In late 2008, the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis. This report featured nine key Lessons for Insurers. Riskviews will comment on those lessons individually…
3. The presence of systemic risks means that insurers should pay attention to not only what
is going on inside their “own houses” but also be aware of what is going on in their
“neighbors’ yards.” Regulators should also pay attention to what is happening in other
Risk management that is inwards directed, referred to above as in “own houses” is not just important because of systemic risk. At any time, the actions of others in the marketplace could have a massive negative impact on an insurer. Most parts of the insurance and financial markets are different each year because of changes that are almost always from “outside”. In insurance markets, there are constant shifts in underwriting standards and pricing strategies of the other firms in the market. New products and product features change the landscape all of the time. Risk managers need to stay aware of how those changes impact on the business that gets written by the insurer. The most important thing to look out for is whether the shifting competition has managed to siphon off the better risks, leaving the insurer with the worse risks.
There are also plenty of times when the rest of the world drags things into the dumps without causing a systemic meltdown. The term Systemic Risk is highly overused right now. While the recent Systemic Risk event will be heavily ingrained in the memories of most of us, it is only the second such event in 75 years. So the risk manager cannot be limiting their concern about the actions of others in the marketplace to events that might become systemic. For example, the 2000 – 2002 equity bear market was quite difficult to firms that were heavily exposed to equities. But even three years of losses there did not cause a systemic breakdown. However, the tech boom that preceded the bust was a clear example of a bubble.
So perhaps, rather than systemic risks, the advice from the report should have read “The presence of bubbles…” Bubbles are much more common that systemic breakdowns and are definitely worth the time and effort that it takes to avoid them. Bubbles can be broadly defined to include those points in the underwriting cycle when premiums are far below break-even.
A former boss of mine once said that the problem with the commercial real estate business is that even if you do your homework and pick just the right spot to build a new building, right where there is no competition and strong demand for the type of space you are adding, all it takes is another fool who doesn’t do any homework, but who see the full parking lot outside your building and with that research in hand builds an identical building right down the street. Overcapacity and you both fail.
That story applies to most things in one way or another in business. And that is a major source of risk – the fool building an identical building right down the street.
Whenever you find that something that you have been doing successfully becomes highly popular, you need to start making contingency plans and find another niche to exploit. You will need both.