Ken Davey explains how organisations need to find new solutions to minimise risk exposure.

In today's climate of limited availability, increased costs and greater emphasis on business returns, financial executives and risk managers must now find new solutions to help minimise their companies' risk exposure. This is especially true in light of new research which has found that contingency planning - once the realm of risk managers - has now reached the highest levels of the corporate boardroom.

The World Trade Center (WTC) catastrophe is unquestionably the largest loss to ever impact the industry; estimated losses currently range from $40bn to $60bn, hitting multi-line carriers the hardest. Prior to the event, however, the price correction was already underway in the insurance and reinsurance arenas. September 11 only compounded an unprofitable situation. After the event, the insurance industry's combined ratio jumped from 110% to 116%, while the reinsurance market's combined ratio skyrocketed from 116% to 143%.

Furthermore, in the area of natural events, insurers are no longer willing to assume all the risks for coverage such as service interruption and contingent time element coverage for suppliers. And the reason? Historically, the frequency of natural disasters has not changed, but the magnitude of the losses has increased. In the past, natural events created a loss of 10 to 15 ratio points, and over last five years the loss ratio points have nearly doubled.

Adding to this financial pressure, the amount of capacity that is available in the marketplace has been reduced 30% to 50%. Large corporations, such as those in the FTSE 100 or Fortune 1000, cannot purchase all the capacity that they feel they need or have had in the past, particularly on programmes in excess of $500m of property coverage. Those requesting coverage in the billion dollar limits often find that it is close to impossible to acquire.

New market emphasis
As a result of the extensive losses sustained in both man-made and natural disasters, there is a much greater emphasis on profitable underwriting as traditional insurance markets consider how to address the associated risks after September 11. In response, today's carriers have turned to modeling events to better understand the consequences; they want to know all the exposures before they offer the capacity. Additionally, reinsurers are asking insurers to model their aggregations in major cities to control the terrorist and cross-liability exposures for companies that write multi-line business.

And as insurance carriers start to take a closer look at the quality of risk as a criterion for underwriting, they are also asking for a larger commitment from customers to improve their risk. Until recently, the long-running soft market and plenty of cheap capacity meant it was more cost-effective to transfer risk to a third party than for corporations to invest in risk improvement techniques. But today, transferring risk is no longer a standard option, and firms find they are paying two to three times what they were paying in premiums prior to September 11. Once a low-cost item, insurance coverage has now become a major budgetary concern.

By significantly impacting enterprise-wide strategic planning, these two key issues - capacity and price - have quickly pushed contingency planning from its former low-profile status into the forefront of the corporate boardroom.

Preparing for disruption
However, the 2002 `Protecting Value Study', recently conducted by commercial and industrial property insurer FM Global, the National Association of Corporate Treasurers and management consulting firm Sherbrooke Partners, revealed that 80% of Fortune 1000 financial executives and risk managers surveyed consider the September 11 terrorist attacks largely an insurance event. This data further underscores the need for adequate insurance coverage and thorough disaster recovery plans.

Based on corporations' reactions to pricing and availability, it is clear that many companies are only just beginning to adjust to the industry's new way of doing business. For although many organisations have contingency plans in place, they are still working off old, pre-September 11 models. Executive managers now must confront the likelihood of property loss and its projected impact not only on profit, but also on competitive market position and shareholder returns.

To address these sudden changes in the insurance environment, corporations are going back to the basics to better understand the risk management process. However, a surprising finding in the protecting value study (available for download at discovered that 50% of the CFOs and risk managers surveyed indicated that they were not well prepared to recover from a major disruption to their top earnings driver, whether that disruption was natural or man-made. The majority of the earnings drivers reported were property-related. The study also revealed that if a disruption were to occur, it would likely cause a sustained earnings hit to 43% of the respondents' companies, while it would threaten the business continuity of 33% of respondents.

Contingency planning should be managed in three ways:

  • review existing plans to ensure they are current - particularly in the light of previously unforeseen events (e.g., impact of the WTC event);
  • work with business operations and corporate finance to ensure plans achieve maximum buy-in throughout the company, are truly comprehensive, effective and workable; and
  • keep contingency plans current at the operational level as well as risk management department level.

    Moreover, the protecting value study reports that more than one-third of risk managers polled believe their company's senior management team lacks a complete understanding of the impact a major disruption would have on their firm's earnings and shareholder value, their company's level of preparation and what is covered by insurance in such an event. Additionally, the study discovered that financial executives are less confident in their company's contingency planning efforts and understate the scope of this planning as compared to their risk management counterparts.

    Why this difference of opinion between risk managers and CFOs regarding contingency planning?

    It is mainly an issue of timing and relevance. Prior to September 11, a contingency plan was probably not viewed by the CFO as a high-priority item - business continuity was the risk manager's responsibility. Certainly, the CFO wanted to know if there was a contingency plan in place.

    However, if there were not any balance sheet breakers present, the CFO would probably not be too concerned about the details of the contingency plan since he knew the company could transfer the risk.

    Today, if that risk cannot be transferred, or if a firm cannot purchase the level of capacity that it had in the past, then a contingency plan quickly becomes top-of-mind for the CFO. Suddenly, issues appear that can significantly impact a corporation's market share, earnings per share and shareholder returns if not dealt with appropriately.

    Learning to `talk insurance'
    To address this ever changing, complex business continuity environment, corporations are partnering within their organizations - and with their insurance providers - to understand their risk exposures and to research available alternatives.

    This presents an opportunity for insurers to take a leadership role in helping executives learn how to `talk insurance'. Executive management, in particular, tends to misunderstand the insurance industry and the impact of reinsurance on programmes. Conducting one-on-one meetings and increasing industry group visibility are just two of the ways insurers can generate awareness of the significant changes taking place in the insurance marketplace. By opening up the dialogue with corporate customers, insurers can better explain the broader issues of the industry's regulatory environment, as well as hot topics such as terrorism coverage.

    Despite the changes in the insurance industry, senior management frequently overlooks and under-appreciates sound risk management. Unfortunately, it often takes a major disruption in a firm's top earnings driver before senior management begins linking shareholder value to earnings drivers, hazards and realising the business value of good risk management practices. Initiating discussions between financial executives and risk managers can help clear up a number of misconceptions uncovered in the protecting value study regarding risk assessment and contingency planning efforts.

    Additionally, an ongoing hurdle for many risk managers is the problem of being able to demonstrate conclusively that they add measurable value to their organization.

    To meet these challenges they should continue to help their companies' executives better understand the risks that they face and assist them in making effective, informed decisions that optimise the balance between risk and return.

    When risk managers transfer risk they should do so with complete confidence both in the integrity of the capacity and, the competitiveness of the pricing, and work with partners capable of providing proven risk management solutions to help protect the value their business creates.

  • Ken Davey is managing director of the international division of FM Global.