Flash back to the dot-com bubble burst in March 2000. Interest rates outpaced the economy and a technology-heavy stock market reacted strongly to an expected ruling in the Microsoft monopoly hearings. The estimated five million day traders, some full-timers and some who merely dabbled between meetings, fueled the online feeding frenzy that had no choice but to correct itself — and hard.
Jump ahead to 2003. Fannie Mae and Freddie Mac held an estimated $90 billion annually in AAA subprime mortgage-backed securities, priced incorrectly and blessed by the federal government. Mortgage lenders began targeting high-risk borrowers and racked up $600 billion in sales by 2006. Real estate speculation skyrocketed. Artificially inflated prices continued to drive up the subprime sector, with these mortgages eventually rising to $1.3 trillion by 2007.
Enter reality. What goes up must come down. And down the rates came as financial firms were caught between rising interest rates and the inability of a large chunk of their customer base to keep paying for homes that had a rapidly depreciating value. The feeding frenzy was over. All that remained was the cleanup.
We can’t say we didn’t see it coming. But we just can’t help ourselves sometimes. The lure of exponential profits can cloud judgment and put companies in a precarious position.
It is a wake-up call for the business world. It is also a call for risk management to re-examine the business from the ground up, looking for those vulnerabilities that could serve up the next crisis-du-jour.
Missed Red Flags
In hindsight, most all of the country’s major economic meltdowns were predictable. And in some cases, they were predicted years earlier. Likewise, there are risks to today’s businesses that may later seem obvious as well. But if you are not paying attention, you could be missing the subtle changes that morph themselves into significant exposures.
For starters, take a step back and take a good look at the big picture. There are many resources trying to show you the panoramic view of your risks. You just have to pay attention.
Studies that attempt to predict the next emerging risk area abound, warning of everything from supply chains and nanotechnology to carbon emission liability and foreign currency. Yet in nearly every instance of an impending crisis the signs are ignored.
In the financial crisis, experts agree that the preceding atmosphere was a large red flag. “I remember being at a conference where someone giving a presentation was talking about how they were seeing, by looking at the models, a national credit crisis coming up,” said Christopher “Kip” Bohn, director of ERM at Aon, New York. “Sure enough that’s what hit us.”
Bohn believes it is often a case of illusory superiority, or the Lake Wobegon Effect, in which one’s opinion of reality is much more rosy than reality itself. This may occur because we just do not consider the unthinkable a viable risk.
Joe Peiser, partner and COO at RMI Consulting in Port Washington, New York, remembers how a 747 hitting the Twin Towers used to be considered an unthinkable risk. He finds a disturbing irony in that. “It should give us all pause,” he said. “We need to remember that the unthinkable does happen.”
Peiser suggests that risk management needs to adopt a more comprehensive brainstorming process with which to uncover that unthinkable exposure. You do not have to look far to see potential catastrophic risks; international market fluctuations, supply chain exposures, foreign manufacturing operations and even internal cash flow issues can threaten businesses.
You start by looking at the top. Tom Mulhare, partner in charge of the financial services and business risk consulting groups at EisnerAmper, LLC in Edison, New Jersey, says putting risk front-and-center at all levels within the corporate culture is the best approach. He believes that today’s risk managers need to review current risks.
Because of cutbacks and staffing issues, he says, many existing risks may have been elevated in severity. Employees may not be properly trained or may not be aware of how to identify, report and prevent certain risks. Thus, companies’ existing risk profiles have changed dramatically. But he is not so sure those managing the profiles have. “Has risk management kept up with it?” he asked.
Peiser adds that risk managers should be looking at the company’s areas of cost-cutting to see what has been compromised. Look at safety, loss control and security to ensure the company is still adequately protected.
One area that should remain strong is insurance coverage. Peiser recounts an adage that all risk managers should remember. “When a loss happens, not one time has anyone ever said ‘it’s a good thing we saved that 5% of premium,'” he said.
Getting management to heed your warnings is another matter. Risk management warnings often go unheard. And while it is easy to blame leadership, it is part of risk management’s job to feed the information up the chain of command. “A risk manager has to be the voice in the company who keeps risk salient whether it be systemic risk that is somewhat outside the company’s control or risks specific to the company,” said Peiser. “It’s not always a comfortable place to be, and you don’t always get listened to, but frankly, that’s the risk manager’s job.”
Threats on the Horizon
According to Aon’s “2010 Global Enterprise Risk Management Survey,” the top 10 concerns for global risk managers are the economic environment; regulatory and legislative changes; increasing competition; commodity price risk; damage to reputation; cash flow/liquidity risk; distribution or supply chain failure; third party liability; and failure to attract or retain top talent. The majority of those are all about the external risk environment.
Peiser adds contracts to that list. By keeping a watchful eye on contracts with vendors and suppliers, he says risk management can quickly identify gaps in the risk transfer process and avoid costly liabilities that otherwise would have gone to the supplier. “Make sure the risk transfer is appropriate, but also make sure they follow up with a certificate of insurance on their counterparty. In tough financial times, the contract may not be enough. What if that counterparty is bankrupt or didn’t buy the insurance? You have to worry about the people you’re doing business with and where they are cutting corners. Are they cutting corners on the insurance they buy or the quality of the insurance? On maintenance? On security?”
This can be of particular concern when dealing with partners in emerging countries. Product liability issues that were once easy to control and cover have now gone global. In an emerging country, the contract is not the final word on liability transfer; it is merely a first step. As Peiser notes, manufacturing companies close down with regularity in other countries, thus shifting liability right back onto your company’s shoulders. A secure contract helps, but Peiser suggests a certificate of insurance from a reputable insurer.
The Elephant in the Room
While the financial meltdown did not harm the insurance industry, there was a huge sigh of relief to see the market relatively unchanged post-crisis. Mulhare believes it is because regulators at the state level have done a good job of keeping insurers’ investment strategies under tight rein.
Still, insurers are not necessarily immune to a financial crisis. Insolvencies occur, though infrequently. Capacity has remained steady, though AIG’s financial business unit’s now famous failure and bailout created momentary panic until the insurance side of the business was declared to be insulated from the financial side. But new products and purchasing instruments, such as premium financing for the life insurance market, could open the ironclad doors of the insurance industry to unexpected, large-scale risks. It is unlikely in the short term, say the experts, but history has proven that the long term is much harder to forecast. Considering the interconnected relationship between the insurance industry and investment markets, it is easier to imagine even conservative investment strategies creating potential risks.
It would seem, then, that the best plan is to diversify your insurance portfolio. “Make sure you don’t have all of your risks in one basket,” says Peiser. “It sounds like an obvious thing, but it’s that kind of blocking-and-tackling [that helps] prepare for the worst event. Have relationships with more than one or two insurance companies. That’s a simple, but meaningful, step to take.”
It seems counterintuitive that the simplest steps are often the most difficult ones to take. But it is only once you take a step back and see the broader view that you will know how important that step was.