Ambiguous Threats and Strategic Risk Management

Joseph Calandro, Jr.
Insurance Experts' Forum, August 8, 2012

Ambiguous threats abound: sovereign debt crises, inflation, deflation, natural catastrophes, pandemics, terrorism, cyber theft/fraud, nanotechnology, etc. The list of potential threats to the insurance industry is both wide and deep; however, practical guidance on how insurers can identify, assess, evaluate, track and mitigate relevant threats is in relatively short supply.

One way to practically screen for potentially significant threats is to evaluate prospective ones against an insurer's exposure concentrations. By focusing on threats that could potentially hit a significant concentration, leading insurers are able to zero-in on the ones most relevant to them. This type of activity is important because many threats are ambiguous.

By ambiguous, I mean being open to, or having several possible meanings or interpretations. One of the best examples of a one-time ambiguous insurance threat is asbestos. While many classify asbestos as a casualty risk, it was also a life insurance risk given the thousands of lives lost due to asbestos-related illnesses. Therefore, the impact of asbestos on the insurance industry was enormous; so much so that many insurers are on the lookout for the next asbestos

It is common for people to think losses like those generated by asbestos occur suddenly and unexpectedly, as once-in-a-lifetime events. However, this is generally not the case and, indeed it was not the case with asbestos.

According to a former manager with Manville Corporation, asbestos losses were caused by "a management blunder, and the blunder was denial. Asbestosis, a nonmalignant lung disease brought on by breathing asbestos fibers, had been known since the early 1900s, and the first indications of a connection between asbestos and lung cancer appeared in the 1930s. But Manville managers at every level were unwilling or unable to believe in the long-term consequences of these known hazards" (Bill Sells, "What Asbestos Taught Me About Managing Risk," Harvard Business Review, Mar-Apr 1994).

The above insight is highly significant and, given the experiences of the recent financial crisis, remarkably current. However, it can be viewed as reducing risk management to a binary decision: completely reduce exposure to a threat or continue business as usual. In contrast, rarely is this the case as ambiguous threats, including, at one time, asbestos, evolve or develop over time. One benefit of threat development is that it provides attentive firms with opportunities to mitigate their exposures, sometimes at extremely economical levels.

A contemporary example of economic risk mitigation occurred prior to the recent financial crisis. Contrary to many financial institutions, a select number of funds and insurance companies took advantage of favorably priced swaps to mitigate their credit risk exposures.

Timely identification, practical tracking and economically mitigating developing ambiguous threats are activities that fall under the realm of Strategic Risk Management (SRM). The strategic part of SRM pertains to acts of investment via the hedging - or reinsuring - of select ambiguous threats and/or modifying business models to mitigate potential exposures. It is important to note that SRM is not just about writing reports on emerging risks of interest.

Business model risks are currently significant given the economic and insurance market environments. In the past, soft markets like the present one resulted in greatly expanded coverage offerings that generated outsized losses, which insurers alleviated through investment returns. However, in the current low-interest rate environment investment offsets are not an option. Therefore, leading insurers are beginning to develop, and focus on, strategic risk management capabilities to better position themselves going into the next extreme event, and there is always a next extreme event or developed ambiguous threat.

Joseph Calandro, Jr., is a managing director in PwC's Insurance Advisory Practice.


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