Managing Strategic Risks
Contributed by Jean-Pierre Berliet
It is not enough for insurance companies to understand and manage the financial risks of their business that can cause insolvency. They need also to manage external “strategic” risks to their business. Strategic risks result from events that can undermine the viability of their business models and strategies or reduce their growth prospects and damage their market value. Strategic risks include changes in competitive dynamics, regulations, taxation, technology and other innovations that disrupt market equilibrium. They also include events and changes in other industries that can impact adversely the going concern viability and financial performance of insurance companies.
Until the present crisis, many insurers did not think much about their dependence on the efficient functioning of credit and other financial markets or the overall safety and soundness of the banking system. Now they do. Although the sub-prime mortgage crisis and resulting credit market meltdown can be viewed simply as market risk events, they should be seen as the combined, unexpected but theoretically predictable result of design weaknesses in institutional and regulatory arrangements and changes in financial technology.
From this vantage point, the near collapse of the financial system resulted from:
- Pro-cyclical effects of capital regulations under fair value accounting standards,
- Explosive growth of outstanding derivative contracts, especially credit default swaps
- The redistribution of housing finance risks (especially sub-prime) across financial institutions on a global basis, facilitated by securitization.
Together, these factors combined to create a time bomb. That it exploded is no market risk event, but rather a failure of risk management.
The explosion could have been anticipated. Had CROs not abdicated their responsibilities to rating agencies and conducted appropriate due diligence, toxic securities would not have found their way to their balance sheets. Similarly, fundamental changes in the characteristics of mortgage products and the creditworthiness of the customer base should have been examined closely. Such examination would have diminished the attractiveness of CDOs as investments, have reduced their spread throughout the financial system and have prevented or reduced the losses of capital that caused confidence to collapse and market liquidity to vanish.
Insurers, however, did not understand that risks to the financial system were elements of their strategic risk. Strategic risk elements embedded in the financial system are difficult to mitigate. They create dependencies among businesses that undermine diversification benefits achieved through underwriting of a multiplicity of risks and exposures. They have a tendency to hit all activities at the same time.
In this area, prudence is the source of wisdom. Companies that have had the discipline not to underwrite exposures that they did not understand, or invest in financial instruments or asset classes that they could not assess to their satisfaction (e.g., tranches of securitization backed by sub-prime mortgages), have withstood the crisis comparatively well. Some of these companies are benefiting from the weakness of their less thoughtful and less disciplined competitors. For example, Warren Buffett’s decision to create a financial guaranty insurer recently and to resume investing in U.S. companies appears perfectly timed to capitalize on opportunities created by the weakness of established competitors and the steep fall in the market value of many companies.
Methodologies for identifying, measuring and managing strategic risks are in their infancy. Since there are no established conceptual frameworks to guide analysis and decision making, building resilient portfolios of insurance businesses and protecting them from strategic risks is a challenge. In their oversight roles, directors and CEOs can help company executives by re-examining the appropriateness of traditions, conventions and modes of thought that influence risk assumption decisions.
They should demand that company management:
- Conduct periodic defensibility analyses of their companies’ business models and strategy, including consideration of weaknesses in institutional arrangements of the financial system. Such strategy review must also focus on the identification and monitoring of emerging trends with adverse effects on competitive advantage and pricing flexibility (loss of business to competitors, emergence of new risk transfer technologies or product innovations, regulatory developments, etc.) that can reduce company valuations sharply and rapidly.
- Reassess periodically the company’s strategy for controlling performance volatility and achieving a balance between risk and return through specialization in risk assumption, diversification (e.g., across lines, industries, regions or countries), ceded reinsurance or structural risk sharing and financing vehicles such as captives or side-cars.
- Assess the possibility for disruption of business plans caused by events that reduce capital availability or flexibility in capital deployment.
- Develop appropriate responses through adjustment in capabilities, redeployment of capacity across lines of activity, change in limits offered, exclusions, terms and conditions, ancillary services provided, lobbying of lawmakers and regulators and participation in industry associations.
- Hold executives accountable for discipline in under writing and investment decisions.
Because the insurance industry has been highly regulated, many insurance companies have not developed a deep strategic risk assessment capability. They need one urgently.
©Jean-Pierre Berliet Berliet Associates, LLC (203) 972-0256 firstname.lastname@example.org