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Risk Scenario

It Happened Here

An ill-advised merger sparks shareholder lawsuits and major losses.
By: | April 22, 2014 • 8 min read
Risk Scenarios are created by Risk & Insurance editors along with leading industry partners. The hypothetical, yet realistic stories, showcase emerging risks that can result in significant losses if not properly addressed.

Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.

A Promising Prospect

Hal Landis walked into the boardroom at Stratton Bank headquarters in Chesapeake, Va. with a glow building inside of him.

Scenario_ItHappenedHere

The chairman and CEO of the bank, he carried in his briefcase paperwork that detailed the possible acquisition of Stratton by Manhattan-based Global Corp.

Global Corp., with about $100 billion in assets, liked the look of the mid-sized Stratton, which held about $30 billion in assets.

With its roots as a lender to the conservative farmers and fishermen of the Middle Atlantic, Stratton had a reputation for producing modest, steady returns and never taking unnecessary risks.

“Shall we get started everyone?” Landis said with a confident grin.

At 63, Landis was in good shape physically and financially, and with what Global was offering on a per-share basis, he couldn’t help but fantasize about the sort of retirement he might now be able to afford if this deal went through.

Scenario_Aon

Scenario Partner

Two hours later, the rest of the board of directors was won over. They voted to accept Global’s offer, conditional on the approval of that corporation’s board of directors.

The Global board meeting to discuss the Stratton acquisition did not go quite as smoothly.

The audit committee had barely completed its report on Stratton’s financials when Augie Desmond, a junior staffer in the bank’s risk management department, spoke up.

“Mr. Bedford,” Desmond began, addressing the bank’s chairman, the formidable Alan Bedford.

Eyebrows were raised. It wasn’t common for junior employees to punctuate Global meetings with unsolicited remarks or questions.

“Nice working with you kid,” the CFO said to himself.

“Yes, Mr. …” Bedford began.

“Desmond, sir, Augie Desmond, from risk management,” Desmond said.

“Yes, Mr. Desmond?” Bedford said, throwing a questioning look at Desmond’s boss, CRO John Fairmount.

“I have serious concerns about this acquisition, sir,” Desmond said.

“There was a piece in the Journal today on a steam-generating solar plant in Nevada,” Desmond said.

Fairmount shot Desmond a look.

“Sorry John,” Desmond said. “I didn’t have time to tell you.”

Desmond continued.

“According to a report from Stanford, the heat from the plant is killing wildlife — lots of it — including the state bird,” Desmond said.

“Wha….?” Bedford began.

“The solar company, Daedalus, is based in Virginia,” Desmond said. “Stratton is the primary advisor on the company’s upcoming IPO. Daedalus is applying for a second permit, an even bigger plant with about $30 million in investment. If the politicians get hold of this thing, and they will …”

“What thing?” Bedford said.

“The bluebird thing sir, that’s the state bird. If this second plant application goes south, that solar company is at serious risk and so is Stratton — I don’t like it sir … I don’t like it one bit.”

“Mr. Desmond what is your background?” Bedford asked.

“I have a Master’s Degree in astrophysics from MIT,” Desmond said.

“And how long have you been in the banking industry?” Bradford said.

“Three months sir,” Desmond said.

“I’ll take that under advisement,” Bedford said.

Without much further debate, they followed the recommendation of the audit committee and approved the Stratton acquisition.

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Nevada Down

The meeting of the Stratton Bank stockholders to vote on the approval of the Global Corp. offer was held in the conference rooms at the Chesapeake Madison Hotel. Before the vote, the floor was opened up for discussion.

Scenario_ItHappenedHere

As he was at every meeting, Smitty Ackles, a shareholder and crabber from Havre de Grace, was first to the mike.

With his enormous gut protruding from between the bands of his cherry red suspenders, Ackles stood at the mike, smiling with wizened eyes at Hal Landis.

“Good afternoon, Mr. Landis,” Smitty said.

“Good afternoon, Mr. Ackles,” Landis said in what the audience recognizes as their standard opening schtick.

There are chuckles throughout the room.

“What I’d like to know, Mr. Landis, is why in the world the shareholders should accept this deal? We have been doin’ alright for 35 years, nobody’s complainin’ about their returns. Why do it?”

“Well, a 20 percent premium on our shares is one reason,” Landis said.

“Not worth it,” countered Ackles. “These boys from New York will bring more trouble than they’re worth, I guarantee you.”

“I’ve known you since you were a boy, Hal Landis, and I’m here to tell you, you’re making a mistake,” Smitty said before ambling away from the mike.

There are more chuckles, but nobody really listens to Smitty. Stratton shareholders approve the deal 2,010 to 15.

Not even a week later, the Nevada Department of Environmental Protection issues a surprise ruling that condemns the second Daedalus plant.

A study from the University of Nevada confirms what the Stanford researchers found. The plant is linked to the deaths of 1,000 Mountain Bluebirds, the state bird. Deaths of other birds number in multiples of that.

Geddy Hayes, an influential Nevada State Senator from Sparks, picked up the football and ran with it. Hayes, a gifted speaker, worked his magic from the Senate floor and killed any remaining chance the second Daedalus plant had.

The application for the plant, which the solar company spent millions on, went under.

Hayes wasn’t done with Daedalus. He pressured state regulators into burdening the existing plant with new regulations — to the point that it began to lose money.

On a Monday afternoon, Hal Landis sat in his office with CFO Dylan Reed, watching a cable news financial report.

The Daedalus IPO launched the previous week and did fairly well, with the share price rising 17 percent by week’s end. The following week was a different story.

Losses suffered by the Daedalus plant are being reported, along with the losses from the failed application for the second plant.

One week after the IPO launch, Daedalus shares are down 30 percent and are in freefall.

“How bad do you think this is for us?” Landis asked Reed.

“I don’t know, I’ve never been in this position before,” Reed said.

“None of us have,” Landis said.

Within two days, Stratton is set upon in a class action by attorneys for disgruntled Daedalus shareholders, who report millions in investment losses.

Poll Question

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Damages

The acquisition of Stratton by Global is set to close in the third quarter. In its second quarter financials, Stratton reports a multimillion dollar write down in connection with the Daedalus fiasco.

Scenario_ItHappenedHere

Weakened by the reputational hit of the Daedalus shareholder class actions, Stratton also begins to notice some alarming revenue declines.

This time, at the Global board meeting where the decision to follow through on the Stratton acquisition will be made, it’s Augie Desmond’s boss, John Fairmount, who speaks first for the risk management department.

“Mr. Bradford, it’s our opinion that we should absorb any frictional costs and abandon this acquisition,” Fairmount said.

“Based on what data?” asked Global’s CFO, Daniel Silberstein, who championed the acquisition from day one.

Fairmount turned to Desmond.

“We’ve run an algorithm that ties share price to reputational damage. Call it a reputational risk index, if you will,” Desmond said.

“Based on what we’re seeing with Stratton, we see share price deterioration tied to reputational problems plaguing the bank for at least the next six quarters,” Desmond said.

Bradford shot Fairmount a look that said, “Again with this kid?”

Bradford and Silberstein aren’t swayed. They like Stratton’s basic book of business a lot. The bank hasn’t had a quarter in 20 years when it didn’t return a dividend.

Global’s board votes 13 to 4 to go ahead with the acquisition.

In the first six months following the acquisition year, Stratton shows a revenue decline of 20 percent over the previous year.

The solar deal in Nevada that went sour is poisoning the bank’s brand with its largely conservative retail banking customers.

A sizable chunk of Global shareholders are fed up. Rather than start an internecine war with their own management, they take action against Stratton.

The allegations are that Stratton failed to disclose the risk of the Daedalus exposure to the Global board and bungled the crisis management of the failed IPO.

———-

Two years ago, if you’d asked Hal Landis who his insurance broker was, he couldn’t have told you. Now he knows him very well.

“You have $10 million in general liability coverage,” the broker explained to Landis over the phone.

“Right,” Landis said.

“Between the Daedalus IPO shareholder actions and the Global shareholder actions, you’re looking at $15 million in potential liability,” the broker said.

“Do you see any indications that your own shareholders could take action against the board?” he asked.

“Not to date,” Landis said.

“You have that much in your favor,” he said. “For the time being.”

“Well, we can self-insure the $5 million on top of the policy if we have to,” Landis said.

“Sure,” the broker said. “But I can’t think of an admitted carrier who will even talk to us next year.”

“What’s an admitted carrier?” Landis said.

“It’s a carrier who’s not going to charge you your right arm in premium,” said the broker.

No longer fantasizing about a rosy retirement, Landis wonders how long he’ll have a job.

Poll Question

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Bar-Lessons-Learned---Partner's-Content-V1b

Risk & Insurance partnered with Aon to produce this scenario. Below are Aon’s recommendations on how to prevent the losses presented in the scenario. These lessons learned are not the editorial opinion of Risk & Insurance.

1. Risk management requires an open mind: Ignoring stakeholders that voice legitimate concerns carries a double-edged risk. The first risk is the magnitude of the exposure brought up by a colleague or shareholder that’s being overlooked. The second is the fact that an issue was raised publicly, thereby documenting a concern that went unheeded by management.

2. Risk by association: Operational risk is such a pressing risk for financial institutions in part because of the number and variety of business partners and clients they take on as part of their basic operation. An inadequate knowledge of the technology, practices and risk exposures of any given business partner can result in reputational and other damages should that business partner fail or incur a sizable liability.

3. Transparency: Companies that fail to properly assess their risk and report it to business partners face increasingly painful regulatory sanctions. A blunt assessment of an organization’s exposures is the first step in that process. Being forthright in communicating risk factors is the second.

4. Analyze cover: Regulatory pressures and a rapidly changing business environment necessitate that financial institutions assess their insurance coverage more frequently than ever before.

5. Risk management is a process, not a program: There is nothing static about risk management. New processes, products and distribution channels in the financial services industry mean that the nature of operational risk is changing constantly. Risk management needs to keep pace with that change or risk losing relevance and value.

Partner Resources

Operational Risk Solutions

Regulation and the Financial Industry



Dan Reynolds is editor-in-chief of Risk & Insurance. He can be reached at dreynolds@lrp.com.
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Crisis Management

Target as Target

Risk experts grade Target's efforts to manage the reputation damage caused by the data breach.
By: | February 3, 2014 • 4 min read
TargetV1

After fumbling its initial response to a massive data breach, Target Corp. has rebounded, according to experts in crisis management.

However, they said, the retailer still faces challenges in regaining consumer confidence, especially among people directly harmed by the cyber attack, which struck at the height of the holiday shopping season.

In late November and early December, malware lodged in the retailer’s point-of-sale system siphoned off account and personal information for up to 110 million customers. But Minneapolis-based Target is not the only company that may have been struck. Luxury retailer Neiman Marcus suffered a smaller breach, and news reports suggest at least six other retailers have been hit. These other companies likely are keeping a close eye on Target’s handling of the crisis.

Critics have focused, in part, on the company’s early communications. Target appeared initially to underestimate the gravity of the situation, crisis consultants said. For example, Target’s first message to customers apologized for the inconvenience.

“You don’t call something like this an inconvenience,” said Rich Klein, a crisis management consultant in New York City.

Initial email (truncated) sent by Target on 12/19/2013. The original email included an additional 4 pages of information.

Initial email (truncated) sent by Target on 12/19/2013. The original email included an additional 4 pages of information.

Subsequent messages from Target used stronger language, acknowledging customers’ stress and anxiety, he said. Messages also switched from assuming customer confidence to promising to regain it, Klein added, praising the change.

“I would still say it’s so much better to get it right the first time,” he said.

2nd email to guests, 12/20/2013.

2nd email to guests, 12/20/2013.

Still, he added, the company made good use of its Twitter feed and Facebook page. Facebook, for example, was used only to communicate about the breach, not to advertise sales, though it also acted as something of a lightning rod for complaints.

Consultants also panned the company’s decision to extend a 10 percent discount to shoppers during the weekend of Dec. 21, a few days after news of the breach first surfaced. While the discount was a nice gesture, it did not adequately address customer concerns and seemed to suggest the crisis had passed, consultants said.

In addition, the company has occasionally appeared to be behind the news, with information trickling out in the media before being revealed by Target, said Jeff Jubelirer, vice president of Philadelphia-based Bellevue Communications Group. “We should expect more from a retailer of that size and that reputation and that level of success.”

A key turning point came on Jan.13 when the company’s CEO, Gregg Steinhafel, appeared on CNBC, apologizing for the breach, reassuring customers and defending the company’s reaction:

Steinhafel should have been giving interviews in December, said Jonathan Bernstein, an independent crisis management consultant in Los Angeles. “They would have suffered less loss of sales and less impact on their stock value if they had been more assertive from the get-go.”

Other observers gave Target high marks for making a relatively quick disclosure of the breach and offering a free year of credit monitoring to customers. The four-day gap between discovery of the breach on Dec. 15 and public disclosure on Dec. 19 was faster than it’s been in other cases, said Alysa Hutnik, an attorney in the Washington, D.C. office of Kelley Drye.

“I haven’t done the math, but I think that would rate somewhere at the very top,” said Hutnik, who specializes in cyber security issues.

Another high point is the prominent role of Target’s CEO, Hutnik said. “He knows there’s work to be done to earn back customer trust, and it looks like he is taking that obligation seriously,” she said, noting that top executives rarely serve as public faces after a data breach.

Other positive steps include Target’s $5 million investment in cyber security education said Michael Soza, a partner in accounting and consulting firm BDO.

“This latest move … is really going on the offensive to show that they really are trying to get out in front of this thing and really attack what is not just a Target problem,” Soza said.

As long as no other damaging details leak out, most customers will remain loyal to the chain, said Daniel Korschun, an assistant professor of marketing at Drexel University in Philadelphia.

But the company will have to work harder to win back customers who suffered directly. They will be hard to find and hard to soothe, especially if they’ve had to spend hours on the phone undoing damage to their credit or bank accounts.

“Those are the ones where the trust has really been lost,” Korschun said.

Joel Berg is a freelance writer and adjunct writing teacher based in York, Pa. He has covered business and regulatory issues. He can be reached at riskletters@lrp.com.
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Sponsored: Lexington Insurance

What Is Insurance Innovation?

When it comes to E&S insurance, innovation is best defined as equal parts creativity and speed.
By: | April 7, 2014 • 4 min read

SponsoredContent_LexingtonTruly innovative insurance solutions are delivered in real time, as the needs of businesses change and the nature of risk evolves.

Lexington Insurance exemplifies this approach to innovation. Creative products driven by speed to market are at the core of the insurer’s culture, reputation and strategic direction, according to Matthew Power, executive vice president and head of strategic development at Lexington, an AIG Company and the leading U.S.-based surplus lines insurer.

“The excess and surplus lines sector is in a growth mode due, in no small part, to the speed at which our insureds’ underlying business models are changing,” Power said. “Tomorrow’s winning companies are those being built upon true breakthrough innovation, with a strong focus on agility and speed to market.”

To boost its innovation potential, for example, Lexington has launched a new crowdsourcing strategy. The company’s “Innovation Boot Camps” bring people together from the U.S., Canada, Bermuda and London in a series of engagements focused on identifying potential waves of change and market needs on the coverage horizon.

“Employees work in teams to determine how insurance can play a vital role in increasing the success odds of new markets and customers,” Power said. “That means anticipating needs and quickly delivering programs to meet them.”

An example: Working in tandem with the AIG Science team – another collaboration focused on innovation – Lexington is looking to offer an advanced high-tech seating system in the truck cabs of some of its long-haul trucking customers. The goal is to reduce driver injury and fatigue-based accidents.

SponsoredContent_Lexington“Our professionals serving the healthcare market average more than twenty years of industry experience. That includes attorneys and clinicians combining in a defense-oriented claims approach and collaborating with insureds in this fast-moving market segment. At Lexington, our relentless focus on innovation enables us to take on the risk so our clients can take on the opportunities.”
– Matthew Power, Executive Vice President and Head of Regional Development, Lexington Insurance Company

Power explained that exciting growth areas such as robotics, nanotechnology and driverless cars, among others, require highly customized commercial insurance solutions that often can be delivered only by excess and surplus lines underwriters.

“Being non-admitted, our freedom of rate and form allows us to be nimble, and that’s very important to our clients,” he said. “We have an established track record of reacting quickly to trends and market needs.”

Lexington is a leading provider of personal lines coverage for the excess and surplus lines industry and, as Power explains, the company’s suite of product offerings has continued to evolve in the wake of changing customer needs. “Our personal lines team has developed a robust product offering that considers issues like sustainable building, energy efficiency, and cyber liability.”

Most recently the company launched Evacuation Response, a specialty coverage designed to reimburse Lexington personal lines customers for costs associated with government mandated evacuations. “These evacuation scenarios have becoming increasingly commonplace in the wake of recent extreme weather events, and this coverage protects insured families against the associated costs of transportation and temporary housing.

The company also has followed the emerging cap and trade legislation in California, which has created an active carbon trading market throughout the state. “Our new Carbon ODS product provides real property protection for sequestered ozone depleting substances, while our CarbonCover Design Confirm product insures those engineering firms actively verifying and valuing active trades.” Lexington has also begun to insure new Carbon Registries as they are established in markets across the country.

Lexington has also developed a number of new product offerings within the Healthcare space. The Affordable Care Act has brought an increased focus on the continuum of care and clinical patient safety. In response, Lexington has created special programs for a wide range of entities, as the fast-changing healthcare industry includes a range of specialized services, including home healthcare, imaging centers (X-ray, MRI, PET–CT scans), EMT/ambulances, medical laboratories, outpatient primary care/urgent care centers, ambulatory surgery centers and Medical rehabilitation facilities.

“The excess and surplus lines sector is in growth mode due, in no small part, to the speed at which our insureds’ underlying business models are changing,” Power said.

Apart from its coverage flexibility, Lexington offers this segment monthly webcasts, bi-monthly conference calls and newsletters on key risk issues and educational topics. It also provides on-site risk consultation (for qualifying accounts), access to RiskTool, Lexington’s web-based healthcare risk management and patient safety resource, and a technical staff consisting of more than 60 members dedicated solely to healthcare-related claims.

“Our professionals serving the healthcare market average more than twenty years of industry experience,” Power said. “That includes attorneys and clinicians combining in a defense-oriented claims approach and collaborating with insureds in this fast-moving market segment.”

Power concluded, “At Lexington, our relentless focus on innovation enables us to take on the risk so our clients can take on the opportunities.”

This article was produced by Lexington Insurance Company and not the Risk & Insurance® editorial team.

Lexington Insurance Company, an AIG Company, is the leading U.S.-based surplus lines insurer.
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