Waking the giant: is insurance becoming irrelevant?
How could anyone suggest that insurance is becoming irrelevant at a time when some of the most catastrophic losses have resulted from unauthorized acts committed to generate fees and commissions, and insurers have continually sought to distance themselves from such losses? Fidelity insurance, for example, has continued to be defined more and more narrowly since its initial drafting. Coverage that once applied to criminal acts was narrowed to cover only dishonest acts and further restricted to cover only dishonest acts committed with manifest intent to cause loss and obtain individual financial benefit. ("Benefit" was, in turn, narrowed to exclude compensation in the form of salaries, fees and commissions.)
How could anyone suggest that crime insurance is becoming irrelevant when the average industry loss ratio for fidelity coverage has dropped into the 20 percent to 30 percent range in recent years?
In fairness, there was a time, about 12 years ago, when financial institution crime insurance almost ceased to exist. Fortunately underwriters found a way to preserve it through radically higher retentions and premiums, while narrowing the scope of coverage. Could it be that insurers have done such an excellent job of protecting this coverage from the possibility of loss that it has, in fact, ceased to be relevant to some of the insured's most critical exposures?
The actions of the insurance industry 12 years ago -- severely limiting capacity, increasing retentions and raising prices -- served to stimulate the rapid growth of the alternative market in the form of Bermuda insurers, captives and other options. The alternative sector is now estimated to represent approximately 40 percent of the commercial market. Are we again at a point where insureds are deciding that traditionally available insurance products simply don't serve their overall needs? What actions can the insurance industry take, not only to keep from becoming irrelevant but to create a valuable partnership role with its clients?
Perhaps the first step is to recognize the growth, consolidation and changes in risk assessment that have occurred in the corporate world. Using the financial sector as an example, in 1977, the deposits of the top 100 U.S. banks totaled $481 billion. In 1997, the total deposits at just the top 10 U.S. banks totaled $787 billion.
During these 20 years, we have experienced convergence both in terms of mergers and loss of institutional distinctions. Twenty years ago, the insurance industry could offer products such as the bankers blanket bond, the stockbrokers blanket bond, the mortgage bankers blanket bond and others. Today, such distinctions are meaningless. Certain banks are extensively engaged in the securities business, both homegrown and acquired, and securities firms in turn provide banking services. Both types of firms, as well as certain insurers, are also heavily involved in trading. We not only have the traditional presence of some manufacturing firms in financial services but also the growing involvement of software manufacturers with financial service products and electronic networks. In addition, we see traditional in-house operations and functions being outsourced to technology and consulting firms.
Such outsourcing creates a very mixed marriage, a joining of the fiduciary and technological cultures. In the traditional fiduciary culture, if a client is injured by the failure of the fiduciary, the fiduciary is generally responsible. In the techno/consulting culture, no such degree of responsibility exists. Rarely will a vendor assume any responsibility for consequential loss to the fiduciary and its clients. Operational functions may be delegated; however, responsibility is not.
I have observed an interesting ancillary development as a result of the growing influence of technology -- the increasing reliance on non-verbal communication in the form of flow charts, thinking models, graphic representations and techno/consultant jargon. I point this out only because it is so antithetical to insurance, which is intensely verbal, with coverage sometimes dependent on the use of "and" rather than "or."
In addition to the externally observable changes, there are also radical changes occurring in the way individual firms view their own risks. While the nomenclature may vary from firm to firm, the principles being applied are the same.
Today, corporations are attempting to view risk systemically. Thinking models have been developed to depict the architecture of risk management within a business enterprise graphically. These models chart the manner in which risks flowing from business objectives can be assessed, controlled and monitored.
The types of risks being identified in financial services companies include: strategic, reputation, credit, market, interest rate, liquidity, fiduciary, transactional and regulatory. Other firms add business continuity, people, physical security and model risk to the list. Some believe that all of these risks can be summarized in five high-level categories: market/credit, revenue volatility, expense variability, operating and capital.
Given the breadth of risk, as it is now recognized, no single discipline is equipped to address the entire spectrum. I have observed a tendency to create two complementary groups. The first includes individuals with sophisticated financial expertise to manage market and credit risk. Complementing this unit is another multifunctional group, sometimes called an operating risk committee, that may include representatives from a firm's legal/compliance, operations, insurance, business continuity, executive management and other areas.
Regulators have been a major catalyst in the advancement of risk management and have themselves become much more sophisticated. The office of the comptroller of the currency recently assembled a team of 11 Ph.D. economists to help examiners evaluate model risk by assessing the complex mathematical formulas that comprise financial models.
In essence, regulators are demanding that financial institutions identify risk laterally across the organization, regardless of its nature. Firms must examine business and operational risk, including fortuitous event risk. This does not mean that a risk is a risk is a risk, and that all risks should be treated and funded in the same manner. What it does mean is that there are a wide variety of risks that require a complex control infrastructure and a multiplicity of risk transfer and funding mechanisms, whether contractual or through internal and external funding arrangements.
Despite the vastly increased capital in the financial services industry, and the fundamental operational changes I have noted, we have yet to see any radical change in the way financial institution insurance products are crafted. The fact that the bankers blanket bond is now referred to as a financial institution bond does not represent the type of change we might have expected to occur.
Systemic approaches to risk assessment do not dwell on the fine distinctions that have traditionally been drawn between insurable and non-insurable risk and indeed highlight the limitations of that approach with respect to operational risk. Take, for example, the exposure to business interruption loss. The exposure to financial loss from the interruption of business for a week, a month or a year is essentially the same, regardless of the cause of the interruption. In fact, in contingency planning, or what has come to be called business continuity planning, relatively little attention is focused on the cause of the interruption. Business continuity plans, as required by regulators, assume the loss of an entire facility without consideration of cause. The plan is designed to restore the operation at a different location with alternative technology, as quickly as necessary, to preclude serious loss.
Yet the insurance industry will only address business interruption caused by physical damage. This is an accident of history, stemming from the fact that the coverage developed from fire insurance at a time when the principal dependency of the insured was on its physical plant. The insurance industry recognized this dependency and became quite expert in protecting the physical plant from serious fire damage. Those who created the Highly Protected Risk industry, including the Factory Mutual firms, became state-of-the-art experts on sprinklers and all forms of fire suppression, detection and prevention.
Today, an insured's principal dependency, often is not upon the physical plant but on technology systems and the information within them. However, a business interruption caused solely by system failure, whether software or hardware, remains uninsurable.
Insurers argue that they don't understand the exposures. This response is not adequate when resources are available to evaluate and underwrite the risk, based on an assessment of the technological environment and the contingency plan. In this way, at the appropriate attachment point, insurance could be made relevant to a firm's overall business interruption exposure, not just one segment of it.
In circumstances where exposures have evolved significantly, is the insurance industry to remain wedded to the past? What I am suggesting is as simple as the old distinction between sales and marketing. Will the insurance industry focus on selling its existing products, however repackaged, or on producing new solutions to the insured's current needs?
It has been my observation, with respect to the life cycle of insurance products, that they often originate in anathema and end in ennui. Some will remember the consternation in the 1970s, when courts held that the financial institution bond covered certain kidnap situations. The insurance industry responded predictably, maintaining that it had not anticipated this exposure or charged a premium and that it would therefore absolutely exclude the peril. Thereafter, insurers seized the opportunity to offer a separate expensive and highly restrictive coverage that over time continued to broaden and eventually wound up a virtual throw-in back under the bond.
I suspect we may see the same thing happen with the employment practices exposure: first excluded, then written separately and eventually, returned to the basic commercial general liability form. Of course, in this soft market, there is a lot of motivation to sell anything new or charge more for coverage that was previously provided in another form.
Directors' and officers' (D&O) insurance may provide an example of coverage revisions being introduced to suit the needs of the insurer rather than the insured. I refer to the allocation issue relative to securities claims. The main reason a large, well-capitalized firm purchases D&O coverage (although I think some risk managers lose sight of this) is to protect individual directors and officers in those circumstances where the firm cannot indemnify them, as in a stockholder derivative action.
When the first insurer announced that for twice the premium, it would acknowledge a 50/50 allocation between the individuals and the entity named in securities litigation, my reaction was that for twice the premium, I could now reduce the coverage I actually wanted by 50 percent. Doubling the cost and halving the coverage did not seem particularly attractive to me, then or now.
In terms of the insurance product life cycle, D&O seems to be at the bells and whistle stage, with an estimated $1 billion in global capacity and the availability of coverage for the entity, pollution, outside directorships, employment practices, spouses and more. I've even heard discussions in which the significance of the aggregate limit has been denigrated on the basis that if we use it up, we'll just buy more from somebody else.
Create Focus Needed
Where should the insurance industry be focusing its creative energies, if it is not to be wedded to the past or consumed with redecorating old structures?
At the primary level, for a firm with a reasonable loss history, insurance remains a very cost-effective method of risk transfer for a variety of risks. However, current insurance products do not begin to reflect the growth and change that have taken place in many industries and in their exposures. There is also a significant potential downside to present multiyear blended offerings, which I believe to be immature products.
Perhaps change can begin most effectively at a level above the limits of traditional insurance. This level will vary by size and type of firm. However, perhaps at this more catastrophic level, insurers can begin to address three categories of risk: traditionally uninsurable perils, technically insurable exposures that could not be insured at the primary level on a cost-effective basis, and, finally, excess catastrophe exposure coverage over existing programs.
The insurance industry, through its narrow focus, has already ceded much of what might have been part of its potential risk management role to the rapidly growing consulting business, and I am not referring to brokers who now call themselves consultants. This, to some extent, may parallel the loss of a significant portion of the risk-funding role to the more broadly defined alternative markets. Insurers will never be all things to all people nor should that be the goal. However, I believe we have reached a critical point at which insurers must define an expanded role within the context of the rapidly evolving circumstances of what has come to be called risk management.
It has been written that "Revolutions are not the cause of change, change prepares the ground for revolution." All of the fundamental changes in the corporate world clearly suggest that a radical change in insurance products is called for. Though we may not all agree on the specific direction to be taken, perhaps we can at least concur with Tennessee Williams that: "There is a time of departure, even when there's no certain place to go."
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|Author:||Kelly, William J.|
|Date:||Aug 1, 1997|
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