manage the cost of risk

How to manage the cost of risk

As one of the pioneers in the risk management industry, Dr Anthony Valsamakis looks at the evolution of risk management. He explains why we need to think differently about capital provision and insurance contracts, among other things, to manage the cost of risk.

I entered the insurance industry at a time when the notion of risk management was developing rapidly. During my tenure at University I developed a sense that ‘event risk’ was being viewed in a distinctly narrow way. I set about clarifying notions of risk, volatility, loss modelling and looking specifically at how risk management/control and risk finance could be integrated. Thus, developing a model for risk management that I hoped would prove useful, practically speaking.

I was fortunate to head a consultancy within an large brokerage,  PFV, which meant I had access to most financial directors and industry heads. This gave me the platform and information I needed to put together a methodology covering risk identification, its evaluation and financing. In 1992, I published my book The Theory and Principles of Risk Management. The fifth edition of which will, I hope, still go to print in 2020. The book was co-authored with two professors, who enabled its spread  into the university and wider environment. In that in a short space of time some of the ideas developed and definitions adopted, became commonplace.

Pioneering the cell captive concept

Whilst at PFV, the team and I pioneered the cell captive concept. It is a construct widely known today and which developed successfully in SA and then abroad. It was the precursor to PCC legislation passed by various captive insurance centres.  When interacting with financial directors it became obvious that the notion of an optimal capital structure (something they were used to) could be likened to an optimal balance between risk retained, and risk transferred through insurance. It was a concept that made sense to them. As such, it was relatively quickly adopted as a desirable risk financing approach when considering financing the consequences of event risk. They were thus the catalyst for the design of a product that enabled the housing and building up of retention reserves that could be used to minimise their cost of risk.  

The so-called ‘contingency risk policy’ was developed in the 1980’s in conjunction with some insurers in the market. They were exciting and heady days as we grappled with aspects around coverage, accounting treatment and capital reserving – all to manage the cost of risk.  From there, it was a natural progression to creating a type of vehicle that could legitimately use risk management funds to better manage the cost of risk. This was based on the underlying philosophy of optimising the risk financing equation and managing risk through effective risk control. We had a strong commercial interest, given that we controlled a significant quantum of retention premiums, and we saw an opportunity in creating a ‘cell’ or segregated risk structure insurer, in partnership with clients. This culminated in the establishment of Guardrisk Insurance Company in South Africa, and after that, similar structures abroad.

In those days, each cell achieved risk segregation by separate contract. As opposed to today where structures are governed by statute in various jurisdictions. We had successfully put together contractual frameworks with separate cells owned by clients that were very sophisticated in managing risk and their financing. Those were interesting times. I was still working under the auspices of a broker and we had to motivate to the authorities how an intermediary, now defined more broadly, could own and manage a special purpose insurer. We succeeded with the help of our insurance partner. The concept was exported to Europe. There, in partnership with a large multinational Insurer, we set up Protected Cell Companies (PCC) arrangements. I was soon looking at doing the same in Bermuda. The environment was conducive to innovation – fortunately lots of people believed in it and , hence our success.

What can insurers learn from banks as capital providers?

The idea of insurers being regarded as capital providers (like Banks) is not adequately talked about or understood. When seen in this context, my view is that the insurance industry displays certain inefficiencies, maybe even deficiencies.  It interests me to view insurance as capital provision, and look at it in the context of providing capital to clients upon the occurrence of a risk event. Capital is released on terms governed by a contract. But when one compares, say, contract certainty achieved in the capital markets to that achieved by the insurance markets, there are marked differences. Often insurance contracts are finally agreed upon (terms, exceptions, subjectivities etc.) late after inception date. Imagine negotiating loan finance with a Bank and agreeing the final terms after loan funds have been released. It just wouldn’t happen.  

When you place the two side by side, and look at the underlying documentation that must pass muster in a traditional capital market, it is apparent that in comparison, the insurance market lacks certainty and delivery speed. No bank will release capital until a contract is understood, fully subscribed to and signed. However, in the insurance industry, contracts sometimes are still being negotiated and finalised up to six months after inception.  

This worries me given the complexity of the risks covered and the triggers for capital release.  I ask myself how has this situation developed, and indeed found acceptance? Is it possible that participants in the insurance industry have developed a ‘laziness’ based on the fact that the probability of ‘no loss’ is greater than that of ‘loss’?  In most instances therefore, the contract inefficiency is not tested, and delays in contract completion show little consequence … until of course things go wrong. Then there is a scramble to decipher the conditions and trigger definitions, governing the release of capital. The current debate around policies responding to Covid 19 losses  is a case in point.

What I am advocating is for the insurance industry to better understand and improve on the writing of complex contracts. There is a probability that payment won’t be called for. However, everyone would be better off if the industry took a lesson from the practices of the other capital markets. Markets which define precisely when capital is released, and enable it to be done quickly. As a practitioner and a consultant in the industry, I am frustrated that, despite technological advancement, we wait far too long for contract finalisation. I would welcome a move towards learning from other capital markets. The mindset that allows us to delay needs to change. 

Why ‘good faith’ takes the industry only so far

A well-functioning insurance sector is a sine qua non when it comes to keeping businesses going. That is, helping them to mitigate against the potentially dire consequences of risk. People don’t always realise this.

The good faith principle is vitally important, and has been a defining principle in the evolution of insurance markets. It has stood us in good stead, but today it is not something we can rely on entirely.

Income statements and Balance Sheets are under pressure – there is an increasing complexity and intensity  around risk and its  consequence. The numbers are very large, and the world has become fundamentally more volatile and complicated. This means that precise risk and coverage definitions are more important than ever. Contracts should be watertight, even if drawn up in good faith. It is intrinsically difficult to ensure that intent is communicated in a way that everyone understands, because writing contracts is an art form in itself.

While we do not need to abandon the ‘good faith’ principle, we should aim to be quicker, more accurate, recognising the vagaries of leaving a contract in a fluid state. I have been involved in trying to replenish balance sheets following losses and it is too often a nightmare to understand the context of a policy and what it was intended to cover. Again, I think the debate we are experiencing worldwide on Covid-19, brings this case into focus.

The continuing evolution of insurance

The evolution of a more scientific way of assessing risk has come a long way. It was inevitable that we would get closer to the mathematics of simulation, and the use of big data to understand expected loss costs.

When I was involved in developing the practice of retention finance, financial directors would ask me  how much they should provide for, and what would the expected cost be against the risk of loss. The questions were certainly not woolly! We had to develop models (used by insurers and reinsurers) and introduce this approach for use by intermediaries. This involved being more scientific in evaluating and quantifying premium (looking at what is reasonable for the underwriter and client). Today, all major brokers boast of this capability – albeit that there still remains some disconnect, misunderstanding or even mistrust between the quants and marketers.

In addition, we are receiving many more requests for data points and parameters of risk and exposure from underwriters, which we were not asked to provide before. With renewals, the request for data is increasing. This puts pressure on intermediaries and clients to provide input that insurers and reinsurers can model. Underwriters say we are not yet at the level they would like to see in terms of the quantity and quality of data. I feel we are getting there.

Market interaction must start early. I welcome the request for data as long as I can understand the modelling that follows that. I see an acceleration – people are modelling more, coming with ranges of prices that intermediaries can check. It is likely that we will be asked for more data for complex risks and exposures, which will be added to the aggregation models insurers and reinsurers use. This has been my experience with renewals of large corporate accounts over the past couple of years.

I do not believe that ‘relationship broking’ will fall away, as some have suggested. All the aspects of our industry have an important role to play: from the underlying and requisite mathematics which form the foundation of our industry, to policy drafting specialists and legal experts, all doing what they do best. You ultimately need someone who can function as an intermediary between supply and demand (of capital!) The psychology of risk is most important. It contributes to the trust built up over time, the understanding of intent, and being able to match demands of clients to supply of capacity and solutions offered by markets.  I do not see this ‘relationship’ aspect of the equation going away. The building up of a long-term relationship with a capital provider is essential when it comes to delivery … and the better we do, the more trust we earn from the markets.

Dr Anthony Valsamakis is a risk management consultant and CEO of Eikos Risk Capital London

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