Operational Risk

There’s rather a good article over at Risk & Insurance today about the desirability of not underestimating operational risk in the context of insurance and reinsurance companies.

>U.S. regulators worry about capital adequacy, of course, but in general have paid less attention to the underlying operational risks. One reason may have to do with the distinctive nature of operational risks — they are often hard to define and difficult to quantify. Operational risks sometimes fall into a gray area in which they are overlooked or treated as a “normal” risk, such as an underwriting risk. For example, how does an insurer classify coverage that it may not have intended to provide?

Quite. And how many times does that happen? Too often for comfort, in my experience.

The article goes on to focus precisely on the ways in which such risks tend to arise:

* **Brokers & MGAs**: “*A significant potential source of operational risk results from the use of third parties — brokers, for example.*” And MGAs, as the authors go on to mention in the case of Unicover, where non-experienced carriers (life assurers in that case) entrusted their fortunes to agents who had an inherent potential conflict of interest, in that their own commissions were fixed by reference to the amount of business – good, bad or indifferent – that they wrote on behalf of their principals.
* **Deficient outwards reinsurance**: who (apart from the brokers) knows who stands where in a long chain of contracts. And who can say where the weak link will be. Can’t pay and Won’t pay problems can arise, causing a ripple effect downstream.
* **Ratings agencies**: They cut your rating, you attract less business, your rating declines further, etc etc
* **Litigation**: Insurance is litigious and all litigation is more-or-less risky. The”*reinterpretation of contract language by U.S. courts in the 1980s as to whether environmental claims were covered by commercial liability policies led to the industry paying out billions of dollars that were not anticipated in pricing. The demise of Equitable Life in the United Kingdom, one of the country’s oldest and most venerable institutions, turned on a House of Lord’s decision about the company’s liability under guaranteed annuity policies sold over a period of 30 years.*”

My old boss, Ken Louw, that sagest of men and a veritable Silenus, used to say to me over a pint in the Gun that there were only about 6 or 7 “issues” in reinsurance and that these tended to recur on a cyclical basis as people forgot about them. This money quote from the R&I article, in turn citing the FT, echoes that appraisal:
>The Financial Times once listed factors behind the demise of a U.K. insurance company — the dominant chief executive, heady expansion by an upstart company in a cutthroat market, self-delusion about the strength of the company and questionable accounting. It cited the factors in two insurance company failures separated by 30 years. These risks are systemic in the insurance industry, and they will surely present themselves again in the future.