortunately, Meltzer says, most insurers won’t risk taking the necessary steps to get to the point where it is common practice for premiums to be paid only after the policy has been delivered. “Most risk managers won’t deny payment until they receive their policy because they are afraid their policies will get cancelled, and because their brokers tell them not to,” Meltzer observes. “I just don’t think risk managers have been proactive enough in order to get to that point.”

However, the greater problem is not for risk managers to expedite the delivery of documentation but rather to develop and understand the details and wording of the policy prior to paying for the contract, according to Matthew Cook and Charles Fogden, senior vice presidents at Willis Canada Inc.

“It has been accepted industry practice for the last 300 years that an insurance policy is delivered after the premium has been paid,” Fogden says. “Recent events, and also partly the Spitzer investigations, have actually shown that to be rather strange.”

Therefore, reiterating Fogden’s point, Meltzer says: “Just getting the policy within an allotted amount of time does not create an aura of contract certainty.”

According to Meltzer, risk managers do not spend enough time on policy language. Instead, she contends, they tend to leave it up to the brokers or the underwriters to present them with thorough policies. Meltzer says many risk managers neglect to take the time and resources to understand a policy and ensure its thoroughness; as a result, many claims are being questioned and insurers are more frequently attempting to rescind a policy.

Risk managers note there is an increasing tendency toward claim denials, facilitated by many insurers looking for “loopholes” in policy language. Therefore, whether or not the policy is received within a 30-day period, it is likely many risk mangers will still face uncertainty surrounding contract fulfillment in the event of a claim. “This is one area where there aren’t enough lawyers involved, because there is no lawyer on the side of the risk manager,” Meltzer says. “The policy wordings are looked at very carefully by counsel on the other side while we (risk managers) merely accept a policy on our own review and that of the broker, who is no lawyer.”

The concern, Liebowitz explains, is that if risk managers are not fully informed and clear about the policy terms and conditions – or if underwriters have written a policy without enough knowledge of industry-specific issues – risk managers might end up with a policy that will not fully cover the risks of potential claims.

However, Garner says, more and more brokers are moving towards standardized contract wording by developing much more “potent, standardized, industry-specific wordings that are much easier to read.”

In order to help risk managers better understand policy wording, the onus should be on brokers to ensure the full and complete disclosure of terms and conditions throughout the underwriting process, Garner says. He notes also that although underwriting is strong in most lines, it is integral for contract certainty that underwriters have sufficient information to write policies without any loopholes. “This is of critical concern to the risk managers because there appears to be a tendency for insurers to go back, during the settlement of a claim, to re-examine the original brokering and disclosure process,” Garner notes. He further references a need for risk managers to engage their own counsel in the process and become even more involved in the underwriting placement of the policy. “Contract certainty means having a document in your hand in a timely manner that you can rely on in the court of law, and having a policy that isn’t going to get interpreted against you as a binder,” Garner explains.

Johnstone reiterates: “When major corporations transfer risk to the insurance marketplace, they have a reasonable expectation that their legitimate losses will be paid on time and without the need for the expense of litigation. This begins with contract certainty – ensuring the contract is written in plain language, and that it’s delivered without long delays between attachment of risk and documentation being delivered.”

When a risk manager does submit a claim, contract certainty guarantees the loss will be settled on the basis of the common and certain understanding of the subject matter written into that contract, Johnstone says.

Fogden says the industry must work towards “institutionalizing” the policy process so that “you actually can’t bind an insurance policy until you have developed the policy detail.”

Moving forward, there is a consensus that contract certainty must focus on wording and disclosure of terms and conditions. To this end, risk managers must partner with their law departments, where they exist, or use outside counsel in order to review the policy wording. “Everyone spends so much time on the purchase part that we forget that the big issue is ultimately being able to receive the money for our claims,” Meltzer says.

ALTERNATIVE RISK TRANSFER

Attaining proper coverage for a risk and being able to rely on policy fulfillment are issues that have been at the forefront in recent years. Hammond says risk managers are no longer concerned with “how much is a policy going to cost.” Rather, he says, greater concern revolves around having the proper mechanisms in place to handle a potential problem.

Risk managers observe that alternate risk transfer mechanisms are increasingly being implemented as more effective and sophisticated vehicles for transferring risk, especially traditionally high-priced, risky covers.

“Alternative risk transfer is just a different way to deal with the accounting of known risk, if you know you’re going to have a $20 million loss sometime in the next 10 years rather than insu
re the risk for $20 million for each of those 10 years you use ART as a way to pre- and post-finance the risk,” Cook says. “ART is a nice cheap way of dealing with risk and it has been a very acceptable risk management tool for 15 or 20 years.”

Johnstone says captive insurance is one such “acceptable” risk transfer mechanism.

The interest in alternative risk transfer is based in part on the repercussions related to recent weather-related losses and events such as Enron, risk managers say. “Risk managers want alternative ways to protect their organizations against unprecedented risks – before the insurance marketplace is affected and dictates how they must respond and go forward,” Johnstone says. “Now, more than ever, risk managers need to be in a position to proactively place their corporations in a position to understand and be prepared to act on sophisticated risk transfer and risk mitigation solutions.”

Unfortunately, recent controversies surrounding some alternative risk transfer mechanisms – such as finite risk, which resulted in sanctions being placed against certain global insurers – has placed alternative risk transfer in disrepute, risk managers say.

“In the last year, there have been a couple of prominent cases in which ART and off-balance-sheet financing have been used for reasons not strictly driven by fortuitous risk management, but instead to either inflate earnings on a public company or to be creative on tax issues,” Cook says.

However, in those isolated instances, the mechanisms were misused and found to be scandalous because they did not involve any real transfer of risks.

“They were used as pure balance sheet mechanisms that didn’t involve true risk transfer,” Johnstone says. “That doesn’t mean these tools are inappropriate or invalid. The mechanisms may still have a place in future sophisticated risk management programs. Today’s industry would be mistaken to ignore and question the entire roster of alternative risk transfer programs because they have only been misused in a relative minority of situations.”

Cook adds that without the use of ART to finance potential risk, risk managers will have to take a “great big fat deductible, and when the refinery burns down, you are just going to have to incur the deductible on your books….and accept the fact that there will be some volatilities on your budget numbers.”

Cook and Fogden agree the inability to utilize ART poses a great problem for risk managers because they will not be able to determine how to budget for potential future risks.

Appropriately used, alternative risk transfer mechanisms will be integral to the increasingly sophisticated risk management programs – particularly for major corporations with complex global exposures, Johnstone adds.

However controversy continues, Hammond observes. He says in order to evade these types of scandals agitating the industry, it may be more prudent simply to “absorb the risk or transfer it through conventional insurance.”

ENTERPRISING IDEA

Strong, traditional underwriting continues to be a safe resource for transfer of risk, but risk managers must respond to the increasing concern that traditional insurance risk transfer may not be able to address all corporate risks. Given the current market conditions – including ongoing concerns about corporate governance, disclosure and transparency – risk managers recognize that in order to develop a sustainable business model, a goal inherent in enterprise risk management (ERM) programs, they must account for the broader, less-traditional spectrum of risks.

In order to manage operational and corporate risks – which ultimately leads to the successful and efficient growth of an organization – risk managers must have access to profitable insurance companies with reliable underwriting, so that they have an outlet for their transfer of risk. While most insurers are maintaining strong profits, Meltzer says the problem is that both D&O and weather-related catastrophes may give way to more complicated market conditions. However, she notes, the “whole post-Enron era” has demonstrated the need for improved corporate governance and the need for public accountability – which is what “sold” risk management to the board. “This is a time when risk managers can truly demonstrate the value that risk management brings to the overall well-being of corporate Canada,” Johnstone says. “We’re overcoming a time of tremendous challenge, where issues surrounding corporate governance have brought risk management to the attention of boards of directors – which is both a challenge and an opportunity for the risk management profession.”

In order to meet this challenge head-on, and meet the demands of today’s transparent, highly-regulated marketplace, risk managers are asking for what Garner refers to as “deeper science and deeper thinking” from their broker partners. “They (risk managers) want new ideas. They want to see a broker community that helps them grow into the future of their business, which is towards much broader risk analytics around enterprise risk management and strategic risk thinking,” he explains. Broker competence around issues of corporate governance is integral in order to meet today’s risk management interests, Garner says.

The foundation of good corporate governance is good risk management that covers broader, enterprise-wide risks, risk managers say. In the new environment of greater transparency, in which risks can arise from any corporate deed, the risk manager’s role is evolving. Increasingly, there is a tendency toward managing and mitigating risk enterprise-wise. “Today’s risk manager must identify and manage multiple and cross-enterprise risks that includes strategic, operational, hazard and financial risks,” Johnstone says. “That’s an important evolution in the responsibility and necessity of risk managers. The profession is growing as a common corporate entity; most corporations today having a chief risks officer that works hand-in-hand with risk managers.”

The role of the risk manager is becoming fundamentally embedded in the insurance marketplace, but, it is the collective collaboration of the risk managers, brokers and insurers that will get the process right.