Part I shared some of Roger Estall’s background and experience from working more than 40 years on helping organizations address uncertainty, developing public standards across a wide field of related topics, and co-authoring a book entitled Deciding. Part II focuses on Roger’s work to help create a Guideline for “risk financing” options, including commercial insurance.
Please tell us about your involvement in the creation of a Handbook on Risk Financing (HB 141:2011). What motivated you to become involved with this project and in what ways do you think the handbook can be useful to organizations?
Before explaining the purpose and utility of this particular ‘handbook’ (HB) and the reason I became involved in its development, it may help to first provide a little background about the general nature of documents of this type and why this HB was developed jointly by two sovereign – albeit neighboring – countries.
General function of ‘Handbooks’
Rather like legislation, national ‘Standards’ are drafted using explicit language. They make clear what is recommended or required but do so concisely with minimal explanatory content.
It is recognized, however, that while standards are prepared by ‘experts’ (or people assumed to be experts) the end-users of standards might not be experts. The practice emerged of also developing ‘companion’ documents (called ‘handbooks’) containing explanatory material, examples and case studies to assist understanding by a wider range of end-users of the related standard.
Such ‘handbooks’ typically have one of three general purposes:
- Provision of an expanded explanation of the standard.
- Explanation of how to apply the standard in a specific sector or in respect of specific issues (sometimes also explaining related jargon used in that sector).
- Additional explanation of a particular technique referenced in the standard.
Why ‘joint’ standards and handbooks?
Although independent countries, the economies of Australia and New Zealand are closely linked both in terms of ownership, practice and, increasingly, regulation. (This is particularly evident across the financial services sector.)
In the late eighties, as part of an overall strategy for closer economic cooperation and efficiency, the governments of Australia and New Zealand signed a ‘joint standards agreement’ (JSA) with a view to reducing differences in standardized practices and products to minimize barriers to trade and enhance productivity generally.
The two countries had, for example, long used the same domestic electrical system (230v, 50 Hz) and the same distinctive 3 flat-pinned outlets making it easy for manufacturers of electrical goods to sell into both countries. The aim of the JSA was to extend such well-proven harmonization practices.
Pursuant to the JSA, the national standards organizations of Australia and New Zealand would, wherever beneficial to do so, establish ‘joint’ committees to prepare standards with the resulting standard numbered in the form AS/NZS XXXX:Year. The same approach was taken with related HBs.
Publication timing, and specific purpose of HB 141:2011
In 2009, within weeks of publication of the first international standard on risk management (ISO 31000) Australia and New Zealand jointly adopted it as their national standard and then commenced work on several companion HBs. These included the techniques of ‘communication and consultation’, managing environment-related risk, managing disruption-related risk, and managing risk in not-for-profit organizations and in sport and recreation organizations.
HB 141:2011, was developed to expand on and explain the technique of ‘risk financing’ which is mentioned in ISO 31000. It replaced a much earlier handbook about ‘insurance’ which was little more than an anthology of insurance jargon.
The new handbook (and the expression ‘risk financing’) acknowledged that insurance is but one technique for making money available on a contingent basis if money could be needed following occurrence of a fortuitous adverse event . Contingent funding mechanisms are a means of addressing uncertainty. By contrast, if it is either known or highly predictable (i.e., certain) that costs of either a particular type or quantum will be incurred, it will usually be more efficient to simply anticipate and budget for that amount.
As well as recognizing and explaining other contingent funding techniques, HB 141:2011 also addressed the important operational and financial interactions between:
- the overall purpose and ambitions of the organization and the characteristics of the contingencies being funded;
- the quantum of funds that might, therefore, be required;
- the actual and perceived likelihood of such funds being required (and the options for and costs of adjusting that likelihood and managing perceptions);
- the cost of various mixes of risk financing arrangements (of whatever types); and
- the required level of certainty that funds will be available when needed (which is why accepting a higher premium if offered by an insurer with a higher credit rating, might prove an excellent investment).
It is rare that insurance is seen as the only means available for funding contingent events – especially those of a magnitude (cost) that is reasonably predictable and hence can be budgeted for, or so small that they can be directly expensed and absorbed as an operating cost should they occur.
At the other end of the scale, the assets of some organizations are sufficiently diverse and large that even in the face of occurrence of a major event, the strength of their balance sheet would allow them to raise funds on the capital markets to fund repair or recovery, just as they would for, say, a major expansion or acquisition.
Past experience of contingent events in both the organization itself and in the sector to which it belongs, while not a predictor of the future, nevertheless feeds into the perceptions of interested parties such as insurers.
Hence, to find the most economic mix of risk financing options, organizations usually benefit from investing in, two related activities:
- making technical or organizational changes that will influence the magnitude and likelihood of contingent events occurring, and
- ensuring that interested parties (such as insurers) have high quality factual information made available to them. (There is an old saying that insurers will seek to fill the gaps in their knowledge with more premium!)
In summary, finding the most effective and efficient risk financing option requires balancing several areas of expenditure (including investment in quality advice) over and above the direct financing costs such as premiums.
HB 141 was prepared in the knowledge that few organizations either seek or succeed in finding that balance with the main barriers being both conceptual and not having access to the full range of relevant technical knowledge. Because of the importance of reliable and efficient risk financing arrangements, such shortcomings can amount to a failure of governance.
I would often be surprised, for example, by the tendency of company executives or even directors to be very interested in the cost of the premium or the fees of broker or advisers, yet ask nothing about ‘the elephant in the room’; i.e., the financial solvency of the insurers and the likelihood that they would be willing and able to pay claims. It would remind me of the saying about ‘doing a great job on the micro detail while unwittingly heading towards the grand fallacy’.
So, the major stimuli for developing HB 141 included:
- using plain language to help the different participants understand the parts of the ‘jigsaw puzzle’ and the options;
- explaining, conceptually, how the interactions between the ‘pieces’ could have a profound effect on total, long run cost; and
- providing a comprehensive list of (8) criteria by which organizations can assess and as necessary improve their current practices (these are set out in Chapter 3 of the handbook).
Although written in the context of risk financing practices in Australia and New Zealand, HB 141:2011 is substantially relevant in all jurisdictions and even includes a discussion of ‘takaful,’ a funding mechanism found in Islamic countries.
I became involved in the development of HB 141 for two reasons. In Part I of this interview, I mentioned that I was a member of the ISO committee that wrote ISO 31000 and a member of the joint Australian/NZ committee that adopted it nationally. I also outlined in that interview the diversity of my somewhat unusual background including experience within the broad risk financing sector as an adviser to many different types of organizations.
This experience meant I understood the considerations which, whether realized or not, underpin risk financing decisions; how these interact and how they can be optimized. These considerations include:
- estimating how much money might be needed on a contingent basis;
- estimating how likely it is that those arrangements might be called upon;
- finding efficient ways to modify the scale and likelihood of what could occur; and
- understanding how well any particular risk financing approach would respond in practice if called upon to produce money.
Understanding these considerations is not a universal skill. Even sophisticated organizations often take risk financing decisions without a sound conceptual grasp of what they are doing or without consideration and careful evaluation of options and interfaces.
Furthermore, practitioners involved in various technical aspects of risk financing, while expert in their own field, are often limited in their ability to explain what they know to others without recourse to jargon. Few know how best to optimize the interface of their own expertise with that of others.
Awareness of this reality helped the drafting team to match the content of HB 141 to its various audiences. Those audiences are described in its preface, but are usefully summarized as including risk financing buyers, sellers, and technicians … and also students.
Awareness of the needs and aptitudes of the audiences also stimulated us to draft the HB using plain language, in a bid to bring about a common understanding. In this I was helped by many years of explaining often complex considerations to senior management and directors, risk financing practitioners, engineers and other operational staff and to decision-support personnel such as general counsel.
One of our frustrations with commercial insurance is the idea that policyholders are transferring risk to an insurance company. Why is this a myth and how should purchasers better think about the use of insurance?
These are excellent questions but let me answer the latter part first.
Role and function of insurance
Strangely enough, even in large organizations, insurance is often thought of as a commodity (albeit indispensable) with there being only a general sense of its purpose or the need it is intended to meet. It is purchased as an envisaged answer to a seldom well-defined problem, by people often oblivious to its limitations and without consideration or understanding of the availability or efficiency of alternatives.
As already mentioned, insurance is a contingent funding arrangement. Its distinctive characteristic is to spread the losses of the few over time and across the many who use this ‘risk financing’ arrangement.
The insurance purchaser envisages there could be circumstances in which money might be needed on the occurrence of fortuitous but foreseeable events and believes (or hopes) that the insurance arrangement will respond timeously and provide those funds in a way, and in an amount, that will meet that need. Whether it does, or not, or whether either insurance generally or any particular version is the best option, can be a different matter.
Of course, regardless of the funding mechanism, contingent funding alone might not be sufficient to restore the organization to its pre-event position. Events which also result in loss of reputation are such an example. Money might repair damage, but good reputations are typically harder to rebuild.
Inevitably, the more likely it is that such funding will be (or is) called upon and the likely quantum of such calls, will, ultimately, affect the cost.
The success of any particular insurance arrangement will therefore depend on:
- adequate definition of the problem it is intended to solve (i.e., the reason contingent funding is needed; how much money will be needed; and when it will be needed by);
- whether the availability of sufficient money can fully solve the problem;
- exploration of the available funding options and their comparative costs and reliability;
- whether expenditure on funding has been optimized with other expenditure that will favorably influence the cost of the insurance arrangement (for example, expenditure on preventative practices and/or provision of relevant information to insurers)
and whether, alone or in combination with other funding methods the insurance arrangement -
- is the most efficient, and
- offers sufficient certainty that it will function as intended.
These considerations, while only briefly stated here, are utterly fundamental and yet seldom are considered explicitly from either a governance or senior management perspective.
Interestingly, even though fundamental, asking such questions does not require detailed technical knowledge even though answering them might. However, failure to ask these questions of those responsible for insurance selection and purchase could amount to a serious breach of a fiduciary duty.
Why the notion of insurance being a means of ‘risk transfer’ is a myth
As my co-author Grant Purdy and I explain in our book Deciding, the word ‘risk’ is problematic, as it has an almost infinite number of meanings and usages. But let’s, for now, treat it as meaning, simply, ‘a problem.’ So, the question becomes, is it a ‘myth’ to see insurance as a means of an organization transferring a problem to an insurance company?
And without doubt, the answer is yes! It is a myth. Although some of ‘the problem’ might (this qualification is important) now rest with the insurer (in return for the premium) some will not, either intentionally (for example that part expressly excluded in the wording of the policy), but also unintentionally. Indeed, as I will explain, irrespective of the policy wording, ultimately none of the problem might have gone anywhere!
I think the underlying reason for this ‘transfer’ misunderstanding is that so often the discussions around insurance take place through a mix of technical insurance language and jargon, of which, since about the seventies, the expression ‘risk transfer’ has become a highly used, yet completely unhelpful example of the latter.
I remember being on the ISO 31000 committee and arguing (successfully) for the replacement of the expression ‘transferring risk’ in the draft standard with ‘sharing’ risk. (Now, of course, I know that the word ‘risk’ is hopelessly compromised but I will park that discussion for the moment!)
Having gained a consensus to that change, one representative from a major first world country whose day job was providing insurance advice across the whole of its national public service angrily insisted that his objection to this change be noted in the minutes. He said: “This would cut across everything I have been teaching for 30 years!”
His problem, of course, was that he had mistaken jargon for knowledge and hadn’t thought about the realities of an insurance contract such as -
- The insurance policy is merely a legal promise – whether it is later kept by the insurer can never be certain as illustrated by some of the great historical insurance company failures. Even though some jurisdictions specify minimum liquidity obligations for insurers, it can be seen from the evaluations of the rating agencies that there are considerable differences between the assessed financial strength of insurers.
- Even with the most careful drafting, the actual effect of the words of the policy when applied to the facts and circumstances of a particular claim will only be known at the time of the claim and may either disappoint or at very least be contested with possible resolution only through expensive litigation and delay.
- Most insurance policies have bottom and top dollar limits as to what they will pay – i.e., at the bottom, a ‘deductible’ amount that is to be funded by the insured, and, at the top, a maximum limit, beyond which the policy will not pay. Clearly, the cost of losses outside those limits (which may not be properly understood anyway) remain with the insured party. Particularly for open-ended exposures, such as in liability (‘casualty’) insurance where there is likely no definitive limit to what can be sued for, or in business interruption insurance (which usually requires nomination of a finite period of interruption over which the policy will respond) there is considerable scope for errors of judgement.
- Insurers often prefer to avoid finding themselves with the whole of the insured egg in their basket and so seek to share their exposure with other insurers via either re-insurance or co-insurance. Whether they are successful in doing so might only be discovered later when a claim is made. While brokers can and sometimes do control which other insurers and reinsurers participate (and how the sharing is structured) ultimately multiple insurers mean multiple potential points of insolvency and thus inability to pay their share of claims.
- Insurers and reinsurers can also have different attitudes and practices in settling claims. Some are expeditious, others are tardy, recognizing, no doubt, that the longer the funds to be paid out remain in their own account, the greater the opportunity to earn interest. Tardiness and disputation are more likely if on becoming aware of the particulars of a claim, a reinsurer feels that their exposure was not properly explained to them at the time of being invited to participate. If reinsurance is arranged by the lead insurer (rather than by the insured or their broker) the insured might not know how their operations have been explained to the reinsurer – which is an argument for the insured or their adviser to control the reinsurance arrangements and flow of information to explain the nature of what is being insured. When there are complex claims, differences in the expertise of each of the insurers to understand and assess the claim can adversely affect progress of the claim.
- Although ‘loss adjusters’ (specialists who are engaged to determine liability and quantum of claims) are meant to act independently, the fact is that they are usually paid by the insurer which is why some insureds engage specialists of their own to verify and if necessary, challenge the judgements of the loss adjuster.
- As explained in Part 1 of this interview, insurance is arranged according to the doctrine of ‘utmost good faith’ (uberrimae fides) requiring honest disclosure of facts that are material to the decisions of the parties to enter into an insurance contract.
Hence, concealment, dishonesty or even negligent error can invalidate the ‘risk financing’ arrangements, especially if such failings are material to the facts of a claim. (For example, a failure to reveal the presence of explosives in an insured property that was not (say) an explosives factory, could invalidate a claim for an event in which the explosives significantly contributed to the damage).
The foregoing considerations explain why organizations should both explicitly and intuitively recognize that they are, at best, ‘sharing’ the ‘risk’ with their insurer(s). The same uncertainties, of course, apply to all forms of contract which seek to position liability, giving rise to the old expression ‘liability will lie where it falls’ (which might or might not be where intended!).
More generally, jargon is an obstacle that gets in the way of thinking clearly about risk financing. What key concepts or terms in risk financing, especially insurance purchasing, create the most confusion and what is a better way of thinking about such concepts or terms?
That’s an interesting question!
The extent of confusion rather depends on which participants in the provision and purchase of risk finance we are referring to. It is also necessary to differentiate between technical language, including those expressions with established legal meanings (e.g., ‘hold covered’) and loose yet ultimately meaningless jargon (such as ‘self-insurance’).
Technical language and abbreviations such as policy, cover, premium, PD, BI, casualty, sum insured, rate, ‘on risk’ excess, deductible, aggregate deductible, exclusions, extensions, layering, proportional participation, manuscript wordings, indemnity period, indemnity value, replacement value, agreed value, insurer, co-insurer, reinsurer, slip, cover note, underwriter, finite risk contracts, lead underwriter etc. are very functional for those involved in negotiating and effecting risk financing arrangements, and seldom give rise to confusion.
Indeed, in some insurance markets such as Lloyds of London, where only those who have formally demonstrated their mastery of Lloyds practices and conventions may operate, huge transactions are often completed by citing just brief labels or descriptors for standard clauses and conventions. At Lloyds, the particulars of the required insurances, the terms and proposed premium rate are summarized on a brief ‘slip’. The broker will use this to first seek the participation of a respected ‘lead’ underwriter with an interest in the type of thing being insured. Such participation is typically effected by the simple expedient of the underwriter recording the percentage being taken and notating the offer with their stamp. The broker will then approach others, inviting them to ‘follow the lead’ to achieve 100% at which point there is in effect, a legally binding contract. Typically, the actual policy wording will not be issued for several weeks (or longer) after the insurance has commenced.
Similar arrangements often apply in more conventional insurance markets with first the issue of a signed ‘cover note’ by which the insurance is incepted (based on negotiations) followed sometime later (excessively ‘later’, in some cases) by the actual policy wording.
All of this recognizes that for the purposes of effecting insurance transactions, established word forms which to non-practitioners can have the appearance of jargon, are in fact a very efficient, precise and effective means of communicating.
However, technical vocabulary is generally unsuitable for explaining or discussing risk financing arrangements with non-practitioners such as the organization’s senior managers or boards. What is required is an awareness on the part of practitioners of the unsuitability of their technical language for discussion with non-practitioners and the adoption, instead, of plain language. That is why increasingly, there is a move to plain language policy wordings. These were first seen in domestic type insurances such as those purchased by homeowners and motor vehicle owners, which are now written in the first and second person (e.g., ‘we’; ‘you’).
In relation to true ‘jargon’, I mentioned the expression ‘self-insurance’. However, if insurance involves ‘problem sharing’ (as per my earlier explanation), how can one ‘share’ a problem with oneself? What is usually being referred to as ‘self-insurance’ is the practice of simply expensing (i.e., paying) any costs incurred when an event has occurred that is not funded by the insurance policy. This occurs when all or some of the costs are lower than the ‘deductible’ (uninsured) component of the policy.
Even so, there are various risk financing arrangements that draw on the financial strength of the organization itself (sometimes with external reinsurance support) but are too complex to discuss here. Funding reserves, finite risk contracts and establishment of so-called ‘captive’ insurance companies (owned by the insured or, in a large conglomerate, by its parent corporation) are some examples.
HB 141:2011 cites the 9/11 attacks on the World Trade Center as an illustration of some of the risk financing principles that you earlier outlined. Please explain what you see as the lessons from that event.
This dreadful event was especially meaningful to me.
It claimed the lives of 298 colleagues of the firm for which I worked at the time - including one close friend. Years earlier however, as a special guest of the New York Fire Department, I had inspected the structural damage caused by the 1993 bombing attack and been briefed on the NYFD’s emergency response. Together with my fire engineering background, I was therefore able to quickly surmise from the 9/11 TV coverage, the mechanism through which the tower collapses occurred. It all seemed very personal.
As cited in the HB 141Handbook, the report by the Milken Institute on the 9/11 attacks on the World Trade Centre suggested that the direct and indirect costs of the attack exceeded US$70B in dollars of the day. To this figure must be added the enormous ongoing costs of aviation security and the subsequent War on Terror. The insured property loss alone was resolved at US$4.55B, with the insurance market also absorbing substantial casualty and other forms of insured loss. These losses became consolidated in the world’s major re-insurance markets leading to a flight of capital from those markets and immediate, upwards pressure on pricing to re-establish lost capacity. This illustrates the cyclical nature of insurance-based risk financing.
Other effects included:
- a requirement for improved understanding of the potential modes of failure of structures with a steel frame. Prior to the attack, the effects of a major fire fueled by vast volumes of aviation fuel and dislodgement of structural fire proofing due to aircraft impact do not seem to have been considered;
- much closer attention to what insurers call their ‘accumulation’ or, in other words, the total financial loss they could experience from multiple consequences of a single event;
- greater attention to policy wordings and the notion of an ‘occurrence’ and whether an attack in two waves each directed at a different yet commonly owned building was a single or multiple occurrence;
- greater urgency in issuing policy documentation following inception of the insurance program to reduce the potential (in the absence of such documentation) for different insurers to assert different interpretations of the wording on the slips in order to avoid litigation and other delays in settling claims;
- improved communication during the settling of claims between insurers and their re-insurers.
More widely, of course, the WTC tragedy brought added focus to the importance placed on contingency planning to minimize disruption and expedite recovery as well as more stringent building codes, better fire department command and control practices and personal protective equipment, and great changes to aviation security.
Here in the United States, insurance purchasing is often disconnected from the day-to-day activities that might fall under the umbrella of operations/enterprise risk management. We will focus on your new book on decision making in the next section but can you offer a few suggestions for bridging this gap?
You’ll appreciate by now that I don’t see any sense or utility in organizations having an ill-named silo called ‘enterprise risk management’, even though this is not uncommon. Indeed, in our book Deciding we describe such approaches as a ‘millstone’, and something to be dispensed with by the organization as quickly as possible! It is therefore a little difficult for me to respond directly to your question.
Nevertheless, in answer to the earlier questions, I have explained how ‘risk financing’ arrangements are inexorably linked to other activities and should, therefore be:
- designed and executed as part of a coordinated conceptual approach,
- consistent with the organization’s purpose; and
- overseen by its governance structures.
There are, therefore, two broad tasks:
- determining the need for, and selecting the method of, risk financing, and
- efficient and effective implementation of the selected and related strategies.
While HB 141 is aimed at broadening the understanding of all who are involved, these two broad tasks are distinctive. The first is strategic, which, given its direct connection with the survivability of the organization, is properly made at the highest level. The second is more technical with numerous operational interfaces and invariably involving diverse technical skill sets.
This suggests to me that it makes little sense to assign the task of selecting the risk financing strategy to a standalone silo or department, or even to an existing department such as finance. The better approach is to use a skilled, relatively independent ‘decision support’ type person, fully versed in the matters traversed by HB141, to oversee and drive the process by:
- developing an annual timetable (risk financing arrangements are typically arranged year on year);
- developing the strategy (in consultation with others including the CFO, CEO and board);
- assigning tasks (whether in-house or by external suppliers);
- facilitating and coordinating decision-making; and
- monitoring, reporting and verifying progress.
In large organizations, this person may need a small support staff, such as for the preparation of options papers, consultation with those dependent on or involved in related activity, and monitoring and reporting progress against the selected strategy.
NOTE HB 141:2011 Risk Financing Guidelines can be purchased online.