Re/insurers need to take a new approach to the investigation, analysis and monitoring of exposures, says Phil Devon.
The ground is shifting beneath the reinsurance community. As a group, reinsurers are well-known for the expertise that they bring to bear on the analysis of physical risks; their engineering expertise is second to none and the separate inspections by teams from reinsurers, in addition to the work undertaken by the insured and the direct insurer, forms the stuff of legend. In addition, the reinsurers' in-house economists have excellent reputations. In bringing all this expertise to bear on the individual insured situation, the traditional approach has been to consider the predictable loss of physical assets through natural disaster or human error.
So, is all well in HQ Re? Or has the time come for the emphasis on sprinklers and contingency plans, health and safety, and project failure to be supplemented by more profound analysis of the insured?
Attitudes are changing in the risk markets. Recent natural disasters and, of course, September 11 have appeared costly against the premiums charged for those exposures, and caused reinsurers to claim that the risk-reward ratio had fallen out of line with the actual situation. Consequently, premiums have been hiked and conditions tightened. Some might say that this change is just the normal insurance cycle following through. But what is different this time around is the pressure on underwriters through the emergence of new, real exposures. The recent crop of corporate failures, particularly in the US, and the potential for class actions and claims against the directors of failed corporations, give real concern for underwriters in classes of insurance where the incidence of claims had been low. That is not to say that underwriters have not been called upon to pay out against some substantial claims - and the hardening market for professional liability insurance is evidence of this - but what we are now seeing is the possibility of reinsurers being exposed in situations of corporate `misbehaviour'.
What is the effect of these incidents on the insured corporation? A claim for loss may have been paid, but the corporation may not have the ability to recover fully to its previous earning capacity. The ability to absorb these potentially corporate life-threatening incidents is a true reflection on the ability of the corporate management.
If, as is suggested, the major emphasis for losses is now more directed towards issues relating to directors' and officers' liability, professional indemnity and fraud (or something approaching it), reinsurers should be taking steps to protect their portfolio, and ultimately their investors, against the rise in this type of loss. Reinsurers' profitability is increasingly becoming as much a function of these new types of loss as hurricanes, explosions and investment returns. Protection of profitability requires a wider analysis of the risks than is undertaken at present, both in terms of the risks themselves and the ability of the insured to analyse the risks and to undertake cost-effective risk management procedures.
As a consequence of this required wider analysis, the traditional proposal form is no longer adequate. Typically, it seeks answers to questions that have clear metrics, for example relating to the size of the payroll, volume of sales and other measures. It takes little account of the other factors that are indicators of management health; in fact, it is little more than a superficial veil that provides much irrelevant information about the real risks in the insured, merely giving an out-of-date snapshot of the insured at some date in the past. For example, what does the wage-roll tell us about the real level of employer's liability exposures? The proposal form says nothing about the management, other than allowing the reader to draw his own conclusions from some historic financial information. And we have all seen just how meaningful that can be.
Standardisation of information, to help overcome the fact that the reinsurers are receiving their information at one remove from the source, is important. Initiatives in this direction will be helpful, but only if the information is answering the right questions.
The recent emphasis on corporate governance, as evidenced by the Turnbull Report in the UK and similar codes adopted in free market countries around the world, should be flagging to underwriters that there are more dimensions to corporate health than the metrics on the proposal form. It is not suggested that the governance and related issues are currently being ignored, but a clear exposition of the state of corporate management health within the insured is not sought as part of the prevailing practice.
Underwriters need corporate governance
Corporate common sense is now increasingly being codified as a corporate ethics policy and a corporate governance policy. From these should flow a series of inter-related policies and codified practices, responsibilities and authorities across the organisation. The question is, therefore, whether reinsurers should now be spending much more time and effort in analysing corporate governance and the management of the insured as well as the physical assets. In other words, there is, potentially, a mismatch between the information being provided by the insured, the investigations undertaken by underwriters and the real risks that they are now facing.
A critical aspect of the underwriting information that is missing from the traditional analysis of risk, is the quality of management, as exemplified by the effectiveness of corporate governance in the company, and its ability to control risk. Underwriters should be investigating the extent to which good corporate governance practice and the attendant corporate disciplines have been introduced into the client organisation.
The requirement for boards to report on corporate governance and risk management in the annual report and accounts has heightened the awareness of these issues at board level. However, merely having to report that the company complies with a code of practice and that the effectiveness of risk controls has been reviewed, falls well short of a categorical statement that corporate governance is effective and that controls are in place and are considered sufficient to be effective against all reasonably forecast risk exposures. Underwriters should be undertaking their own investigation.
As transparency in decision-making and investor influence increase, it is only a matter of time before an investor group in one of the major reinsurers sues for a lack of due diligence when the reinsurer is called upon to pay substantial claims. To protect itself from such an eventuality, a reinsurer should be investigating the extent of corporate discipline in an insured, alongside the sprinklers and fire extinguishers.
Importance of good corporate governance
Good corporate governance is as much about the quality of management as the existence of structures and processes. The ability of management to recognise the danger signals in any situation - whether these are competitive pressures changing strategic direction or the impact of changing technology on the traditional product line - is arguably more important to the underwriter than a proposal form. This leadership quality will show through in the day-to-day management of the business and the effectiveness of the corporate governance measures. Equally, the ability of management to listen to and interpret signals from the marketplace may be the difference between a workable strategy and an ill-conceived, misdirected one.
There is a tendency among many writers and practitioners to limit corporate governance to the board, and its direct relationship with the shareholders, and the executives of the corporation. However, in reality, corporate governance extends right down into the corporation and affects the behaviour of all executives, managers and employees. While the senior management can set the tone of the corporation, it is the employees who generally comprise the interface between the company and its customers and other stakeholders. Middle management is where the responsibility for implementing action plans such as risk reduction processes usually rests. It is often their analysis that has highlighted the need for action in the first place.
Management's analysis of the impact and chance elements of individual risks provides the basis for further investigation and analysis, and the proposal of risk reduction techniques. Typically, however, there is often a `soft' element to the risk profile, which needs to be identified and communicated. Communication channels are therefore as important to the effective management of risk in the company as a detailed set of instructions.
Corporate governance should not be looked upon as solely a board issue. Effective corporate governance extends across the whole company and the reinsurer's corporate health engineer therefore has a multitude of potential sources of information.
Capturing the message
Management, of both the insured and the underwriter, must be able to answer the question, `Is the company well-run and in compliance with all accepted codes and conventions?' However, information sources tend to be diffuse and existing processes are archaic. Any attempt to import best practice from external sources results in a fat fee payable to the consulting arm of the company's auditor. What is required is the ability to very quickly and effectively initiate a quick aggregation of the qualitative and quantitative opinions of representatives from different parts of the organisation.
By Phil Devon
Phil Devon is a director of Cognitix Ltd, a London-based consultancy which has developed an approach to measuring the extent to which good corporate governance has been implemented in organisations, and its effectiveness. Further information is available from www.cognitixglobal.com .