15/03/2010

By Bruce Hepburn

Early this year Mactavish published the first of a two year programme analysing the impact of the recession on business risk. Our key finding was a marked upturn in many risks arising as companies adapt to the most challenging trading conditions in a generation. Even as we take tentative steps back to growth, operational disruption remains the underlying reality within an increasingly interconnected economy. We also found that often new risk developments were not yet well understood or communicated, creating uncertainty for both shareholders and insurers.
An intuitively 'common-sense' conclusion aligning with recent business comment, this work was based on detailed evidence from a broad programme of consultation across corporate Britain in 2009. As the initial scene setting paper of a wider programme, we were also surprised at the intense interest shown by a cross-section of business trade bodies, regulators, insurance industry players and their investors. For many, the combination of greater risk woven across the fabric of the economy and a limited ability to understand its drivers doesn't sit comfortably, especially in light of the financial sector's failure to adequately assess its exposures.
However, perhaps the group for whom this work should have the greatest resonance is the professional risk management community. The mix of factors clearly creates a step change in the complexity of the challenge risk managers face, and to the importance of getting it right. This is an unprecedented opportunity to help the more proactive exponents
of the profession leap forward. As the US industrialist Henry Kaiser put it: "Trouble is only opportunity in work clothes".
As well as dealing with this increased change and complexity, risk managers begin the challenge with a double handicap. First, an insurance industry adapted to a low standard of disclosure, making differentiation of those who better mitigate such risks difficult. Second, a legal framework around non-disclosure which places a burden on corporate risk managers far above what most assume to be the case. This is a big issue, with the Law Commission due this summer to publish its policy statement on business insurance. At face value, many conclusions in their initial 2008 consultation paper set out the need for reform: "The current duty of disclosure can operate as a trap (and) policyholders may be denied claims even when they act honestly and reasonably".

A fairer framework
While the law appears to put a lot of the cards in the hands of insurers, in practice the reality of negotiation when an unexpected claim occurs is, of course, rarely black and white. Nonetheless, the risk managers most aware of their rights and obligations find themselves in an uncomfortable position. They will be monitoring upcoming developments closely and hoping for a fairer framework that aligns theory and practice while supporting and rewarding diligent risk disclosure. Although it is uncertain whether a major shake-up will result, the fact that such reform is finally on the table presents a huge opportunity for the risk management industry. Working with a range of industry partners, we expect to publish a dedicated report analysing this subject later in the year.
So, in addition to a perception of worsening risk and a few major structural handicaps, there's even more to current conditions to make life difficult for a risk manager. Insurance market price and capacity conditions are likely to harden in the near future - with a good chance that the delays we're seeing will make the subsequent response harsher, as per previous cycles. Risk managers will have to work hard to avoid taking the fall when this response hits some sectors and companies disproportionately. Whether they recognise it or not, most companies are today a lot more dependent on insurance - and sensitive to its fluctuations - given financial pressures and ongoing difficulty in debt and equity markets. Recognising the interconnected nature of today's economy, and systemic risk within it, makes the job of understanding, analysing and communicating risk harder than it was 10 years ago.
Perhaps our strongest conclusion is that customers must take the lead in driving change, in an environment of reduced broking fees and tight underwriting margins, since they are the ones closer to risk details and driving risk management improvements. Insurers and brokers are
used to working with the current tools and responding to changes to the risk environment, mainly once loss patterns have already changed.
If customers want the insurers to more proactively accommodate and respond to better risk information, they need to aggressively drive the disclosure agenda rather than expect to be asked the right questions. Fortunately, this also helps manage the legal obligation to disclose all potentially relevant information. Again, the current environment provides the stimulus for risk managers to improve their lot, rather than resign themselves to a market cycle where swings in price and capacity can deviate wildly from underlying risk.
This takes us back to the question we've been asked most following our first paper - what can risk managers do now to overcome this challenge, handicaps and all? Our stock response is that this has three equally critical components: first, building the risk management function's own insight into detailed operational risk and how it's changing; second, strengthening the internal network across the business to increase risk management visibility and understanding; third, closely working with operational colleagues towards a step-change in communicating risk.
Despite the increased difficulty of this challenge for many, forward-thinking buyers have had recent success with a number of disclosure innovations. Examples range from inviting insurers to present regularly to the board on company risk issues (ensuring senior insurer representation and a direct line of communication), to building company-wide risk management sub-groups across operational functions, to radical re-thinking of the depth and presentation of traditional submission data. No single solution will be the right course of action, but a challenging environment provides conditions for the risk management to build its role and effectiveness.

A complex task
None of these issues are entirely new, even if they are taking on greater importance. What's more, it would be unfair not to recognise that corporate risk governance has been subject to important innovation in recent years. Our report points to comment from a range of regulatory and business bodies on the increase in formal risk reporting structures being put in place, and of future reform to risk governance structures (such as the UK Corporate Governance Code).
While our research concurs that the prevalence of risk registers and board risk committees is much higher than a decade ago, many risk managers raised the concern that these tools often seem distant from many of the nitty-gritty operational risk issues they worry about. Inevitably, they also tend to be stronger when considering events of which management have some experience, rather than the mitigations and operational drivers behind the real 'Black Swan' events that carry the greatest potential for a major unexpected loss. Of course financial risk assessment remains critical and many companies' strategic positions in flux, but our work also points to a raft of operational risk change not yet being communicated, which risk managers believe often isn't given enough priority in such formal risk mechanisms.
So decision making around insurance requirements, and even the risk placement process that governs insurance cover, often remain somewhat divorced from formal governance efforts. On the surface this must suggest some misalignment. Again, it likely falls to the risk management community to build the case for this bridge - ensuring risk governance reform proves effective across all risk categories.
To conclude, it's clear that the job of a corporate risk manager is becoming more complex. The days of totally outsourcing the process to your broker and selecting from a straightforward carrier shortlist based on value and credit ratings alone are firmly behind us. However, our interviews with hundreds of leaders in the risk management community suggest that this challenge can be seen as an opportunity to drive a renaissance in the role of the risk manager.
Unfortunately, the track record of the insurance industry in assisting this progress is patchy. Much discussion around disclosure and risk analysis progress belies little practical change to how risk is communicated and deals done. A clear objective of our Sector Risk Research programme is to help understand the changing disclosure requirement, assist companies in building the most effective response to these challenges and to ensure their progress is rewarded.
Key upcoming research includes reports on critical issues discussed here, and we will pick up in more detail two areas:
l Analysing in more detail the most interesting and critical new risk issues emerging by sector, looking in particular at specific new disclosure needs and guidelines
l Critical industry themes affecting buyers, including a review of the legal duty of disclosure, the impact of legal reform and the adequacy of risk governance guidelines
Beyond industry R&D platitudes and marketing bumpf, the challenges posed by risk disruption provide risk managers with an extraordinary opportunity to assert their role, and for insurers through supporting this to better inform and protect themselves. Genuine 'win-win' outcomes are rarer in business than is claimed, but where reducing uncertainty in the face of economic upheaval is the key factor one must exist. Overdue such progress may be, impossible it is not.

Bruce Hepburn is chief executive of Mactavish and will be a member
of the Question Time panel at IRM's Professional Development Forum in April