Risk Management: The Road Less Traveled

By nature, risk managers are a cautious breed, some would say, with an aversion to taking chances, finding comfort in the status quo. But in today’s market, that kind of stability is hard, if not impossible, to come by. The creativity of risk managers is being borne of necessity as they struggle to maintain the integrity of their insurable risk portfolio in a market of drastically higher prices, tighter terms, new exclusions, lower limits and severely reduced capacity.

A survey of U.S. risk managers conducted after January renewals of this year, and released at the Risk and Insurance Management Society (RIMS) conference in April, shows that the number one concern of risk managers is price, but that coverage is a significant concern, followed by capacity. That same study, conducted by Munich-American Risk Partners, showed that many risk managers were responding to rising rates by taking larger deductibles, but that self-insurance was also becoming a popular option, with captives being used by about 35% of respondents.

And, perhaps even more telling, 69% of risk managers predict that their relationship with their insurance provider would change over the next 24 months, with 23% saying they would be considering changing carriers. In light of these findings, CU set out to determine how Canadian risk managers view the changing risk landscape and if they, like their American counterparts, would be looking to new alternatives in the current hard market. Also, do they perceive the relationship between insurers and corporate risk buyers changing in light of the market?

Shrinking market

Canadian risk managers faced a vastly different market post-September 11, although there was a general expectation of price hardening prior to that. “The market moved very quickly. Some people had to renew before they knew what the terms were really,” says Nowell Seaman, manager of insurance services for the University of Saskatchewan. Even now, risk managers continue to feel on shaky ground in not knowing what to expect from the coming renewal season. Seaman explains that there is a great deal of education about the market and alternatives before many risk managers.

Underwriters are requiring more detailed information than ever before from their corporate clients, notes Steve Kelly, general manager of insurance and risk management for Sears Canada. Even companies that have been with the same carriers for years are being asked for this kind of thorough information. Price increases were only the beginning of the problem, with across-the-board hikes beginning at 25% and ranging as high as 300-400% for some “troubled” lines such as directors and officers (D&O) and high-risk industries including construction and energy.

But these increases were coupled with new exclusions for mold, which Kelly calls “the asbestos of the 2002 year”, cyber risks, and of course, the highly-publicized removal of terrorism coverage. Wording of contracts has also been an issue, says Kelly, for example changes in margin clauses that impact the “accepted margin for error” in reporting property values.

Some risk managers feel as though they are facing “the exclusion of the day” as insurers keep come up with new restrictions on coverage. This is a frustrating scenario for risk managers, says Sue Meltzer, assistant vice president of risk management and insurance for Sun Life Financial Services. And, while the cyclical nature of insurance pricing meant that the current hard market was expected, the changes in limits and capacity this time through are unique, says Chris Mandel, president of RIMS and assistant vice president of enterprise risk management (ERM) for the United Services Automobile Association (USAA). The result, for risk managers is “you’re paying more and more for a heck of a lot less…it’s a sea change from the insurance cycles we’ve seen in the past”.

New risk managers who may be experiencing their first hard market are to be sympathized with, but “even more experienced risk managers didn’t have the same problems with capacity that they are now,” says risk management consultant Heather Pearson, president of Pearson Enterprises. Furthermore, “for any risk there might have been 10 companies interested in writing that, and now there’s two, and those two can only write half as much coverage,” says Greg Belton, president of broker Hunter Keilty Muntz and Beatty. “There aren’t as many alternatives.”

“There’s no question that everybody found the marketplace had desperately shrunk,” adds Joe Restoule, senior risk consultant for NOVA Chemicals. “People we had traded with for years found themselves going from being able to put [a limit of] $100 million on a risk to $25 million.” He also points to the reduction in Lloyd’s capacity in Canada, as well as that of domestic Canadian insurers. “You might need twice as many markets to make up the same limits.”

The net impact of changes is a treacherous market facing risk managers. “Costs are going up 25-fold when you look at everything [price increases, cuts in terms and limits, lack of capacity],” says risk management consultant Karen McWilliam. Risk managers are then faced with the “terrifying task” of putting a proposal in front of their corporate management and boards that includes these kinds of terms. “Risk managers are over the sticker shock, what they’re grappling with is how to deliver the message [to boards and upper management].”

“The difference with this so-called hard market, was that everyone knew, there was so much in the news. At the board and CEO level, maybe before they let their insurance buyer handle that function, now it’s become an issue,” Belton says.

Restoule uses the example of one company he is aware of in the petro-chemical sector, considered a “high risk” sector by insurers, who saw property premiums go from $5 million to $32 million in the most recent renewal. “That’s a big challenge, going into your senior management and telling them about that kind of increase.”

Bad behavior

In a recent informal survey of about 40 Canadian risk managers, Meltzer asked what their foremost concerns are. A major theme, she says, is that risk managers were not sure if the philosophy of establishing long-term relationships with insurers during the soft market had really paid off as the market turned, and if they “might be better off shopping around. They really thought underwriters were going to underwrite, but clean risks don’t understand why those increases are being put on across the board.” Risk managers thought insurers might be looking more towards clamping down on claims payouts rather than simply instituting across-the-board increases regardless of whether a risk has a poor loss ratio or not. “I want to continue to deal with financially strong insurance companies. This means they need to make a profit,” adds Meltzer. “I don’t seriously object to the price increases, but I do object to the method in which they’re being applied.”

Insurers are reacting in an “unpredictable, volatile way”, says McWilliam. Companies are unable to get quotes in some cases, are facing huge price increases or receiving outright denials for certain classes of business. “Why is a risk that was acceptable for the last five years suddenly not acceptable?” she asks. Understanding that the price of reinsurance has risen, McWilliam does not understand why this has not simply been factored into underwriting, rather than clients facing dramatic increases or being unable to get coverage at all. To her, this is an example of “greed and opportunism”, and she predicts that underwriters who have treated their corporate clients badly will find them gone, either to another insurer or to an alternative vehicle.

Sources note that all lines of business have been impacted, including cat risks that have not necessarily seen significant losses. Says Mandel, “It seems like they [insurers] used 9/11 as an excuse to treat hurricane risks the way they do terrorism.” Belton admits that, although most insurers are “doing the best they can” to respect relationships with their corporate clients, nevertheless “we had some comp anies getting off risks mid-term and not because of losses.”

Some corporate clients are resentful of what they perceive to be a “knee-jerk” reaction on the part of insurers, concedes Steve Mallory, managing director of Marsh Canada. Clients understand the “macro issues” – rising reinsurance rates, underwriting losses, Wall Street’s reaction to insurance and reinsurance stocks – but are concerned that dramatic changes are being made overnight. “Clients appreciate that it’s time to give back some of the premiums that had been slashed in the 1990s, [but] as the premium decreases were gradual, so should the increases be gradual.”

Kelly sees those companies who saw rates drop the most during the soft market now facing the stiffest increases. “This market was going hard before 9/11, those people who took advantage of the buyer’s market are seeing the largest increases. Now, the shoe’s on the other foot, due to the fact that you were way under [in terms of rates] in the past.”

“You could call insurers opportunistic, but there are a lot of those insurers who will say we’ve been opportunistic for the last 10 years,” says Ed Martingano, risk manager for Oxford Properties. He, and Meltzer allow that, despite the current increases, rates will not likely return to pre-soft market levels, just as they did not return to 1979 levels during the hard market that followed in 1986.

Waiting for 2004

The second concern risk managers highlighted to Meltzer was “when will it all end?” Sources approached for this article agree that the current hard market will likely last until late 2003 or more likely, early 2004.

“I don’t think we’ve seen the worst of it,” says McWilliam, who has heard that some July cat reinsurance renewals face increases even higher than those seen last December. She senses that early 2002 financial results will determine the course of future renewals. “Maybe capacity will be more reliable, but I don’t see pricing changing.”

Belton is advising clients to “gird yourself for at least two years of higher costs and decreased coverage”. Martingano wonders how well prepared some companies are to to face future increases. He notes that even a 5% increase in the next renewal is “huge on top of what has already happened”.

Several issues continue to dominate the risk management agenda, with no resolution in sight, including exclusions such as terrorism coverage. “No one knows when the private market is going to reinstate terrorism coverage, if ever,” notes Restoule. “These problems are not easy and obvious,” comments Neil Parkinson, partner in KPMG’s insurance practice. “For example, it’s 10 months later and they’re still groping for a solution for airline coverage.”

New capacity has been largely based offshore and in cat reinsurance, explains Belton, so it is unlikely to solve the capacity crunch facing Canadian buyers. Parkinson agrees, noting that this reported US$12-$15 billion in new capacity is unlikely to hasten soft market conditions. “Most of it is offshore, largely in places like Bermuda… that capital does not replace insured losses from 9/11. Also, it’s not by and large ‘naive capital’.” It is established players forming new vehicles to capitalize on the hardening reinsurance market. Nevertheless, Restoule sees opportunities in this new capital. On a recent trip to Bermuda he says there was “a vibrance” in the market. “We were tripping over our brethren in risk management, moving from upstart to upstart, hoping to attract these new upstarts to their risk portfolios.”

Need versus want

In the most recent renewals, risk managers report having little time to look into new opportunities, or even to shop around. The approach taken by most was to increase deductibles or not to insure some risks at all. “Needs” were the priority and “wants” were foregone. “Basically, they’re buying limit until they run out of money,” comments McWilliam.

Whereas during the soft market insurers would “throw in” coverage, says Belton, “during a market like this you have to sit and look at ‘do we need all this coverage?'”

Companies also had to “market themselves” to insurers as never before, to demonstrate themselves as a good risk, says Martingano. With no control over the market itself, the best response is to go “back to basics and make sure your entity is a good risk”.

Brokers have certainly earned their paychecks, with corporate clients all wanting to shop, to “blanket the market” with submissions in hope of finding the best price and terms, says Mallory. As a result, underwriters are in gridlock, overwhelmed by all of the submissions coming across their desks.

But, as risk managers move in to the second and third rounds of the hard market, sources agree that the temptation to look at alternative risk transfer (ART) mechanisms grows. “I can tell you that an adverse market provides very strong motivation for risk managers to look at alternative market solutions,” says Seaman. “An unfortunate effect for insurers may be that the opportunity to underwrite high-quality, profitable risks is lost as corporations develop and implement solutions that are less affected by market cycles.”

Parkinson says insurers expect to lose a certain amount of business to ART, and are prepared to do this in the face of mounting underwriting losses. Interest in ART, including captives, is reportedly growing, he adds. “It stands to reason that this [the hard market] changes the equation. More people can cost justify it.”

“Some are being forced not to deal with insurers,” says Mandel. “There will be those who get to that point [looking at ART options] because they have no choice.” However, he has not seen the same rise of alternative markets thus far as occurred during the mid-1980s with the rise of the Bermuda market.

Captivating market

Self-insured retention and captives seem to be the biggest draws in the ART market, with many risk managers commissioning captive feasibility studies, so much so that they are now being placed on waiting lists. The Vermont Captive Association reports that a record number of captives have been formed there in the first half of 2002. “I know for a fact that there have been more captives developed and initiated in the last six months that in any other period,” notes Mandel. He sees captives as a “natural alternative”, with the opportunity for industry association captives, other group captives and even rent-a-captives for small to mid-sized companies who cannot afford, to or do not have the manpower, to establish their own captive.

Captives, although risky, may seem less so compared to other risk transfer options, Kelly notes. “The capital markets scared everybody. There doesn’t seem to be a lot of confidence in those. Captives are a known market, self-managed and maintained.” Reciprocals are also gaining interest, sources report. As a member of the Canadian Universities Reciprocal Insurance Exchange, Seaman says his experience has been positive. “The increased retention of risk within a reciprocal reduces dependence on insurance and reinsurance and, consequently, mitigates the effect of a hard market cycle on overall premiums.”

However, Meltzer wonders if risk managers have not waited too long to look at these alternatives, specifically captives. “The same thing happened in 1986,” she reasons. “By the time they finished their captive studies, the market had changed [softened].” Certainly, there is a cost to going offshore, and with very few options here in Canada (British Columbia is the only active onshore captive domicile, although New Brunswick has opened its doors without any takers), risk managers are likely looking to the Caribbean or perhaps U.S. states such as Vermont and Washington.

Martingano acknowledges there is fear about making a massive, costly change given that rates could recede in a relatively short time. “If rates go back to 2000 levels, we end up with a vehicle that really doesn’t have the value for us. It’s an expensive mistake.” Reciprocals also present challenges, requiring a “champion”, in the words of McWilliam, to get the ball rolling. “It’s somewhat counter-intuitive to business practic es to get into bed with a competitor,” she adds.

And, as Mallory notes, reciprocals may not make as much sense in Canada given the lack of substantial exposure to cat risks that usually prompt such a solution. There is general agreement that if a captive or reciprocal is considered, it should be viewed as a long-term commitment, with value in both soft and hard market conditions. “It shouldn’t be viewed as a panacea to the hard market,” says Belton.

Other alternatives may also hold some appeal, McWilliam notes, including borrowing mechanisms, stand-by lines of credit, internal reserve funds. She sees financial institutions other than insurers drawing interest to these options. “It’s a whole field risk managers didn’t look at because they didn’t have to,” notes Pearson of the potential in borrowing mechanisms and reserving. And lower interest rates may add to the attractiveness of borrowing.

Still other industries are looking at establishing their own insurance or reinsurance “companies”, such as has been discussed for the airline industry. Several energy companies, including NOVA and Petro-Canada are among the founding members of s-Energy, an excess mutual insurer for the international energy industry, based in Bermuda. Restoule says that in his 23-year career this was his first opportunity to forge new ground, although energy companies have some experience in the past with forming mutual insurers for certain lines of business. “The challenge was being able to go in front of executive leadership and the board and ask for capital. I have not met risk managers who have done this, asked for capital to set up a new insurance company.” Being able to demonstrate that through s-Energy corporations would actually get more coverage for less premium and answer availability issues in the private market was the key.

Despite the rapid, dramatic changes in insurance terms and pricing, it nonetheless remains a good option in the eyes of many risk managers. As Mallory notes, “The [Canadian] industry has always been perceived worldwide as having the most inexpensive insurance prices.” Meltzer agrees. “Insurance, even at new rates, is still pretty cheap. If we could transfer other risks in our company as cheaply as we can our insured risks, I think we would.”