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Katrina: why risk management failed: the record insured losses from Hurricane Katrina show that insurance companies need more discipline in managing risk assumption.

According to several industry sources, Hurricane Katrina inflicted record property/casualty losses of $35 billion to $55 billion at the end of August 2005, an amount large enough to wipe out most of the estimated pretax operating profit of the entire insurance industry for the year. Even worse, the low-end estimate of Katrina losses is five times the amount of direct premium written in the affected states and 50 to 100 times the expected yearly profit on this business.

How could insurance companies write business exposed to such enormous risk without charging rates that would compensate adequately for losses of this magnitude? How could their risk management processes allow this to happen? A post-mortem review suggests that management's focus on meeting financial objectives that are not explicitly risk adjusted may have been a major cause of this breakdown. In the absence of risk adjustment, expediency can drive operating decisions that meet short-term objectives but are ruinous in the longer term. The lesson of Katrina is that risk-adjusted performance measures, strengthened risk governance processes and controls and other key steps are urgently needed to mitigate the impact of future mega-events and to enhance company resiliency.

A Disaster in the Making

Many discussions of Katrina's impact on the insurance industry seem a little disingenuous: too much pointing to the failures of catastrophe models to provide accurate pre-event severity and frequency estimates; too much protesting that, had the numbers been better, companies would have underwritten the business with higher deductibles, lower limits or not at all, or would have secured more reinsurance protection. This hand-wringing obscures the fact that exposure concentrations in New Orleans were well known. They were a disaster waiting to occur.

The typical company also knew that, at prevailing rates, premiums were inadequate in many areas along the Gulf Coast. Yet this did not stop it from writing the business. Many companies had the tools needed to identify, and measure the risk. Few, however, had the discipline to take appropriate action to avoid, mitigate, or transfer the risk. How did this happen?

Withdrawing from an area exposed to catastrophe risk is difficult and typically is not viewed as urgent as long as the going is good. Although ultimately inadequate, the premiums earned in such an area contribute to profits in all the "good" years; by contrast, withdrawing reduces premium and profits, may alienate important distributors and can create a political backlash. Adding to this dilemma, over the past 20 years management has been under pressure from regulators, rating agencies, and shareholders and their representatives.

Embarrassed over their failure to spot financial impairment in a number of companies that became insolvent in the mid-1980s, regulators started to devise risk-based solvency monitoring frameworks and capital adequacy regulations that enabled them to intervene at the first sign of trouble. In a parallel development, rating agencies refined their rating methodologies and stepped up their monitoring activities.

The regulatory goal of ensuring solvency, however, conflicts with the goal of ensuring affordable and available coverage. Concerns about affordability can lead to rate suppression, increasing insolvency risk or forcing insurers to withdraw from the market. Concerns about solvency, by contrast, could drive rates so high that coverage becomes unaffordable.

This conflict is exacerbated in catastrophe-exposed areas and produces matching conflicts for insurers. When the rates needed to support writing in these areas are so much higher than the rates allowed by regulators, a company must decide whether to accept the business at inadequate prices or to withdraw. It then can either let a competitor write the business or accept a lower price than is indicated by actuarial analysis.

The enhanced performance expectations of shareholders and boards place additional pressure on management. If a company's financial performance lags, or new developments suggest that it cannot sustain its performance, financial analysts and professional investment managers will act swiftly to reduce or even eliminate their positions. Threatened with lawsuits from disgruntled shareholders, boards and directors have become willing to intervene more forcefully in company affairs. At the same time, partly because of concerns about personal reputational risk and potential liability for misconduct, boards have become a growing force for increased risk aversion.

Management has responded to these pressures by assuming more risk. Although GAAP reporting has evolved to include the evaluation of risky assets and liabilities, financial reports and performance measures are not required to be "risk adjusted." Therefore, the numbers included in financial reports prepared trader GAAP or statutory, accounting can be correct, yet misleading with regard to changes in an insurer's risk profile. The absence of risk adjustment in reporting, when combined with "stretch" objectives, may encourage management to engage in activities that enhance reported financial results and also increase the volatility of earnings.

Ironically, chief executive officers and senior management may have more incentive to pursue risky strategies when performance has lagged, when the value of their economic stake has declined, or when they are at risk of being removed, than they are when performance has been good. Under such circumstances, they may be drawn to strategies that have high potential rewards but also high risk, such as writing catastrophe-exposed business at inadequate rates.

Winner or Loser?

A long-held view in the industry is that a "big one;' devastating enough to hurt every company, would not be a concern. Under such circumstances, regulators and the federal government would have to intervene and help restore the industry. Katrina calls this wisdom into question. It suggests that an extreme event may not be equally devastating to all companies. Better-prepared companies may be more resilient and suffer comparatively smaller losses.

Such companies would be better able to refinance themselves and take advantage of the market disruption caused by an extreme event. They could have their choice of the business that would leave weakened competitors (which might be insolvent or downgraded). They might even be able to make acquisitions on favorable terms because sellers would have fewer options. It is also conceivable that after a "big one," the Justice Department would relax its interpretation of antitrust restrictions to permit mergers that would restore the viability of the industry and accelerate the return to normally functioning insurance markets.

Future winners are revamping their risk measurement infrastructure and are becoming more systematic in introducing risk adjustment in business decisions. The leading companies also are devoting resources so that they can become more resilient in anticipation of future extreme events. They understand that extreme events are a real threat, as well as an opportunity.

Key Points

* Management's focus on meeting financial objectives that are not explicitly risk adjusted may have been a major cause of Katrina's large insured losses.

* The goal of revamping risk governance should be to align all key constituents' perspectives on short- and long-term risks and rewards.

* Leading companies are devoting significant resources so that they can become more resilient in anticipation of future extreme events.

Key Steps to Revamp Your Company's Risk Governance

The question now facing insurers is how to prevent a recurrence of the risk-management failure demonstrated by Hurricane Katrina. Insurers must strengthen their risk governance structure, processes and controls; establish effective risk-adjusted performance measures and targets; and implement internal compliance mechanisms to ensure adherence to risk policies that are consistent with shareholders' risk tolerance.

The ultimate goal of a plan to revamp risk governance should be to align the perspectives on short- and long-term risks and rewards of shareholders, boards, rating agencies, regulators and management and to develop a supporting framework that includes the following measures.

Communications with investors. A key element in improving the risk management process is enhanced communications about the risk/reward trade-offs made by management. Investors dislike companies' lack of transparency in communicating clearly what strategies they are pursuing and what risks they are taking.

Management also should explain and justify the risk policy and risk limits that guide company operations and disclose the mechanisms that have been put in place to measure, report and manage the accumulation of risks.

Special role for boards of directors. Katrina also demonstrates that it is time for boards to obtain independent assurance about the effectiveness of companies' risk-management processes. To do that, boards will have to demand that the reviews performed on their behalf be deep enough to capture the many subtleties in contract language, structures and limits that underwriters use to shape the profit and risk characteristics of insurance contracts. They also will need to ensure that incentive compensation plans do not provide perverse incentives and hold management accountable for breaches of policy.

Increasing Company Resiliency

Katrina challenges insurance companies to become more resilient by rethinking how they conduct their business.

In the long term, the industry can mitigate catastrophe losses by promoting safer building codes and appropriate zoning. But in the short term, there isn't much individual companies can do except to manage their exposure to catastrophe risk. This requires action in the following areas:

Determining catastrophe risk capacity. Insurers must determine their catastrophe risk in relation to:

* Shareholders' tolerance to earnings shocks or capital losses.

* The dilution investors would suffer if the company needed to raise additional equity to stay in business.

* The impact of catastrophe risk exposure on a company's ability to maintain its desired rating or even remain viable, given available paid-up capital and the cost and availability of contingent capital (for example, private or public reinsurance, insurance-linked securities).

As they evaluate their capacity for catastrophe risk, insurers need to consider the pricing adequacy of the business and related probable maximum losses, the availability and pricing of reinsurance coverage and the possibility of a ratings downgrade. They also must evaluate secondary effects such as the loss of other business in the event of a down-grade, the possible hardening of the market (especially the reinsurance market) following a disaster, and the effect on the volume and profitability of other business that is sold through distributors and may be "affected by a reduction or withdrawal from high-risk markets.

Companies must address these questions and ensure that the risk tolerances and interests of each key constituency have been considered. Anything else would leave management exposed to charges of negligence and liable for possible damages.

Managing underwriting. Companies need processes that align underwriters' risk assumption with the company's capacity for catastrophe risk and risk-adjusted profit targets. This requires a risk-data capture and monitoring system that can interface with catastrophe simulation models to help identify concentrations and aggregations that need to be reduced. Underwriters can develop strategies to achieve greater geographic diversification through redirection of selling activities; selective cancellation/nonrenewal of policies; or reduction of PMLs and alignment with risk tolerances through changes in policy terms, exclusions, increased deductibles and reductions in limits; or simply higher rates.

Managing relationships with distributors. Katrina shows that companies that distribute insurance products through independent agents or brokers must develop sharper insights into the risk profile and expected profitability of the business they write through each distributor. They need to develop the capability to link exposures to each distributor in order to analyze the risk-and-return characteristics of distributor relationships, in total and by client, and conduct more meaningful relationship reviews. They must clearly set out for distributors what business they will accept, in what volume and at what price, and what business they will decline.

Managing relationships with regulators. Katrina underscores the consequences of writing inadequately priced risks in catastrophe-exposed areas. It shows that companies must use their risk data infrastructure and tools to analyze the risk/return profile of exposures in each state. Armed with this knowledge, companies could decide more accurately how to respond to the limitations imposed by regulators. Companies writing business in states with significant catastrophe exposures should use this information to request that the state accommodate their needs for more adequate rates, creation of a reinsurance facility for losses from extreme events, agreement on a mechanism providing relief to companies through special assessments on state premium, and accumulation of catastrophe reserves on a pretax basis.

To prevent future risk management failures, insurers must:

* Strengthen their risk governance structure, processes and controls;

* Establish effective risk-adjusted performance measures and targets; and

* Implement internal compliance mechanisms to ensure adherence to risk policies that are consistent with shareholders' risk tolerance.

Contributor Jean-Pierre Berliet is a senior manager in Ernst & Young's Insurance and Actuarial Advisory Services practice. He can be reached at
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Comment:Katrina: why risk management failed: the record insured losses from Hurricane Katrina show that insurance companies need more discipline in managing risk assumption.
Author:Berliet, Jean-Pierre
Publication:Best's Review
Geographic Code:1USA
Date:Jun 1, 2006
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