Risk And Insurance Management Practice.

Introduction.

The purpose of this paper is to review risk and insurance management issues of particular relevance to companies and to consider enhancements which might be brought about to improve their performance in this vital area of their corporate strategy.

The analysis is based upon data widely available to the general public with specific examples where applicable, gained within companies. A review of personal injury claims within the U.K. is provided together with a review as to the importance of captives, an active corporate risk management philosophy in order to control risk and lastly developments within regulatory environments and the insurance market.

The analysis provides clear guidance as to how companies can improve their handling of risk management issues, raise their operating margins and the perception which people have of them.

1 The Claim Effect.

Critical to any company's operational status, is the level at which it has to make claim payments. The following sections provide a review as to the general culture with particular reference to the U.K..

1A Blame and Claim.

The most important issue facing the majority of companies today is the rising level of personal injury claims which they are forced to handle. The following chart evidences the trend over recent years as within the U.K., as produced by the Compensation Recoveries Unit.

Chart Showing Total Number of Claims in the U.K. with an involvement of the Compensation Recovery Unit.

2000 - 2001 612,120
2001 - 2002 614,126
2002 - 2003 619,546
2003 - 2004 557,186
2004 - 2005 755,875
2005 - 2006 675,422

The figures show the number of claims for which the DHSS seek reimbursement of benefits paid. The overall number of claims in the U.K. is considerably higher, though sadly accurate statistics are not widely available. As Mayou made clear within a survey carried out some years ago, there are often a significant number of psychological injuries such as post-traumatic stress disorder, which fail to enter into statistical databases. The study concluded that the number of claims in the U,K may run towards the one million figure per annum.

There is an upward trend as evidenced by a 30 fold increase in the past 30 years. The blip can be attributed to the effect vibration white finger, silicosis and other similar style of claims within the mining sector.

Many surveys attribute the rise in claims to the availability of insurance and the fact that it is compulsory for companies to have insurance for both motor and employers liability. 86% of all reported claims by terms of volume fall within these definitions.

The following tables show in turn the burning cost, frequency and severity of motor claims. There is clearly a discernable upward trend. Though the statistics relate purely to the motor industry, the overall picture as given is similar to other insurance sectors. It seems more than likely that this increase will persist over the coming years. It is also important to deduce that many insurers remain barely profitable and at some stage, there must be some increase in rates, to ensure that they remain solvent.

A table showing combined operating ratios for insurers.

combined operating ratios

A table showing number of losses in the U.K. per annum.

Number of losses in the U.K. per annum

A table showing the average value of claims per annum in the U.K.

Average value of claims per annum in the U.K.

Whilst the number of claims has risen, the cost has risen by 133% over the period compared with an increase in the retail price index of only 45%. 70% of claims now involve solicitors, which increases the quantum and number of claims beyond which would otherwise be the case. This is likely to increase.

The effect of the rising level of claims will have a serious consequence on companies margins and operational abilities. This process is compounded by the fact that the majority of third party claims are 'slips and trips'; low value high frequency claims, which fall to be considered within most companies deductibles.

Legal representation has increased due to the assumption that insurance companies representing third parties, will reimburse incurred legal expenses. In 90% of court cases, the defendant is supported by an insurance company. The latter are largely unwilling to contest liability. With a heightened fear of legal costs, such companies even 30 years ago settled 86% of cases before trial. This is exacerbated due to the fact that the rules of tort are known to favour the claimant over the defendant. Even though insurance companies prefer to settle prior to trial, there has been a marked growth in litigation over the last 50 year period. Since conditional fees were introduced, though the number of claims has yet to increase significantly, the cost of each claim has risen markedly. This is of particular relevance to companies with large risk retentions and is likely to get worse.

Worse still have been such legal cases as Heil v Rankin which have dramatically increased the level of settlements for personal injury claims. The Ogden tables which act as a basis of negotiated settlements, have aggravated this trend as they are used as a base from which third parties calculate levels of settlement. Previously settlement levels were much more dependant on negotiation between the relevant parties. With the cost of care currently rising 2% per annum greater than the retail price index, this acts to make the situation bleaker for companies than would otherwise be the case.

Though companies may not be able to avoid liability, they can take actions in order to mitigate the worst effects of the so called 'claims culture'. These might include notices advising staff to wear protective gear or take care when walking across greasy floors, and when interfacing with the general public; post notices in visible locations advising of the company’s restrictions on the extent of their liabilities. This would act as a clear defence mechanism against unwanted claims. The alternative method to restrict or even avoid liability altogether, is regular enforcement procedures such as instigating a system of regular checks of the shop floor, equipment and provide staff with formal training.

The government suggest that there is no such thing as a “claims culture”. Information available suggests that though the level of claims is not spiralling out of control, it is nevertheless rising. Though the level of accidents has not increased drastically, the propensity to claim has risen. The end conclusion is that the level of claims will become an increasingly dominant issue.

1B) The consequential effect and solutions.

Companies concerned must devote sufficient resources to tackle increasing claims. In recent years, they have become increasingly reliant on self insurance arrangements. It is not unheard of for a major company to pay out £30 million in uninsured losses per annum. This clearly has a dramatic effect on bottom line performance and on its long term viability. Often losses are hidden away in subsidiaries operating cost structures.

Deteriorating loss records have coincided with insurers’ insistence on ever higher levels of deductibles. The result is that companies risk management cost structure is higher than would otherwise be the case.

One company, a few years ago had deductibles of only £1,000 for each and every incident. Over two renewals, the company's insurers increased these to £250K per loss. Few losses exceed these high deductible levels meaning that many companies have become largely self insured.

Many companies have large unwieldy claims departments to handle losses within their risk retentions. These are insufficiently trained for the task required and many of the claims handlers consider it more economical to settle claims rather than investigate them. This is of particular relevance in a typical year such as 1996, 81,000 claims as subject to the C.R.U. criteria fell below £2,500. Though risk prevention measures are utilised, there are still too few checking mechanisms Statistics show that motor claims are usually settled without a full review of the company's respective liability.

A solution is to outsource their claims handling. To accrue the optimum benefit, companies need to reward the third party administrators for actively controlling the level of claim settlements. This ensures that the company's claims are handled in an efficient and cost effective fashion, though has the disadvantage that it loses effective control. An alternative solution would be to ensure that staff are adequately trained and properly supervised.

Company claim handlers rarely give consideration to possible third party recoveries and over compensate small claims as proved by research carried out by Cardiff University. It is not unreasonable to surmise that a system of complacency has spread through corporate bodies. This as partly as a result, of a breakdown in the lines of communication between the board room and the shop floor.

One solution would be to provide company health and safety representatives with disciplinary powers, should procedures not be followed. Companies must also be minded of the increasing powers of the H.S.E. and the punitive action they can enforce on them for failing to follow legislation, as well as the introduction of the new offence of corporate manslaughter. Disciplinary action and attention to H.S.E. requirements should operate hand in hand, though in reality frequently do not. In attempting to resolve this problem, companies must adapt their corporate structures to ensure that they operate both in a clear and co-ordinated fashion, whilst being effectively managed. Though the increased costs may act as a deterrence, the hidden benefits will normally outweigh the former.

Companies should sample audit some of their files as this would highlight deficiencies in their systems and reveal any underlying causes of accidents. The latter would act as a control mechanism to help prevent further similar style losses.

2) The captive argument.

Recent decades have seen the growth of alternative risk transference regimes such as the usage of captives. Captives have a separate legal status to that of the parent organization though the benefits revert directly to the owning company. They are particularly suited to companies operating large fleets of motor vehicles, which have high frequency, low value claims.

The most important benefits of a captive include;-

  • Having a pseudo independent body within the corporate group, assists in bringing risk management issues to the fore. As an effective independent entity, a captive would not be subject to the same political restrictions as would an internal body.
  • Obtaining reinsurance coverage for a captive is generally easier than seeking insurance coverage from the primary insurance market, as a captive has the ability to access reinsurance markets.
  • The parent company is more likely to be able to identify the cost of claims, as loss records are more quickly available. Discernable trends also become known at an earlier stage. Captives can also be used as a quasi-independent body to audit the company's claims. Though one can achieve such a result by employing a T.P.A. handling agent, the latter may be much less effective as there is no direct linkage mechanism with the parent company. Ultimately, a captive can offer a reward and punishment system for operating subsidiaries, thereby enhancing the company’s risk management policy. It can also act to centralize the risk management function, creating a sole body within the organization responsible for the operation of its risk management policy.
  • A captive can decide on which risks to retain and those to reinsure out. This is not easily possible when purchasing insurance in the primary market. It can retain the profitable risks whilst reinsuring the remainder.
  • When reviewing captive usage, it is of particular relevance to mention some of the key financial benefits:-
    • 35% of all premiums in the primary market are swallowed up in administration costs, whilst captives generally operate on 10% margin. Some manage to operate on a margin of 0.5%.
    • As E.L. and third party motor insurances suffer from long tail settlements, a captive can earn interest on retained premiums.
    • Profits made by the captive can be repatriated to its parent and are taxed at a lower rate than revenue earned by the main corporate vehicle. CFC legislation offers the benefit that profits may not have to be repatriated to the parent for a period of two years. By having its own captive, the parent can offset premium and claim payments against its corporate tax bill.
    • Captives allow the corporate body to make savings on professional fees such as brokerage and they can earn commissions on reinsurances as placed by it.
    • Companies can realise the full benefits of high deductibles and the premium discount benefits these bring.
    • Captives can spread premium cost over a greater time period and iron out the cycles of the insurance market. The average cycle for a captive is ten years, whilst three or less, for the general insurance market. This allows the parent greater certainty in setting its’ long term strategy.

Other benefits of captives include the ability to insure a wide range of risk not normally insurable in traditional markets and security as regards the long term existence of insurance cover in such areas as terrorism and professional indemnity, which have generally declined in recent decades.

The only realistic alternative to a captive is total self insurance. This creates more complications than it solves, as it is much more difficult for a parent organization to hold reserves for claims (Incurred but not reported), than for an insurer. To be self insured, a company might need a credit facility with a commercial bank to cover unexpected / high value losses. This has one large disadvantage, due to the fact that it may well impinge negatively on the parent's ability to seek funding for other projects. It may also adversely affect the ability of the parent to trade effectively as potential customers would be wary of dealing with a company which has no insurance cover. The only real benefit would be the saving made on I.P.T. ( Insurance premium tax ). Only the largest of companies with large asset bases can afford to be totally uninsured.

59% the F.T.S.E. companies captives seek no reinsurance coverage. 30% of all industrial premiums now underwritten globally are to captive companies. Smaller companies often fear the cost of a captive can be prohibitively expensive, though this is not the case as there are methods to restrain costs such as the creation of a 'protected cell captive' whereby administration costs are shared with other companies. Mutuals, one alternative, suffer from the lack of ability to influence corporate policy.

Captives have a stronger relationship with the parent / Client Company than normal insurance companies and can influence corporate risk philosophy far more effectively as they often have a direct linkage with companies treasury departments. The main benefit is to reduce a company’s outlays as regards risk management as evidenced by one of Britain's biggest corporate’s which has calculated that it has saved up to £1 billion over the last few years.

3) The failure of risk management regimes.

In an ideal world corporate information would be transferred throughout the organization, at the touch of the proverbial button. In most structures, there is an ever increasing importance given to the "waterfall effect", whereby information flows smoothly and efficiently between each layer of the corporate body. Some companies are better organized than others. The larger corporates have a tendency to give risk management practice far greater emphasis in setting group strategy, whilst smaller companies all too frequently treat risk management as an side issue. Whilst many board directors have clear concepts as to how to set strategy within their corporate framework, implementation at grass roots level is often more difficult. Many companies, do not have effective strategies for the implementation of a risk management policy at shop floor level, nor can adequately manage claims. Though in theory it is relatively easy to change corporate philosophy, in reality changes are far more difficult to implement.

The larger corporates understand the varying types of risk and properly evaluate it. Risk management control forms an active part of their overall group structure. The companies concerned do not necessarily "throw" money at the issue; but ensure that funds are channelled carefully to the required zones. Their departments such as those covering health and safety and insurance tend to interrelate closely with each other.

The question that has to be asked, is whether there is sufficient internal momentum in place to ensure that the necessary structures will be fully assembled within the majority of companies, or whether they will come to accept the current 'modus operandi' as the operating norm.

4) What of insurance corporate and risk management philosophy.

When reviewing corporate philosophy in relation to its organizational structure, one must assume the perfect model exists whereby every key department of a company interrelates perfectly with each other and the board of the company. Most follow guidelines as set out by Turnbull. These provide clear guidelines for the framework companies should create, in order to secure good corporate governance. For risk management, this allows a regular review of company frameworks which address the risks facing the company and the extent to which they may wish to manage them. Such mechanisms are normally reviewed annually within the audited accounts. This annual review will encompass a review of the framework's effectiveness, discuss as to whether sufficient actions are being undertaken to remedy any potential shortfalls and lastly identify whether an increased level of monitoring is required.

Though such regimes as Turnbull create a framework for operations, it does not provide the detailed structure needed to operate such a system. Nor does it review a structure's relative effectiveness on a day to day operating level. To quote from the Financial Reporting Council, "it is clear that there is no prescribed form or content for the statement setting out how the various principles in the code have been applied".

The optimum solution may never exist, though companies can clearly improve on their current performance. One statistic which shows that companies fail to achieve the necessary competence in this regards was recently uncovered in a report compiled by the European Regulatory Risk Awareness survey. This identified that 51% of companies do not have any form of crisis management plan. Risk management rarely receives the attention it deserves at board level. The solution is to have a risk management representative sitting on the board.

Whilst some companies have similar structures, they either have not fully understood the position they face, or are unable to implement any substantial improvements. Some have no specific risk management function and rely on external providers. In the latter case, risk management issues are barely mentioned at board level and hence no effective control mechanism exists. Others, whilst having a specific risk management function, have fractured lines of communication between the risk management function and the board. This in turn leads to the corporate body failing to perform the tasks required of it,.

Within a well run risk management function, knowledge of trends of claim types and issues regarding corporate performance in this arena are easily transferable to the board. Clearly, where the link is tenuous, the corporate body can not adapt its policy in order to improve overall corporate performance. To use one prime example, there have been occasions when defective equipment has not been reported through the corporate body for a considerable period of time, thereby engendering a situation where further avoidable losses occur.

Whilst in the past, many companies 'outsourced' their risk management function, the trend has increasingly been away from this style of approach. The creation of an internally based structure is only part of the overall procedure towards formulating an active risk management function. Such a structure requires proper management control with direct reporting to the company's board.

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5) Corporate Governance and the future of risk management culture.

Companies within the U.K. and the U.S.A. are increasingly subject to ever tighter corporate governance. This includes the Woolf legal reforms in England, which provides for strict time deadlines as regards the investigation and handling of claims. Similar rules apply in other parts of the U.K.. F.S.A. regulations have added to the regulatory burden. Companies within the U.S.A. are similarly affected as evidenced by the Sarbanes Oxley act. Though the intention was to tighten companies accountancy regulations, this has spread its' net into the insurance field.

The Sarbanes Oxley act provides specific responsibility for the finance department and the finance director. Though it does not act to specifically review the minutia of a company's operating structure, it does put into place a requirement to review risk assessment, control activities and information gathering / monitoring techniques. Should companies fail to comply with the requirements of the Act, regulators have the power to curtail a company from further trading and imprison the company's chief executive or finance director. One recent article advised that "risk management responsibilities have expanded dramatically under SOX because of the new law's disclosure and internal financial control requirements". The Act was brought in to ensure 'transparency" in companies and. requires quarterly reporting for U.S.A. domestic companies, though only annual reviews for foreign owned companies. Such a review must include annualised changes in perceived risk, a review of the company's internal control mechanism and monitoring system of its risk, the effectiveness of its reporting system and also any weaknesses discovered in the corporate body. It must also review the framework utilized for monitoring its risk assessment techniques.

Implementation is still at an early stage. As the controls embedded within the act are rigorous, management resources are diverted away from running the company's business. A recent survey showed that a quarter of companies have no procedures in place to deal with regulatory risk and further still that 45% had no formal structure in place for risk management compliance. In addition it has been found that only 23% of companies operating in the U.S.A. have risk management personnel involved in the decision making process as regards SOX compliance. It is clear that senior management need to be aware of the cost and implications of the new regulations. Of those who have procedures, how many of them are adequate? There is the ever present danger that without being sufficiently prepared, there will come a time when these companies will have their operating ability curtailed due to their inability to meet with the requirements of an existing or enhanced Sarbanes Oxley Act, or any other legislation in other countries. Such inaction would act to limit the operational ability of such companies and therefore have a dramatic effect on their bottom line profit figures.

In the U.K., the Woolf legal reforms set in motion changes to the manner in which claims are handled. As of May 2010 a further enhancement beyond those as previously made, has come into effect whereby companies have 15 days in which to assess and formally respond to third party liability claims. As regards employer’s liability claims, there has been a recommendation made that the period allowed should be set at 30 days, tough this as yet has not been formally set in motion. Whilst the time period as regards handling third party claims is advisory to a large degree, it is clear that more draconian measures will ensue in due course. This will put further strain on an already restricted resource level. It will clearly have implications to those companies who have lengthy chains of command involving insurance companies. Either a more efficient way of handling claims must be created or the lines of communication brought to work at an ever faster pace. The ultimate answer for many companies including those with a heavy claims burden must be to shorten the lines of communication and handle the claims themselves. The lengthy time period with which claims would otherwise be handled through insurers, would leave little if any time for any delay or error.

One recent article epitomized the situation by saying, "the risk manager must look ahead to identify prospective claims and to evaluate the impact of pending laws and regulations and court decisions that could affect the company and its business. Failure to act in this regards, will act directly against the company's operating ability". Regulatory risk, it is abundantly clear, will become an ever increasingly important factor in companies future strategy.

6)The Changing Face of the Insurance Market.

Many suggest that the insurance market is an inefficient mechanism for transferring risk as premiums are high, and claims processing is slow and cumbersome.

The insurance market over the last twenty years, has reduced cover and increased premium rates. One can not blame the industry, in light of its loss record. In the past, insurance agents or brokers frequently provided 'value added' services as part of their overall service. With increasing concern over potential exposures / errors and omissions and the fact that they were effectively providing a free advice centre, many of the ‘add on’ services have disappeared. Many brokers have increasingly become no more than processing agents. The smaller brokers who still to some extent offer the "all embracing" service are all too small to handle a larger company's insurance requirements. This evolution of the insurance market will play an increasingly dominant role in the way in which companies must adapt their risk management philosophies to the realities of the modern day world. This process will involve placing insurances directly into the market themselves. This could in turn lead to them bearing an ever increasing burden of the process' administration. The alternative for those companies who do not subscribe to this 'brave new world' will be serious. Companies need to initiate a process to bring on board a sufficient resource level, in order to be able to operate within the this new world. Though some companies have begun to develop such a corporate strategy within this field, many have largely ignored the situation. This needs to be redressed!

The insurance market, particularly Lloyds, is currently undergoing its biggest ever transformation. Whereas in the past business was conducted on a trading floor, the process is being replaced by an electronic market place, whereby contracts will be enacted at the touch of a button. This will bring tremendous benefits to those who take advantage of such system and will substantially reduce the cost of transacting insurance. There is also a gathering momentum towards standardization of contract wordings; bringing about a uniform market place. The standardization of insurance policies should give added momentum to companies seeking alternative insurance arrangements such as the usage of captives. Though there have been new product launches by some insurers aimed at particularly the S.M.E. sector, these will have little effect on the larger corporates insurance regimes.

Given this state of affairs, the larger Plc. companies have already distanced themselves from the active role which they used to play within the insurance market. Given the ever increasing pace of change, it is quite clearly time that other smaller companies follow their example, as the benefits that used to be provided by brokers "value added" services cease to exist. Having said the latter though cannot detract from the fact that insurance brokers are more knowledgeable concerning potential markets than are their clients. By altering their risk management policies, the companies concerned will be able to operate a more cost effective solution to their insurance purchasing and claims handling arrangements.

One point to bear in mind is the fact that we are currently experiencing a “soft market” though this cannot go on indefinitely, due to the fact that for example, motor insurers are currently making year on year losses in an attempt to gain market share. There will come a point whereby the insurers will need to increase their rates, if only to maintain long term financial stability. Though the motor market epitomises such trends, it is not the only sector of the insurance market which is currently suffering the same fate.

7) Insurer security and pricing.

With the onset of the credit crunch, the long term viability of insurance companies has become a critical issue. Companies must give an ever increasing importance to the credit worthiness of their insurers. Those insurers with a wider asset base, offer better long term security. This must be borne in mind, especially when companies are subject to long tail claims such as asbestosis, which only manifests itself many years after the applicable policy has expired.

Hardening rates are an integral part of the insurance cycle and as such, companies must budget for rates increase. Failure to do so can have an adverse effect on the long term viability of a company's business.

Conclusion.

A structured risk management philosophy must reduce the risk profile of the company and protect its asset base. The risk profile can be measured by the propensity for companies to suffer losses. Companies may decide to accept a relatively high risk profile as the cost of enforcement can be higher than the benefit which a lower rate of incurred claims may bring about. The European Regulatory Risk Awareness Survey found "organizations across Europe know they are at risk but are not employing appropriate specialists to alleviate these threats". Though companies have moved from employing “insurance managers" to a position where active "risk managers" are engaged, this has been slow, and self insurance has now largely become the operating "norm". The evolution of the risk manager has acted to enhance risk management practice, but not resulted in a curative solution to the underlying issues faced by companies. Risk managers are able to offer much greater control over their insurance function which is not readily available in a situation where external insurance companies are actively involved in the equation, though they need to be given more active powers as regards steering the corporate body. Further still, though risk management principles may sometimes be embedded at the top of a corporate structure, it is either not understood or worse still ignored, at the lower echelons of a company. This can only be solved by a change in the corporate philosophy which may take some time and external influence.

Companies must take action to improve their performance. To summarise, they must;-

  • Create a more integrated company structure in order to ensure that risk is properly assessed and managed.
  • Control the level of claims as made against them and if possible actively seek mechanisms which will act to reduce the level of their payouts.
  • Adapt their insurance arrangements where applicable to take advantage of the benefits which captive regimes offer.
  • Adapt to the changing face of the insurance market.

There is a clear need for companies to improve their strategy within the risk management field, in what must safely be called a core area of their operating environment. This can be brought about by the employment of sufficient expertise. Most companies would expect a payback time on any investment in respect of risk improvements within a two year period, though it is likely that such an investment will only reveal its true benefits over a much longer payback period. This is becoming an ever more important issue, as more companies retain an ever increasing share of their risk.

All too often, companies only become aware of substantive risk management issues, when they have a major loss. By this time it is too late to put protective systems in place, to protect themselves from the worst effects.

*Charts are sourced from LIRMA / IUAC

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