Risk Management After Japan's Disasters

Last year, Richard Whitt joined the growing list of finance professionals who have made the leap from the finance function to the top of their company. After five years as CFO, the 47-year-old CPA and former KPMG auditor was named president and co-chief operating officer of US$2.2-billion-a-year Markel Corp., an insurance company listed on the New York Stock Exchange.

On a recent trip to Hong Kong, Whitt spoke to CFO Innovation’s Cesar Bacani about CFOs becoming CEOs or COOs, the continuing evolution of the finance function, the implications of catastrophic events like the earthquake in Japan on risk management in companies in general and the insurance in particular, and other issues. Below is the final part of the freewheeling interview:
The Japanese earthquake and associated disasters continue to affect global supply chains.
The world is so interconnected there are ripple effects, and they’re being felt right now. Japan has shut down production in certain factories and moving production to other places . . . until they get production back on line in the automakers, for example.
A contingent BI [business interruption] policy would potentially cover some of those supply chain issues. We at Markel don’t write it [contingent BI cover]. It’s such a difficult exposure to get your head around, as people are now learning, seeing what happened in Japan and how it may ripple and affect Australia, as an example, as a huge trading partner with Japan.
One of the reasons that Markel wouldn’t write that cover today is that everything seems to correlate at some point, as we have seen in some of the last few large scale disasters. Insurance is based on fact that you can diversify, and through that diversification, reduce correlation. What we’re seeing in these mega-catastrophes such as Katrina and now the Japanese earthquakes and tsunamis and the ensuing issues at the power plants, is that things tend to correlate once these disasters get to a certain level. You just can’t predict what’s going to happen as a result.
So what can the CFO do? Is contingency BI cover, assuming the company can get one, a good option?
You should ask your insurance brokers to look into it for you. As a CFO, you would also be looking to mitigate the rest of the supply chain. Insurance is part of the answer, but it’s not the whole story. There are other mitigation tools.
The pricing [for contingency BI insurance] may be something you would have a real difficult time coming to terms with. You’re trying to think through what can happen to you and you have to decide how much you’re willing to pay to mitigate that risk.
Where they see that they’ve gotten over-dependent on one supplier, what a lot of companies do is try to find ways to spread that out, to diversify. It’s the same thing in the insurance business, where you’re dependent on the larger brokers – the Marshes, the Aeons, the Willises. It’s a fact of life, they control a large portion of the market.
One of the things insurance companies try to do is to look to see if they can develop relationships with the next group of brokers, to diversify away a little bit from the [large brokers] because you don’t want so many eggs in one basket.
Is it cheaper for a CFO to go directly to the insurer rather than through a broker?
Clearly you have a different level of acquisition costs and so you can differentiate price. So the smarter insurers out there, and there’s a number of them, they differentiate pricing of the product based on what the acquisition cost is. The longer [a product] has to go through that distribution chain, the more commission gets added to it.
What you’re starting to see is the more technical commercial risks, the ones that maybe need also a lot of capacity, they’re going to go through all the way through the wholesaler and on to the insurance company. They need consulting, they need the full boat.
There are at least three pieces to the insurance market. There are the complex risks that most CFOs are going to be binding, that probably goes all the way through the wholesale [large broker] channel. Maybe smaller businesses, they might get it done with a retailer [second-tier broker].
Quite honestly I don’t see a business owner of a certain size buying direct. I can see maybe a one-man or two-men architect firm [doing so], and we’re preparing ourselves for that. But the bigger you get, the more assets you have to protect, you probably want some consulting to go along with what you should buy. I think you would at least go to a retailer.
Can a CFO ask two or three brokers for quotations?
Many do. Tendering is quite common in Asia.
At Markel, we obviously buy insurance for our own business. Like a lot of other companies, you tend to work with one supplier. We’ve used Aeon Benfield it for a number of years and they a wonderful job for us. But every once in a while you might say: hey should we look and see what Willis can offer.
But it’s a lot of work to switch your broker every year. As long as you think the brokers are doing a nice job for you, giving you good advice, pushing the insurers hard to get to the best price whatever the market conditions are at that point, you don’t want to switch every year – at least we didn’t want to switch every year because it’s a lot of work. They get to know your company, they get to know your exposures and what you need in the wording, all those sorts of things are really critical if you really think about it.
Who in Markel takes care of this, the CFO?
Yes, my CFO now, I passed the baton on to her, so the purchase of our corporate insurance programme falls under her.
And she’d be looking at it from the point of view of risk management . . .
Absolutely. You know, risk management was wonderful for the insurance industry because if you’re really working hard at your enterprise risk management, you start discovering risks that you really didn’t think about previously.
It doesn’t necessarily mean you buy insurance coverage, but I can tell you that as a result of ramping up our risk management programme, we identified additional risks and we looked at what would it cost to purchase cover for those risks.
You don’t have to buy insurance, though. Sometimes you just need to accept the risk.
You have to make a cost benefit decision. You have to decide: Are we retaining the risk or are we going to lay it off to the people writing our corporate insurance policy?
It’s basically operational risk that you need to be aware of. You need to manage it, and obviously one of the tools which you can manage it is insurance. But there are other tools.
With all these disasters going on, CFOs may be asking themselves: What do these mean to the business and what can we do about it?
I think probably the biggest thing everybody’s looking at is their risk appetite for catastrophic risks today. This is just prudent.
As an insurance company, you ask: How does what I’m getting in terms of actual losses, how do those match up with what I went in and expected? Is it more? If it’s more, then what went wrong? Did I miss something? Do I need to tighten my risk appetite? Do I need to do a better modelling of my catastrophe risk?
If it’s less, that’s good, but maybe I’m not stepping out enough in terms of the amount of insurance business I’m writing in that area. You have to assess it, and right now, everybody is doing that.
The first thing everybody [in insurance] did was stare at the TV in shock and horror because the devastation and the loss of life is just dreadful. But after initial shock, everybody started tearing through the book of business and asked: What policies do I have that are going to be exposed to this event? How bad do I think it’s going to be? What does that look like compared to what my models are telling me I should have on a 9.0 earthquake in Japan?
Would those models need to be tweaked?
All the modellers – AIR, RMS, EQECAT, all the rest of them – will take all this data, once it’s in, which will be a while, and they’re going to update their models.
And what does it mean for insurance premiums?
That’s a great question. My sense is it’s going to mean premiums go up. I would say at this point it’s an earning issue for the industry. It’s not a capital issue, although that’s not to say certain individual companies might have a capital issue at this point.  
There are not so many reinsurers in the world anymore and they’re going to want [higher prices] going forward, not just from the people in Japan and New Zealand and Australia, but from the rest of the world as well. If [an earthquake] can happen [in Japan], it can happen in California, it can happen in Madrid, we can see windstorms in the southeast of the US. I think the reinsurers are all going to be pushing for more price as reinsurers’ programmes come up.
CFOs will have no choice but to pay the higher rates.
Yes, you’ve got to cover your exposures . . .  It’s concerning, when you think about it, the ring of fire around the Pacific. You had the Chilean earthquake last year, and then you had two big quakes in New Zealand, and now a disastrous quake in Japan. It’s almost like it's going around the ring of fire. If I were sitting in California right now, I’d want to make sure my earthquake coverage is up to date.

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