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Failure of risk governance in the Indian banking system

In Banking, Risk, Risk Management on July 2, 2018 at 9:47 am

 

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In the Nirav Modi case, a single rogue employee’s actions have threatened to wipe out more than a quarter of Punjab National Bank (PNB) shareholders’ equity. This incident follows other similar international scandals in which Nick Leeson brought down Barings Bank, and Hamanaka caused significant losses to Sumitomo, both in 1995. This brings up the question whether such occurrences can be prevented or at least minimised with a long-term solution rather than simply a quick fix.

Enterprise Risk Management (ERM) is designed to minimise the likelihood of such occurrences. The state of the art is to use ERM for risk management and the three-lines-of-defence model for risk governance. Worldwide, financial institutions such as banks and insurance companies have implemented risk governance and are continuously improving their practice of it. India trails behind international best practices in risk governance by almost a decade.

Before ERM, companies relied on Traditional Risk Management (TRM) where each department or project head used to manage the risk in their own areas of operation. Organisations were unaware of their risks in a holistic manner. In 2004 the Committee of Sponsoring Organizations (COSO, a group of US-based academic and practitioners’ organisations concerned with financials and assurance) introduced an ERM framework. Under this framework, the board of directors plays a key role in setting and overseeing the risk governance infrastructure, ERM policy, and risk appetite statement, and management executes it. Risk appetite sets the amount and type of risk a company is willing to take to meet its strategic objectives. A set of risk-mitigation and reporting processes support the execution of the adopted policy.

The three-lines-of-defence model is a structure for risk governance where front line staff represents the first line, board and risk professionals such as chief risk officers (CRO) are the second line, and auditors the third. The first line of defence is responsible for managing their activities within the bounds of the risk policies and frameworks set by the board, and reporting risk events and emerging risks. The second line of defence oversees risk management. The CRO’s office ensures that risk limits are followed and reported. The board sets the risk policy by specifying the types and degree of risk that the company is willing to accept. It sets and enforces clear lines of responsibility and accountability. The third line of defence consists of auditors who provide independent assurance that risk governance is working as it should. Risk culture ties together the three lines and reflects their collective beliefs, values, and attitudes towards risk based on their shared understanding of the organisation’s ERM policy.

Indian regulations too require risk governance. Financial institutions such as banks and insurance companies are required to form risk management committees of their boards, and have a risk governance infrastructure such as an ERM policy and risk appetite statements. However, the P.J. Nayak Committee on banking reforms found that Indian bank boards spend hardly any time on strategic matters such as risk management. It quotes one example in which the board spent as much time on the taxi fare reimbursement policy as on NPA recovery. With a lack of leadership from the top, it is not surprising to find a poor risk culture and the occurrence of incidents such as Nirav Modi’s.

In our research on risk governance, we find that even in advanced countries a regulatory nudge is generally necessary for financial institutions to adopt risk governance seriously. It is common worldwide, especially on complicated issues like risk management that are difficult to do well, that companies comply in form rather than substance. Regulatory skills and expertise therefore determine whether companies comply in substance or merely in form.

After the global financial crisis of 2007-08, risk became a major issue for regulators worldwide. They attributed the crisis to excessive risk taking and a lack of risk disclosure, and levied heavy penalties. Year 2013 was the most disastrous year in terms of penalties for financial institutions. In the U.K., the Financial Services Authority (FSA) was split into the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). Regulators such as the FCA have moved from regulating not just conduct but also culture. The latter cannot be measured, but with expertise in doing so it can be managed.

FCA’s focus on culture required an increased focus on changing the systems and process within companies to integrate new regulatory requirements. One large and mature British insurance company we studied already had all the elements of the risk governance infrastructure in place, and yet found that it was not meeting FCA’s high expectation on risk culture. It took up the challenge of enhancing the risk culture and was able to do so by developing a cognitive risk culture—one where people across all three lines of defence understand risks well, and also their responsibilities in relation to those risks.

The change was accomplished by creating a cadre of first-line staff called risk champions who are not risk experts; rather they are front-line staff working partly with the risk function and given an extra role of creating risk awareness in the organisation. The risk champions helped improve communication between the first and second lines of defence. The company also developed IT tools to better communicate risks throughout the organisation. The improved communication resulted in the development of a cognitive risk culture.

The regulatory push therefore led to an improvement even in one of the largest and most respected companies. Our learning from this case is that regulators can make a difference even to well-managed companies. Company executives and boards can make a difference by adopting the spirit of continuous improvement.

Indian banks need to align risk culture with the three lines of defence model not just in form but also in spirit, so that risk becomes a part of day to day decision-making rather than a year-end audit or compliance activity. To this end, India needs board members and senior executives of financial institutions to develop the skills and expertise that would put them on par with the best globally.  To shape risk governance in banks, the Indian banking regulator, RBI, needs to act as a supervisor to guide, nurture and improve the current standard of risk governance. To do so, the RBI must develop expertise and keep up with global best practices. Sustaining economic growth requires nothing less.

(Views expressed are personal.)

originally published in Fortune India https://www.fortuneindia.com/amp/story/opinion%2Ffailure-of-risk-governance-in-the-indian-banking-system%2F102074

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Women! Open the Pandora Box of Strategic Risk

In Risk, Risk Management on November 19, 2017 at 2:34 am

WomanRisk

Women! Open the Pandora box of strategic risk. Untangle it and mix it with your strength and weakness. This is the time when your strengths must speak.’

In general, the perception is ‘women are risk averse’ and therefore take fewer positions as CEO of a company. Alice Vaidyan (CMD of GIC Re) and Indra Nooyi (CEO of Pepsi) are well-discussed the examples of emerging successful women in the corporate world. Recently, I was the speaker at Conference on Empowering Women Entrepreneurs organized by FICCI partnering with NITI Aayog as a part of Road to GES Series at Chennai. During my presentation, I discussed that organisations’ face three types of risks: external risk, internal risk and strategic risk. Several women entrepreneurs during the forum discussed the issues related to unavailability of infrastructure to kick-start the business, and if they start it, it remains as small scale for years. They are not able to take it to next level. Why women need hand holding while men often do not complain about this. The market data also reflects the same:

After a high score in World Bank’s rankings for ease of doing business (Improve 30 places), India has declined in its overall Global Gender Gap Index ranking of the World Economic Forum (WEF). It slipped 21 places on the index to 108 behind neighbours China and Bangladesh, primarily due to less participation of women in the economy and low wages” (Excerpt from a News Report).

A few professors from University at California and Virginia found in their research that before 2007-08 crisis, large institutions have taken greater risk than the market average and booked the losses (Erkens, Hung, & Matos, 2012). The issue was more related to lack of understanding of risks undertaken and its inter-relatedness with other risks. If we accept some strategic risks which we do not understand, we cannot rightly estimate the consequences. There are three ways to deal with such risks: do not take such risk, take but fewer risks or thoughtless /thoughtful expansion to satisfy the greed of more and more profits. Women entrepreneurs, in general, chose the first or second option while large institutions chose the third one. For large entrepreneurs’ this made sense as they have the large capacity to take risks with structured systems and processes and capital to absorb the shock. Women entrepreneurs have less exposure to large strategic risks; they lack in capital back up. Also, they are surrounded by the culture issue of ‘not a failure’ therefore they can-not afford failures as it may serve as bread and butter for many of the families having kids and senior citizens. Emerging questions are: who will help them? How can they survive and sustain?

Understanding of Strategic Risk is one of their weakness. Even I found strategic risk-taking ability is the problem of many developing countries. Companies often know ‘what they can-not do’ but often don’t know ‘where they are good at’. Good means whether they are the better than their competitors in the local industry, country, globally or for simply a niche. It is the argument similar to a journey. If you don’t know where you want to go, you may fail many times. For example, the level of preparation needed to visit a cold place is substantially different than a requirement of hot place. Knowing you want to go locally or globally will make a significant difference. I met a very influencing lady at a conference in Lyon, France. The Turkish lady was the owner of a top scarf brand similar to the level of Louis Vuitton (a scarf costing around $ 1000). Though she was from Turkey, she decided to buy wool and silk from China, hired a team of designers from Italy and opened the first store in Switzerland. After the success of her scarf in Europe, she expanded throughout US and Asia including Turkey. I was also impressed with a CRO of a large reinsurance company who was very confident that they were the best in the aviation business and exploited the opportunities when the situation arises.

Understanding the strategic risk is important for the women executives. The gender does not change the business paradigm, the environment remains the same. In my opinion, women are NOT risk averse, they are in much better position to understand risk than their men counterparts. Afterall, it’s always ladies first ……..

References:

Erkens, D. H., Hung, M., & Matos, P. (2012). Corporate governance in the 2007–2008 financial crisis: Evidence from financial institutions worldwide. Journal of Corporate Finance, 18(2), 389–411. http://doi.org/10.1016/j.jcorpfin.2012.01.005

An Organisation Risk Pendulum

In crime, fraud, Risk Management on September 9, 2017 at 7:17 am

“Risk is often misinterpreted as a bad thing; however, it is not. Business needs risk to grow and thrive. Understand it, take risks which help you fulfilling your purpose. The key question remains how to balance risk pendulum in the organizational life”.

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If your company offers a unique product, any risk which provides a value to the product or customer is worth considering, however, the proportion should not be increasing 50% risk for a minuscule value to the customers. Think twice whether you are capable of handling enhanced risk for value creation. If you are unable to handle it, build capacity and then take the proportionate risk. On the other side, some risks are inherent in the business. For example, fraud risk. You will be surprised to know that fraud risk is often considered strategic risk. Tightening of controls in the business may be considered as a constraining activity in short-run but imagine in the long run, employees say that these frauds happened under the nose of senior management and question their integrity? What is the relevance of board, risk management team, auditors and audit committees in such instances?

A country with negligible crime rate (i.e. Dubai) attracts high investments while a country (i.e. Nigeria) with relatively very high crime rate has to struggle in inviting investors. Do controls play a positive role in business? Yes, it not only reduces the risk but also provides efficiency to the business with a potential of strategic advantage.

Many of us heard that after 2008 crisis, some large organisations are reluctant to take further risks. Does it mean they are over-matured and declining, or markets are exhausted, or they have just become risk averse for some period? This shows how a crisis impacts the speed of the Organisational Risk Pendulum. When the speed is low, what these organisations do – sit idle, focus on weakest links in organisational process or improve their strength in one or two core domains or simply learn from others mistakes. Over and above this, some companies wait for the crisis to occur because they are expert in dealing with crisis situations. For example, Business Continuity experts get maximum business after a crisis. Enterprise Risk Management and Risk Governance experts do the same, many consulting and credit rating companies take over the customers and markets. A more generic example is a doctor. When a pandemic spread in the society, doctors suddenly become highly in demand. It is clear that investment in risk management enhances the organisation capacity to maintain the speed of organisational risk pendulum during the crisis while it provides confidence to retain the speed in normal and volatile market situation.

Another key question arises How to drive your organisation at a speed to maintain an equilibrium between the risk of riskiness and risk of safety? What is right – Riskiness, stability, survival?

I believe all are important as Enterprise Risk Management (ERM) by definition maintains a balance in downside and upside of risk and uncertainty and considers all risks holistically. Knowing your organisational risk at integrated level provides a strategic direction to the company. Don’t wait. Know what you don’t

Who is the owner of risk in an organisation?

In Banking, CRO, Finance, Insurance, Legal, Risk Management on July 17, 2016 at 5:10 pm

In this blog, I indulge in a debate that who is the owner of risk – Is it CEO, CRO or different parties and how organisational risk is linked to society?

Chief Executives such as CEO and CRO provide foundation to a firm’s sustainability with their generic, specific capabilities, expertise and leadership to control and administer resources in current dynamic business environment. Role of CEO and CRO in relation to risk have presented greater ambiguity in practice and questioned the existence of widespread myth “CRO is the owner of risk and is the ultimate risk manager of the company.

Roles of CEO and CRO are significantly different however, often it is considered that CEO is expected to make risk based decision making while ownership of risk lies with CRO and accountabilities is set to the board.

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An actor is not implementer, an implementer is not decision maker and a decision maker is not held accountable.

During practice, a CEO acts as a ‘Risk Manager’, ‘Decision maker’ and ‘Influence of risk culture’.  To become a successful CEO, a CEO has to demonstrate his/her abilities to cope up with failures while gaining strategic leverage by exploiting opportunities.  A CEO influences significantly the risk culture of an organisation. Consider an organisation with Japanese, Chinese, British or American CEO, you may imagine the difference in culture as different expectations are set. A CEO style should complement with Company’s culture. If a company is relationship focused, and believes in shared decision making, its CEO should promote collaborative efforts. Another CEO may bring a ‘PUSH-PUSH BACK’ culture by enforcing rules without understanding the difficulties of ground staff.

A CRO acts as ‘Implementer and reporter of risks’, ‘Risk Advisor’ and ‘Communicator of risk culture’. CRO implements risk management policy and reports integrated risks to CEO. He/she also advises on critical risks for important projects, supports in formulation of risk policy when needed by the board and further to CEO on risk related matters. Expectations are set by the board, Chairman and CEO in risk related matters such as how much and what kind of risk the company is willing to take.

Other than CEO, CRO and board, there are other contender of ‘ownership of risk’ in the company.

  • Each and every person working in the organisation are the owners of their own risk.
  • Head of Departments are owners of their department’s risk
  • Shareholders are the owners of the company’s entire risk
  • Stakeholders are the owners of company’s entire risk
  • Risk and uncertainty is beyond the capacity of ownership

This week, I attended International Sociological Association (ISA) conference in Vienna which impacted my thought process of linking risk with society. A business success cannot be determined by its profit/loss or share market price without thinking of impact of its actions on society. Roots of organisations emerge from sociology as organisations are considered as ‘social entities’. Thinking about only economic benefits leaving society apart, may not be a sustainable long term strategy. This is perhaps the reason why ‘reputation risk’ has become one of the challenge for companies in global markets. Companies have burnt their fingers and learnt several lessons in recent financial crisis. The need of clear ownership, roles and responsibility of risk have been clearly known to companies and require attention in risk policy formulation and implementation. Michael Porter, a Professor of Harvard known for his highest influence on executives and countries, highlighted that businesses need to focus upon ‘shared value’ by integrating their economic interest with interest of the society to promote sustainability.  This raised a question “Should companies bother about ‘social interest’ in their risk related decision making process?”

Risk management based on ‘shared value’ for all stakeholders considering social interest has a great potential in promoting sustainable practices. Perhaps, this can deal with the issues of ownership of risk. It is usually debated who owns the risk but it is hardly discussed to whom this risk belongs to.

Reference:

http://aom.org/Multi-Media/Academy-of-Management-Perspectives/Interview-with-Professor-Michael-E–Porter-from-Harvard-University-.aspx).

 

Role of CRO Forum in India

In CRO, Insurance, Risk Management on February 26, 2016 at 3:57 pm

 

This blog is in continuation from my previous blog ‘Do Indian insurance market need a professional CRO forum?’. Indian insurance market essentially needs a Chief Risk Officer (CRO) Forum to set new standards of professional practices. Most of the insurance companies in India are head-quartered in different cities. A CRO forum can bring together geographically spread talent and knowledge of CROs of various insurance institutions to benchmark good risk management practices. The overall aim is to promote robust risk management practices within insurance industry.

Most of the academics and practitioners such as Anette Mikes, Robert Kaplan (Professors from Harvard University) and James Lam (Famous Risk Practitioner and first CRO) in risk management area claimed that risk is evolving and need to be discussed. A famous Professor from MIT Peter Senge provides insights upon the stages of learning. He defined advanced stage of learning of experts is through discussion and participation.

 

At beginning level, the role of CRO Forum in India could be:

  1. To promote best practices in risk management to enhance business
  2. To discuss issues and challenges in dealing with risk and risk based decision making
  3. To provide insights on emerging and long-term risk
  4. To discuss regulatory shifts and implications
  5. Involves a theme based monthly learning and discussion eg: Fraud Control, risk reporting etc.

At later stage, A CRO forum may involve publication of white papers, special issues and risk based discussions.

Essentially, forming a CRO forum is a forward looking and proactive approach for the industry to spread awareness of emerging and complex risks and to enhance overall risk based capacity of the industry. The process can be started with five steps approach:

‘Identify’: The list of risks insurance companies are facing

‘Prepare’: A well discussed and repeatable plan for the risks faced

‘Capability’: Understand your industry capability to handle those risks

‘Detect’: A continuous monitoring plan to detect and monitor the risk

‘Share’: Sharing the risk learning (theme based) within the group every month

Kindly share your view points.

Do Indian insurance market need a professional CRO forum?

In Finance, Legal, Risk Management, Uncategorized on January 18, 2016 at 3:01 am

Recently, I interviewed CRO’s and senior management of Indian and UK insurance companies and found that most of UK insurance companies CROs often discuss risk related matter locally every month and at least attend two international CRO forums/institutes such as GARP, IRM or CRO forums at London market every year. They have also attended many risk certifications and top risk trainings. Surprisingly, I found rarely any CRO in India discuss risk related matters at local level and very occasionally they attend international level forums.

Decision Making Process, Risk Management

A CRO forum is a group of professional risk managers and CRO developing and promoting industry best practices in risk management. It is a platform where CRO’s can join together and discuss their issues. Recently, there is an increase in financial investments by foreign partners of many Indian insurance companies such as Standard Life, Aviva, AXA, Tokio Marine and Bupa. Efficient risk management is one of the most crucial aspect by these giant foreign MNC’s. India is emerging insurance market and there is high potential for growth.

Insurance companies in India are managing risk in their own silos from long time. Currently, there is no common forum where insurance companies can discuss their problems in managing risk and improve awareness about emerging risks. A platform is needed where foundational information can be provided on how to adopt and implement robust risk frameworks. A common pool of funds needed for research for setting examples of best practices and learning from mistakes. Perhaps, a Centre for Risk Governance would be best option.

Risk management implementation has to be enhanced at local, national and international level but how that remains an open question. Visibility of benefits of improving risk management practices are not short-term. Without enough capital, training of senior management in risk management is practically impossible. In such scenario, a CRO forum can play a promising role in uplifting Indian insurance industry risk management expertise. This is a need of hour.

Building trust and sharing data pose another challenge. Does it risk the reputation of insurance companies? Think of positive side, if it could be possible to have a forum where we can discuss risk related issues, enhance risk capacities and embed risks into strategic decision making, it would be few of the most desired objective for the companies. This obviously, require a professionally managed CRO forum with independent governing body.

Kindly share your views.

A Simple understanding of Complex Risk

In Banking, Insurance, Risk Management on July 5, 2015 at 5:43 pm

Many of us in our daily life struggle with understanding of risks.  A well-known risk among our community is easily understood by all of us because potential negative consequences are obvious to us.  We also support that the risk which have potential low uncertainty, can be called simple risks. There is hardly any issues in understanding such kind of risk. For example construction of a road, driving a motor vehicle. Also for these risk statistics for long timeframe is available such as some accident in last 50 years in particular region. Based on this understanding, we can drive conclusions very easily such as State A is more accident prone than B. But what if risk is not simple, it is rather complex.

A complex risk is commonly understood as the risk which is not simple risk. Think if same risk is understood differently by many people who lead to many interpretation. It may be called situation of ambiguity where no conclusion can be drawn. Will you call it simple risk? Professor Otwin Renn defined ambiguity arise when there is an existence of multiple values. So, if a same building is inspected by three engineers and all of them provided different risk ranking such as low risk, medium risk and high risk. How conclusions can be drawn about the risk profile of the building. It can be said that there is difficulty in understanding the risk of this particular building.

Another situation where a single risk may affect a large population. It generally comes to the mind that it may be some natural disaster such earthquake or flood. What if two different risks occur separately such as default of securities and natural disaster but with no interaction. The effects will be severe in each case. If interaction between two or more risk affects the large society and risk is embedded for long time so it is difficult to find how risk originates and who is responsible for this. This is certainly called a complex risk with ambiguity. Such type of risk is known as Systemic risk (don’t get confused with Systematic risk).  

Systemic risk does not confined to a particular state or region but it may accelerate across national boundaries and may result in crisis. Its analysis is dependent upon the interdependencies among risks in holistic manner and Ripple and Spill over effects. Can anybody outsider/stranger attempt to understand the risk within organisation, houses or societies? Is there any short cut to understanding of risks? It is difficult to answer because it requires deeper understanding of risk which requires time and flexibility.  A risk in-house A to F could be different than Risk of house G to N as “Not all risks are equal”stated by Dutch Health Council, 1995

Therefore, there is a greater need to understand our own risk, risks where we work and in our societies. A deeper understanding of risk can untangle the complex bunch of interconnected risks and simplify our problems. 

Is low quality marketing staff – a problem for insurance industry or a risk?

In Insurance, Risk Management on August 18, 2014 at 4:17 am

Last week, I had a meeting with HR head of a leading insurance company in India. I was surprised to know that the insurance companies marketing department is facing more than ‘90% attrition’ every month for last 3-5 years. Such high and consistent attrition has decreased the quality of hires and created pressure to recruit more agents. Insurance companies HR department has to recruit lower quality agents to fulfil the vacancies according to strict time lines given by the management. The consequence is the decreased sales output and mis-selling of the policies. The management expectation from these agents have grown over time, which created more pressure on existing employees and caused attrition. The problem has become spiral due to high growth expectations but eventually the circle is not completed. There is not much effect on the balance sheet of insurance companies because of high attrition – which creates a question of whether it is a risk or problem. It raises further questions –

          Why insurance companies are not able to retain good talent in marketing?

          Why Insurance products have push factors why not pull factors is generated?

          Does this pressure will ever bring “excellence in the services” of insurance companies?

          What is the big reason for increasing customer complaints and lapsation of policies?

          Will it degrade the trust of existing and potential policyholders?

Spiral Problem of Insurance Industry

Insurance products have so many terms and conditions and involves complicated language which is difficult to understand. The industry is based on trust as insurance product/services are intangible in nature. What an agent communicate, customer believes and product is sold, in addition to this, the payment is also given in advance. What worries – the declining trust of customer?

Obviously, development of talent of the marketing agents can be helpful. We should try to understand the current process. How much time an agent spend on building a company’s product knowledge. Does he only want to understand the benefits of the products which he can sell to the customer or have interest in spending time the needs of customer and have reliable growth. From insurance agents’ point of view – to accomplish high targets and to save his job, selling fast is the most logical solution in the current scenario. Therefore, we may see some instances where some insured are sold more than 10 life insurance policies of different companies by informing numerous benefits to gain advantage of commissions and targets rather than single policy which is suitable to person’s need.

Low quality marketing staff is not considered a major risk until its interconnection to other problems is easily overlooked by insurance industry. There is a growing need to have better quality marketing people in Indian insurance industry which require extensive training in this area. If bonus of the marketing employees are set on the basis of retention of customers with the company, I think they can be better motivated to understand customer needs.

Comments welcome.

Ruchi Agarwal

Owner of my own Risk – Me or others ?

In Banking, Finance, Insurance, Risk Management on February 25, 2013 at 8:11 am

When an individual see the Risk – it looks 4 letter words. It is well said “This will not happen to me”, it is unusual not to avoid it. Actually what is the risk? It is a threat, loss of opportunity, unexpected happening of loss. Who is the owner of the risk – individuals themselves? It is the duty of risk owner is to prevent, reduce, transfer and control the risk.

 

It is just a Four letter word – RISK

Corporates also own the risk; risk manager owns the risk of each department. He/she may set procedures/systems to prevent/reduce the risk, he may transfer the risk to the insurance companies. Insurance companies owns the risk of various corporates and individuals but here the system works little different. Although insurance companies manage the risk however the risk lies in the hands of insured, It is also in the hand of GOD which can be seen any time in floods, earthquake. Its invisible based on set of calculations and predictions.

These insurance companies retain certain part of the risk in their hand and transfer the risk to the Reinsurance companies. Now situation changes dramatically – Reinsurance companies accepts the risk of same individuals/corporates from Insurance companies without knowing who actually they are, only based on set of terms and conditions and documentation submitted by insurance companies. The ownership of the risk is still in the hands of insured.

The reinsurance companies transfers this risk to Retrocession companies who practically don’t know the country of origin of the insured at the time of acceptance of risk, only a set of group risk based on certain conditions are accepted. The ownership does not change hands, insured still can increase or reduce own risk. Finally the set of risk reached through derivative market eg; CAT bond to the public. Individual own their own risk. “its better not to avoid risk rather deal with that”

James bond or CAT bond, who is our saviour from catastrophic losses

In Banking, Finance, Insurance, Risk Management on October 22, 2012 at 7:17 am

 

“Shocking! Positively shocking!” – Sean Connery as James Bond in Goldfinger

In show business, it is easy to save humankind from catastrophe by James Bond. He can avert nuclear disasters, stop tsunamis and change course of meteorites. The real life is different. Catastrophe means loss to people, society and economy.

The biggest challenge today to the insurance companies is not mere fraud risk, low reserves or depression of the economy – it is the risk arising out of catastrophes, which can severely affect their solvency position.  In last 10 years, catastrophes like 9/11 attacks on WTC, hurricane Andrew, Katrina and Wilma have shaken the reserve and stability of the insurance industry in United States. According to Swiss-Re, a leading reinsurance firm, year 2011 witnessed losses from catastrophes totalled $35.9 billion, greatly surpassing the average of $23.8 billion for the years 2000 to 2010. The insurance company solvency is endangered, when losses increase up to a substantial level – to safeguard either insurance company has to raise the premium or its reserves will be gobbled up by single big catastrophe.

In past 36 years, catastrophic losses have hit the insurance companies’ very hard and resulted in insolvencies of small and large insurers (Stipp, 1997; Swiss Re, 2000; Mills et al., 2001). Between the year 1969 and 1998, nearly 650 U.S. insurers became insolvent (Matthews et al., 1999). According to Guy Carpenter (2007), if one considers the 20 most costly insured catastrophes that occurred in the world (1970–2006) – half of them happened in the United States. Thus, it does not come as a surprise that the Gulf of Mexico has become a world peak zone for the insurability challenge.

Insurers use many tools for reducing their financial vulnerability to losses (Mooney, 1998; Berz, 1999; Bruce et al., 1999; Unnewehr, 1999; III, 2000). These tools include raising prices, nonrenewal of existing policies, cessation of writing new policies, limiting maximum losses claimable, paying for the depreciated value of damaged property, non-actuarially based discounts instead of new-replacement value, or raising deductibles, better pricing & claim handling (Dlugolecki et al., 1996 & Born et al.,2006 ). The catastrophe events will also effect insurer’s pricing policies, shift the default risk indicator and change the risk assessment methods. Sometimes, insurance firms also face regulatory intervention to reduce insolvencies (eg: Solvency II, SOX).

Currently, few Insurance firms hedge their portfolio by catastrophe risk financing by going into equity market. Catastrophe risk securities are of two types – catastrophe bonds (CAT bonds) and catastrophe insurance options. Both types benefit insurers by making money available to offset catastrophic losses. Insurance companies issue CAT bonds to transfer extreme losses from natural catastrophes such as windstorm, earthquake and floods. Property and casualty insurers typically develop catastrophe risk management strategies that combine determination of risk appetite, measurement of exposures, pricing considerations, processes to limit exposure and utilization of reinsurance or capital markets to transfer risk to third parties.  Due to massive increase in insured losses from natural catastrophe, catastrophe bonds (CAT bonds) played a vital role in increasing the underwriting capacity and reducing probability of default for the insurance companies.  There is a wider chance that insurance companies who use securitization methods will be able to reduce or completely avoid the default risk.

There are many similarities between James Bond and CAT bonds. Like James Bond, CAT bond is the hero of Insurance and reinsurance world to save average person from natural catastrophes losses like flood, storms and typhoons etc. James bond will complete his mission by using modern gadgets; CAT bond use advanced equity market financial tools to get success. No doubt, the CAT bond is James Bond of financial world.

But ofcourse nobody entertains the way James Bond 007 does. Like you I am eagerly waiting for the new movie Skyfall. Comments welcome !