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Financial Institutions

Assessing Third Party Risk

Companies must assess the risks of vendors that provide critical operations or have access to customer information.
By: | October 21, 2014 • 4 min read
RMA Survey

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.

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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.

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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.

Katie Kuehner-Hebert is a freelance writer based in California. She has more than two decades of journalism experience and expertise in financial writing. She can be reached at riskletters@lrp.com.
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Supply Chain

An Eye on the Chain

Being a prompt payer insures against insolvency supply chain risk.
By: | October 15, 2014 • 6 min read
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Supply chain risk had been steadily escalating for the last few decades, but it took natural disasters in Japan and Thailand in 2011 to bring the true extent of the risk to the surface.

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In addition to the enormous financial and human losses suffered in those countries, businesses around the globe faced major disruption as key suppliers were wiped out and supply chains ground to a halt.

It was a harsh wake-up call.

“The events in Japan and Thailand really gave rise to a realization of how much greater the risk in people’s supply chains is today than 10 or 20 years ago,” said David Shillingford, senior vice president, supply chain solutions for Verisk Analytics.

“Supply chains have become more efficient — thinner, longer — but in many ways less resilient.”

Video: Supply chain risk management as discussed at the University of Bath.

In the automotive industry, for example, there are significant interdependencies regarding raw materials and parts. The Japanese tsunami wiped out essential component manufacturers and halted car production around the globe.

Meanwhile, added Shillingford: “Supply chain disruption in the pharmaceutical industry can be very costly because of the value of the ingredients, and in both pharmaceuticals and food there are evolving compliance risks to consider too.”

In fact, in today’s interconnected world, almost all industries are affected by supply chain risk. And as an increasing amount of production is farmed out to specialist manufacturers — often in emerging markets — risk is becoming more concentrated.

Sid Feagin, director, enterprise risk management, Aon Risk Solutions, noted that it is now common for firms across many industries to farm out 85 percent or more of their core product to a long chain of suppliers.

“In many cases the risks associated with this are uninsurable, which makes the management of supply chain risk paramount to the success of an organization,” he said.

A Lack of Visbility

However, gaining visibility into the risks of suppliers deep into a complex supply chain is extremely difficult, and many companies have turned to analytic software for help.

“A lot of businesses have a pretty good grip on their direct suppliers, but it’s the second, third, fourth tiers in their supply chains where there is a gap in knowledge and information and an accumulation of risk,” said Caroline Woolley, leader of Marsh’s global business interruption center of excellence.

Computer manufacturer Lenovo uses suppliers from all around the world. According to Mick Jones, the firm’s vice president of supply chain strategy worldwide, analytics have become an essential risk management tool in addition to improving business efficiency. So much so that the firm has created a role akin to a “chief analytics officer,” running analytics teams stationed around the world, he said.

Caroline Woolley, Leader, Global Business Interruption Center of Excellence, Marsh

Caroline Woolley, Leader, Global Business Interruption Center of Excellence, Marsh

“Analytics offers massive value to the business. We are at a start of the journey of using analytics to help us focus on risk. We are investing a lot of time in getting product visibility and order visibility along the entire supply chain, which is an area we can always improve on,” said Jones.

Jones explained that analytics have become essential given the volatile environment of the last five years characterized by natural disasters, socio-economic unrest and financial instability.

“The algorithms in the software are becoming more intuitive and intelligent, so you are able to do more with data and analytics,” he said.

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“In four years, we’ve moved from a very ‘descriptive’ analytics approach — reporting, scorecards, dashboards — through to a more ‘prescriptive’ approach, using simulation and optimization tools to almost predict what is going to happen going forward.”

However, meaningful data on supply chain risk is patchy because a great deal of supply chain risk is not insured and companies typically don’t keep detailed records of their losses. Such risk historically fell between the cracks as far as insurers were concerned, but the last decade has seen a number of specialist products emerge to protect companies against these risks.

“These losses were treated almost as operational risk, which was something companies had to deal with on daily basis, so they weren’t recorded,” said Woolley.

“As we are seeing more of these incidents and getting more data on the impact of supply chain risk, we are seeing a lot more interest in alternative supply chain policies.”

Shillingford said that analytics being developed by Verisk could make it easier for both companies and insurers to identify and calculate the impact of supplier risks more accurately.

“We want to encourage ‘risk-adjusted supply chain optimization.’ Often, supply chain optimization focuses only on efficiency, but we rarely hear people talk about risk and resiliency. In order to do that you have to put a value against the risk,” he said.

“The events in Japan and Thailand really gave rise to a realization of how much greater the risk in people’s supply chains is today than 10 or 20 years ago.”  — David Shillingford, senior vice president, supply chain solutions, Verisk Analytics.

“The chasm between the amount of risk not insured at the present time and the amount of capital available to be deployed to insure supply chain risk [results from a] lack of visibility into the risk. If we are able to provide that visibility it could be the biggest risk transfer opportunity of the next 10 years.”

Tracking Insolvency Risk

While data on weather or catastrophe-related supply chain losses is increasingly abundant, it is far more difficult to track the risk of insolvency within a supply chain in real time. The financial data of companies is released sporadically and can be incomplete. Given the precarious nature of the economy since 2008, the risk of suppliers going bust is very real.

“Insolvency is a significant risk but it may be near impossible to fully understand,” said Feagin. “The key to understanding whether a supplier is solvent or not comes down to access of information.

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“I see companies relying on various sources of information which may be too old or inaccurate to draw relevant conclusions from.”

According to Shillingford, while there are a variety of companies that offer services to assess financial strength, “each has a different methodology, usually expressed as a score, and all face similar challenges obtaining financial data for suppliers to their client’s suppliers.”

Indeed, the software industry has yet to develop an approach that can map solvency risk in real time.

Jones said that analytics play virtually no role in mitigating insolvency risk in Lenovo’s supply chain. “We deal with global suppliers who are based in many parts of the world and the data is difficult to get, but we do have a very sound supplier management approach that allows us to identify issues earlier and more collaboratively.”

Feagin said it’s crucial for companies to focus on their relationships with their suppliers, rather than just crunching numbers.

“In order to get these numbers you need to build up a relationship and trust with the suppliers. Without a strong relationship, you don’t have much power to gain information.

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“There is not a piece of software out there that can tell you whether or not to do business with a particular vendor — it comes down to taking a strategic and focused approach to managing supply chain risk.”

He also noted that companies add uncertainty to their supply chains by failing to pay their suppliers promptly.

“The greatest insurance [against insolvency risk in the supply chain] is being a prompt payer and having a good relationship with suppliers,” he said.

Antony Ireland is a London-based financial journalist. He can be reached at riskletters@lrp.com.
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Sponsored: Liberty International Underwriters

A Renaissance In U.S. Energy

Resurgence in the U.S. energy industry comes with unexpected risks and calls for a new approach.
By: | October 15, 2014 • 5 min read

SponsoredContent_LIU
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

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Robert Rokicki, Senior Vice President, Liberty International Underwriters

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

SponsoredContent_LIUCurrent 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.”

Buyer Beware

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.

SponsoredContent_LIU

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

SponsoredContent_LIUHas 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.

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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.


LIU is part of the Global Specialty Division of Liberty Mutual Insurance.
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