Assessing Third Party Risk
The financial services industry is in “high gear” to reassess third-party risk management practices in response to regulatory guidance.
Institutions are investing in technology to improve reporting and analytics, so that third-party risks are appropriately assessed and that controls are effective, according to the Third Party/Vendor Risk Management Survey, recently released by the Risk Management Association and sponsored by MetricStream.
It’s not just about assessing the risks from vendors and their subcontractors, but also affiliates, debt buyers, agents, channel partners, and correspondent banks, to name just a few third parties that banks and credit unions work with, said Edward DeMarco, RMA’s general counsel and director of operational risk/regulatory relations/communications.
Best practices are in “an evolutionary state,” DeMarco said.
“Prudent third-party risk management requires that the third party be risk-assessed in connection with the enterprise and not simply any one individual business line.” — Edward DeMarco, general counsel, Risk Management Association
“Multiple business lines and functional units within an institution might have their own special relationship with the same third party,” he said. “Prudent third-party risk management requires that the third party be risk-assessed in connection with the enterprise and not simply any one individual business line.”
Institutions are also increasingly putting pressure on to make sure third parties assess the risks of their own contractors, DeMarco said.
“For example, a bank might hire XYZ appraisal company, and that company might sub out to appraisal companies 1, 2, 3 and 4,” he said. “While the bank won’t require a report because they are not in control of those relationships, the banking company does expect its third party to assess their risks.”
Other survey findings include:
• Nearly 50 percent of the respondents said their institution’s risk management functions were responsible for oversight of vendor risk.
• More than 50 percent said their institutions send questionnaires to vendors for risk management purposes.
• Roughly one-third said they have more than 25 “enterprise critical” suppliers that have the potential to affect their entire organization in the event of a failure.
• More than 75 percent have in place a supplier code of conduct that suppliers must acknowledge.
Negotiations with third parties and vendors can be time consuming — and cyber insurance coverage is “an integral part” of those conversations. –Michael O’Connell, managing director and financial Institutions practice leader, Aon Risk Solutions.
Peter Foster, executive vice president and one of the leaders of the cyber risk group at Willis, said that many of his financial institution clients require their vendors to complete a Statement on Standards for Attestation Engagements (SSAE) No. 16, which is a guidance from the American Institute of Certified Public Accountants.
“But this is the minimal of what a vendor should be doing to demonstrate how they are protecting their systems,” Foster said.
“That report really doesn’t get deep into the weeds whether or not the security around the data or around operational applications is really secure.
“Financial institutions should take a step further with a set of questions or a physical audit of a vendor, particularly if the application is more critical to operations or contains customers’ personally identifiable information.”
Institutions should also require third parties to have a technology errors and omissions policy with cyber insurance built into the one policy, he said.
An institution should require third parties to name it as an “additional insured” and provide it with certificates of insurance to cover any disruptions, including liability to cover unauthorized access or unauthorized use of data.
An institution should also have coverage for vicarious liability and direct liability under its own cyber policy, which would cover a data breach resulting from outsourcing, Foster said. That way, the institution will be covered if its third party doesn’t have a policy or its policy doesn’t provide such coverage.
Such is often the case with cloud computing firms, he said.
“We recommend [third parties provide coverage] because it should be the first line of dense — the vendor who causes the breach should be paying for the breach,” Foster said. “But we’re also cognizant of the fact that many vendors will not provide that coverage and that the bank needs to use that vendor.”
Negotiations with third parties and vendors can be time consuming — and cyber insurance coverage is “an integral part” of those conversations, said Michael O’Connell, managing director and financial Institutions practice leader at Aon Risk Solutions.
“Also, a critical part of these discussions centers around who is liable for what part and how much of the loss, especially when there is a breach of confidential data,” he said.
From a risk management perspective, he recommended that vendor risk assessments include answers to these questions:
• Does the insurance fully cover the liability of the insured due to an incident caused by third-party providers?
• Are regulatory investigations, fines and penalties addressed?
• Are first-party business interruption and crisis management included within the cyber policies and are there full limits or sublimits?
“Additionally, the contingent business interruption component must include increased attention to the number and complexity of third-party relationships,” O’Connell said.
Firms must have a complete plan for loss mitigation, restitution, and a response to the potential reputational damage that may be caused, he said.
Legal Spotlight: October 1, 2014
Firms Given More Control Over Independent Counsel
Signal Products Inc. manufactured handbags and luggage using a design known as the “Quattro G Pattern executive in brown/beige colorways,” in accordance with its license from Guess? Inc.
In 2009, Gucci America Inc. filed suit against Guess?, Signal and others, claiming the design “infringed on a distinctive Gucci trade dress known as the ‘Diamond Motif Trade Dress.’ ” Signal’s share of the infringement claim was $1.8 million.
Signal filed suit in U.S. District Court in California after its insurers — American Zurich Insurance Co., which had issued a primary commercial general liability policy, and American Guarantee and Liability Insurance Co., which had issued an umbrella liability policy — refused to pay $1.9 million in defense costs.
Zurich countersued, seeking a summary judgment that it was not required to reimburse Signal for a $750,000 interim legal payment to the primary legal firm retained by Guess? (of a total $1.9 million in fees for Signal) or for $1.2 million in legal fees for a second law firm that represented Signal in the action.
The insurers argued they were not required to pay fees to the second law firm because Signal had already retained another law firm to represent it, and that the fees were not incurred in connection with Signal’s defense.
U.S. Judge Christina Snyder in August rejected requests from both sides for summary judgment, ruling more information was needed to determine reasonableness of legal fees and other “genuine issues of disputed material fact.”
However, she did rule, in this case of first impression, that Signal could use more than one law firm as independent counsel when there is a potential conflict of interest in insurance cases.
“Having accepted that multiple attorneys may serve as … counsel, there does not appear to be any principled grounds for requiring as a matter of law that all of those attorneys need to be employed at the same law firm,” she wrote.
Scorecard: The insurers may have to pay up to $1.2 million to the second of two law firms, in addition to possibly having to pay up to $1.9 million in litigation costs to the primary firm.
Takeaway: California law allows an insured to retain more than one law firm as independent counsel in an insurance dispute.
Attorneys’ Fees Not Included in Damages Exclusion
Both actions were settled by PNC: One in 2010 for $12 million — which included $3 million in attorneys’ fees, $77,857 in costs and expenses, and $15,000 toward incentive fees for the representative plaintiffs — and one in 2012 for $90 million, including $27 million for attorneys’ fees, $183,302 for reimbursement of costs, and $30,000 in plaintiffs’ incentive awards.
On May 21, a U.S. judge in the Western District of Pennsylvania recommended that the insurers cover the settlement costs. Both Houston Casualty Co. and Axis Insurance Co. had issued policies with a $25 million liability limit, subject to a $25 million retention.
In June, U.S. Judge Cathy Bissoon in that district disagreed. She ruled that the insurers were not responsible for the part of the settlements that returned overdraft fees to customers — since fees were excluded from the definition of “damages” in the policy.
Attorneys’ fees and costs totaling $30.3 million, she ruled, were not excluded. She ordered more proceedings on the claims expenses and damages.
Scorecard: Two insurers are responsible to cover up to $30.3 million for attorneys’ fees and costs that were included in settlements of two class-action lawsuits.
Takeaway: The fee exception to damages does not extend to the entirety of settlement costs, particularly attorneys’ fees, costs and incentive awards.
Underwriters Must Pay Recall Costs
When Abbott Laboratories agreed in December 2000 to acquire the global operations of Knoll Pharmaceutical Co., it notified its Lloyd’s of London carriers, in accordance with its product recall insurance coverage. That coverage stated the new entity would automatically be covered, but additional premiums would have to be negotiated.
As part of the negotiation with a group of underwriters led by Beazley and American Specialty Underwriters, Abbott indicated there was no “current situation, fact or circumstance” that would lead to a claim under the Accidental Contamination policy (which would include any government drug recalls).
A premium was eventually paid and accepted in July 2001, even after the company advised the underwriters that the U.S. Food and Drug Administration may pull Knoll’s popular thyroid drug Synthroid from the market.
The company and its underwriters did execute in October 2001 a “tolling agreement … that would allow the parties to preserve their rights with respect to any Synthroid-related claims.”
On March 6, 2002, the Italian Ministry of Health suspended all sales and marketing of sibutramine (manufactured by Knoll as Meridia).
Abbott filed a claim under the policy, and on May 16, 2003, the underwriters informed Abbott the tolling agreement was cancelled because Abbott “had not fully responded to their document and information request.” When it asked what information was needed, Abbott received no response.
On June 2, 2003, the underwriters filed suit to rescind the policy, while Abbott countersued for a declaratory judgment for coverage, breach of contract and “vexatious delay damages.”
A judge rejected the underwriters’ claim for recission, noting that the insurers had accepted the additional premium and that the Synthroid situation had been disclosed in a timely manner.
For damages, the court put the company’s losses at $155.2 million. Minus a deductible and 10 percent coinsurance, the underwriters were told to pay $84.5 million, plus about $2.8 million in costs and interest.
A three-judge panel on the Appellate Court of Illinois, First Judicial District, upheld that decision on appeal on July 28.
Scorecard: The underwriters have to pay $84.5 million plus $2.8 million in costs and interest.
Takeaway: By accepting the premium and failing to pursue issues of due diligence, the underwriters undercut their argument for a “material misrepresentation” by the company.
A Renaissance In U.S. Energy
America’s energy resurgence is one of the biggest economic game-changers in modern global history. Current technologies are extracting more oil and gas from shale, oil sands and beneath the ocean floor.
Domestic manufacturers once clamoring for more affordable fuels now have them. Breaking from its past role as a hungry energy importer, the U.S. is moving toward potentially becoming a major energy exporter.
“As the surge in domestic energy production becomes a game-changer, it’s time to change the game when it comes to both midstream and downstream energy risk management and risk transfer,” said Rob Rokicki, a New York-based senior vice president with Liberty International Underwriters (LIU) with 25 years of experience underwriting energy property risks around the globe.
Given the domino effect, whereby critical issues impact each other, today’s businesses and insurers can no longer look at challenges in isolation one issue at a time. A holistic, collaborative and integrated approach to minimizing risk and improving outcomes is called for instead.
Aging Infrastructure, Aging Personnel
The irony of the domestic energy surge is that just as the industry is poised to capitalize on the bonanza, its infrastructure is in serious need of improvement. Ten years ago, the domestic refining industry was declining, with much of the industry moving overseas. That decline was exacerbated by the Great Recession, meaning even less investment went into the domestic energy infrastructure, which is now facing a sudden upsurge in the volume of gas and oil it’s being called on to handle and process.
“We are in a renaissance for energy’s midstream and downstream business leading us to a critical point that no one predicted,” Rokicki said. “Plants that were once stranded assets have become diamonds based on their location. Plus, there was not a lot of new talent coming into the industry during that fallow period.”
In fact, according to a 2014 Manpower Inc. study, an aging workforce along with a lack of new talent and skills coming in is one of the largest threats facing the energy sector today. Other estimates show that during the next decade, approximately 50 percent of those working in the energy industry will be retiring. “So risk managers can now add concerns about an aging workforce to concerns about the aging infrastructure,” he said.
Increasing Frequency of Severity
Current financial factors have also contributed to a marked increase in frequency of severity losses in both the midstream and downstream energy sector. The costs associated with upgrades, debottlenecking and replacement of equipment, have increased significantly,” Rokicki said. For example, a small loss 10 years ago in the $1 million to $5 million ranges, is now increasing rapidly and could readily develop into a $20 million to $30 million loss.
Man-made disasters, such as fires and explosions that are linked to aging infrastructure and the decrease in experienced staff due to the aging workforce, play a big part. The location of energy midstream and downstream facilities has added to the underwriting risk.
“When you look at energy plants, they tend to be located around rivers, near ports, or near a harbor. These assets are susceptible to flood and storm surge exposure from a natural catastrophe standpoint. We are seeing greater concentrations of assets located in areas that are highly exposed to natural catastrophe perils,” Rokicki explained.
“A hurricane thirty years ago would affect fewer installations then a storm does today. This increases aggregation and the magnitude for potential loss.”
On its own, the domestic energy bonanza presents complex risk management challenges.
However, gradual changes to insurance coverage for both midstream and downstream energy have complicated the situation further. Broadening coverage over the decades by downstream energy carriers has led to greater uncertainty in adjusting claims.
A combination of the downturn in domestic energy production, the recession and soft insurance market cycles meant greatly increased competition from carriers and resulted in the writing of untested policy language.
In effect, the industry went from an environment of tested policy language and structure to vague and ambiguous policy language.
Keep in mind that no one carrier has the capacity to underwrite a $3 billion oil refinery. Each insurance program has many carriers that subscribe and share the risk, with each carrier potentially participating on differential terms.
“Achieving clarity in the policy language is getting very complicated and potentially detrimental,” Rokicki said.
Back to Basics
Has the time come for a reset?
Rokicki proposes getting back to basics with both midstream and downstream energy risk management and risk transfer.
He recommends that the insured, the broker, and the carrier’s underwriter, engineer and claims executive sit down and make sure they are all on the same page about coverage terms and conditions.
It’s something the industry used to do and got away from, but needs to get back to.
“Having a claims person involved with policy wording before a loss is of the utmost importance,” Rokicki said, “because that claims executive can best explain to the insured what they can expect from policy coverage prior to any loss, eliminating the frustration of interpreting today’s policy wording.”
As well, having an engineer and underwriter working on the team with dual accountability and responsibility can be invaluable, often leading to innovative coverage solutions for clients as a result of close collaboration.
According to Rokicki, the best time to have this collaborative discussion is at the mid-point in a policy year. For a property policy that runs from July 1 through June 30, for example, the meeting should happen in December or January. If underwriters try to discuss policy-wording concerns during the renewal period on their own, the process tends to get overshadowed by the negotiations centered around premiums.
After a loss occurs is not the best time to find out everyone was thinking differently about the coverage,” he said.
Changes in both the energy and insurance markets require a new approach to minimizing risk. A more holistic, less siloed approach is called for in today’s climate. Carriers need to conduct more complex analysis across multiple measures and have in-depth conversations with brokers and insureds to create a better understanding and collectively develop the best solutions. LIU’s integrated business approach utilizing underwriters, engineers and claims executives provides a solid platform for realizing success in this new and ever-changing energy environment.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Liberty International Underwriters. The editorial staff of Risk & Insurance had no role in its preparation.