Nathan Skinner of sister title Strategic Risk explores the big issues

Risk management in a crisis

Like a youth team striker being bumped to Manchester United’s starting line-up, risk managers have suddenly moved from the sidelines to the centre of the action.

Companies appoint chief risk officers to present to the board a picture of the company’s overall risk exposure. In the past, these people might have been shunted aside. But, in light of the downturn, it has become clear that risk management is only truly effective if it is done strategically and at board level.

“Risk managers will have a bigger audience than we have had in the past,” says Aymeric Boyer-Vidal, director of audit and risks for GDF-Suez, a French energy company.

“The financial crisis is a crisis of the risk management system itself. Some companies thought they were not exposed to certain risks, but in fact their exposures were very strong. It was a failure of evaluating the right level of risk. More and more people are aware of that,” he says.

Corporate disasters such as AIG, Lehman Brothers and Northern Rock have reminded the business community of the need for sophisticated high-level risk management. One of the shortfalls in the financial sector was that risks were too segmented, which made it difficult to get a clear picture of the total exposure to bad debt.

Boyer-Vidal believes risk managers should build their professional status on the back of the crisis. “We have a tendency to look back and inside our companies. We should build systems that have the capability of looking outside and assess the threats coming down the tunnel; we should pay attention to those signals.”

So, while the financial crisis has revealed serious problems with how risks are managed in large institutions, these problems need to be highlighted before they can be fixed.

This “awakening” will apply mainly to financial companies, as risk management is more operational in industrial companies – they rely less on risk models. “A model only encompasses what you have learnt from past situations,” says Boyer-Vidal.

In the current economic turmoil, some risk managers could be worried about making unpopular decisions – some may even be concerned about their job security. But they have an important role in challenging conventional wisdom.

“For certain managers, risk management is seen as a structure that reduces their liberty – or raises costs,” says Boyer-Vidal. “It is always an issue to convince senior management that it is the right investment which is in the long-term interest of the company.”

But Boyer-Vidal does not believe that executives will cut investment in risk management. “The opposite will be true,” he says.

Supply chain disruption

The unstable economic environment has left many global supply chains under heavy strain from corporate insolvencies. Political risks and civil unrest are also taking their toll.

In the fourth quarter of 2008, the number of companies filing for bankruptcy in England and Wales leapt to 4,607 – an increase of more than 50% on the same period the year before. The collapse of Woolworths is a stark example of what can happen to a supply chain when one link fails.

Companies are increasingly reliant on each other; those buyers and suppliers that are best integrated into networks have some protection. If a company buys or sells products in such a volume that it makes itself a key component to lots of supply chains, it has a better chance of survival.

“Those companies operating on the periphery are going to be more exposed and may find it hard to get beneficial credit terms,” says Paul Culham, active underwriter of marine and special risks for Kiln.

Credit insurers have been blamed for exacerbating the problem by removing safety nets for some of the UK’s largest retailers such as JJB, PC World, Curry’s and Woolworths (before it went into administration). Withdrawing this protection makes it hard for businesses to continue trading on credit.

There is some good news, however. After pressure from the business community, the government has proposed stepping in as a lender of last resort for credit insurance.

Meanwhile, strikes and civil unrest in response to falling wages can shut factories or ports, disrupting the movement of supplies. Measures aimed at protecting the domestic employment market could also pose problems. These include trade restrictions, such as India’s ban on Chinese toy imports.

“Buy American” provisions in President Barack Obama’s stimulus package for the US economy are also a sign that the administration may pursue protectionism in future.

To make matters worse, modern supply chains are increasingly intolerant of disruption. They rely on just-in-time manufacturing, which means if a product doesn’t arrive when it is supposed to, there can be knock-on effects further down the chain.

Companies are also less resilient because they have reduced spare inventory to a bare minimum in an effort to wring every drop of cash out of their supply chain.

Businesses, which are unlikely to have pots of money lying around to respond to a disruption, are looking for financial protection.

“As the constraints of the financial crisis hit, contingency funds tend to shrink. If there is a disruption it could bring a company down. In that case, the option to transfer risk into the insurance market becomes much more attractive,” says Rupert Sawyer, associate director of special risks for Miller.

Is now the time for a captive?

Captives are best described as an insurance company set up to insure a single business’s own risk. The company can use this insurer instead of taking out a policy with an outside provider.

The creation of captives tends to be linked closely to the insurance cycle. It has bottomed out at the same time as global economies have slowed, encouraging companies to examine whether they could save money by setting up a captive.

Captives also become popular when insurers put pressure on companies to retain more risk by increasing deductibles and premiums, or when there is insufficient capacity in a particular area.

A survey of about 100 delegates at a recent London conference arranged by the government of the Isle of Man, an up-and-coming captive domicile, showed many insurance managers favoured captives in the present economic conditions.

More than 80% of those surveyed said they would allow their companies to take control of their insurance spend. (The market is hardening at the same time as companies are under pressure to cut costs: one way to save is to retain premiums in a captive.)

Furthermore, as insurers retreat from certain markets, buyers looking for risk financing are left with few other options. They see captives as a good way of encouraging insurers to partner with them on certain bad risks.

If a company can show insurers that it is putting part of the risk into its own captive (in other words, retaining some of the risk itself) the market may be persuaded to take on a portion of the risk, or to reinsure it. The company is convincing the insurer that it is a good risk and that it is serious about mitigating the risk because the business will lose out too if there is a loss.

“Sharing the risk with an insurer is an argument you can use to convince them to partner with you,” says Marie Gemma Dequae, president of the Federation of European Risk Management Associations.

If a company owns part of the risk then it’s more likely to want to manage that down to an acceptable level. One area that insurers are currently scared to touch is credit risk, which could lead more captives to take this on.

Buyers have long enjoyed the extra bargaining power that comes with owning their own insurance operation; the threat of captivating a costly programme can help them secure the terms they want from the market.

Setting up a captive when you don’t have any cash can be difficult – a little like buying a house without a deposit. Bank letters of credit are one way of financing the reserve needed to pay claims when they come in. But banks have learnt their lesson and are now jittery about handing these out without the proper securitisation.

However, setting up a captive with its own reserve means taking money out of the business at a time when cash is needed more than ever.

There is less interest in captives where the market has yet to harden. Property prices, for example, remain competitive but this is traditionally a line of business popular with captives.

“It is a difficult time for setting up a captive,” says Merise Wheatley, managing director of Heath Lambert’s insurance management division. “Until the market hardens there is going to have to be a very strong case.”