Five risk trends to watch.

As the risk manager of a major manufacturer, I've long been an observer of the changes sweeping both the insurance industry and corporate risk management. Today, many of the most important trends are linked in some way to the growing tendency to roll pure risk and financial (or speculative) risk into one risk-management program. Here's my take on the most important changes in risk management today and why I think it's important to keep pure risk and financial risk separate functions.

Pure vs. financial risk. In some risk-management corners, it's now fashionable to merge "pure" risks (those with only downside potential, such as property losses or civil liability) and financial risks, such as currency hedging and derivative trading. The latest theory is that regardless of the source, risk represents a single exposure to the corporation.

But mergers are for corporations, not for risk managers. Successfully managing pure and speculative risk requires two very different skill sets. In most corporations, there's some convergence at the senior management level. In other words, the treasurer or CFO often oversees both pure and speculative risk management. But the promoters of merging the two areas, mostly purveyors of products or services trying to broaden their markets, often imply that one small staff group can manage both functions if given the right computer software and consultant tools (guess whose?).

The essence of successful pure risk management is minimizing negative results by actively avoiding losses, through fire prevention, fleet auto safety and favorable contractual indemnity terms. Speculative risk management involves seeking the best passive results for events usually beyond the company's control, such as geopolitical or macroeconomic events that could cause unpredictable currency value swings. These risks are best managed by judgment, prudent hedging and, in some cases, just good luck. Clearly, these two areas of risk management are different animals, and the danger of having one generalist staff address both functions is that they'll do neither well.

DAZED AND DISORIENTED 

Insurer and service provider consolidation. Several recent insurance acquisitions - instead of creating bigger, more capable survivors - have resulted in disoriented bureaucracies that are trying to eliminate their competition in hopes of increasing their pricing profile. This is happening among both insurers and insurance brokers, in the United States and in Europe.

Although insurance companies tell you the customer will continue to drive competition among the remaining suppliers, many risk managers are skeptical. The good news is the merged entities seem to have healthier balance sheets, which should make them more able to accept business without the need to spread the risk to reinsurers. This could reduce prices for the insurance consumer. We'll see.

Self-insurance/risk retention. Today, Fortune 1000 corporations are increasingly turning away from the commercial insurance market for day-to-day loss financing in the lower-level working layers of their insurance program, because of the dollar-trading nature of the transactions. Since small losses are analytically predictable in frequency and cost over time, why not budget and pay for them directly, instead of paying the loss costs plus the add-ons to the insurer, who's done exactly the same analysis?

A recent survey of forest products companies with annual sales ranging from $500 million to $20 billion shows the average deductible on corporate auto liability insurance programs exceeds $1 million per loss. Ten years ago, the average program for the same group showed deductibles of less than $250,000, with higher fees paid to the insurers for claims management. Competition for market share among insurers has permitted buyers to wring costs out of the system for risks the company can assume without disrupting the balance sheet.

This trend is strong and permanent in North America, but it hasn't taken hold in other parts of the world. Insurers elsewhere don't want to give credit for the reduction in their own frictional costs by granting larger deductibles, because it would reduce their cash flow. Therefore, no savings have been available for corporate customers. Companies operating globally find themselves with fractured programs, taking large risks in the United States, with deductibles ranging up to $5 million per loss, yet struggling to find insurers who will give credit for any deductible greater than $50,000 in Europe, and even less in Asia. At a time when most companies are trying to reduce internal costs, we as risk managers should do anything we can to develop a more efficient risk-financing mechanism. You may want to consider integrating some of these fractured programs into corporate-wide balance-sheet protection.

GLOBAL IS A STATE OF MIND

Just how global is your global program, anyway? Insurers know corporations want to operate globally, so they market themselves accordingly. Unfortunately, when you read the fine print, almost no insurers can consistently deliver in far-flung countries. For example, only one or two Western insurers are licensed to operate in China. Many have cooperative agreements in smaller countries with local insurers, but the cooperation seems to wane after you pay the premium.

Other insurers say "global" and mean "North America and most of the European Union." For example, take a look at your directors and officers liability insurance policy. It probably says it protects your officers for covered events anywhere in the world. But under most policies, "covered events" are those covered by U.S. laws, which excludes theories of liability in Germany, France and other countries. Make sure you examine your policy and ask questions about exposures in the countries where you operate.

Business interruption is an increasingly complex exposure. An increasingly tangled web of manufacturing and distribution can cause significantly larger losses than in past eras, when manufacturers had redundant production and inventory capacity to absorb demand swings. The concept of just-in-time inventory and other efforts to reduce working capital means that when even one small part of a facility has unscheduled downtime from a fire or machinery breakdown, it creates significant ripple effects throughout the corporation, as well as its customers and suppliers. This has been clearly demonstrated over the past year in the auto industry, which had several strikes at single facilities. These dramatically affected the companies' overall manufacturing networks.

In one case widely discussed in risk-management circles, a fire broke out in a carpet-manufacturing facility that was part of a large multinational corporation and had an estimated exposure of $25 million. After the fire, it turned out that because of the interrelationship among the company's facilities, which neither the insurer nor the manufacturer had fully appreciated, the total damages, including lost sales, were eventually valued at over $500 million! Developing a thorough understanding of the downstream effects of a production stoppage is a difficult task. Again, it requires a focus on pure risk management factors, such as manufacturing processes, logistics and building construction characteristics.

Each of these trends indicates corporations will continue to rely on specialists to lead their pure risk management programs to truly reduce their long-term cost of risk, in a separate endeavor from the speculative risk efforts. The more sophisticated the program, the more the corporation will rely on dedicated professionals to fine-tune their programs to improve the cost profile. Finally, the more things change, the more they stay the same. It's just as true as ever that losses are preventable and aren't necessarily inevitable. That's the key difference between managing pure and speculative risks.

Mr. Langsdale is corporate risk manager at International Paper Co. in Memphis, Tenn. You can reach him at [phone].