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For hundreds of years, companies have relied on insurance to mitigate most risks. Ever since underwriters first started insuring ships in London in the 17th century, insurance has been the primary risk management solution. However, as the risk climate in the world changes at an ever-increasing rate, this era is drawing to an end. Especially for companies with the largest and most complex risks, the insurance option is under pressure that makes it increasingly irrelevant.

What are the forces at work that are changing the role of insurance in risk? First is the huge increase in the magnitude of catastrophic losses. Insurance always provided coverage for what were considered to be the big exposures. These exposures tended to be natural disasters, but not always. In the past five years, however, the concept of catastrophe has been redefined. Directors' and officers' lawsuits, intellectual-property battles and product liability issues often easily exceed the damage done by a fire. Shifting political winds in countries that manufacture many of our goods or provide key natural resources can translate into huge losses, sometimes overnight. As global companies become more vulnerable to outsourced customer and research operations, miscommunication and political change can cost far more than the typical large liability claims of the past. Increasingly, the risks that keep CEOs awake at night are considered by the insurance carriers to be "uninsurable."

"Windstorm (coverage) in the Gulf for oil platforms is not there at commercial rates so far this year, so the oil companies will go bare it seems," says an executive at a large broker, referring to exposures in the Gulf of Mexico. "I think we are spreading the risk a gallon at a time."

There are also contractions in capacity in other areas. After Sept. 11, 2001, most insurers eliminated or restricted coverage for terrorist-type acts and looked to a government-backed solution to lessen the exposure.

Though the concept of third parties doing intentional harm to property was nothing new--vandalism coverage had long been a part of property policies, for example, and the Oklahoma City bombing inspired no such universal contraction of coverage--once a truly large loss hit, insurers immediately called for a terrorism exclusion and suggested that only the government could, or should, provide coverage for acts of terrorism. This meant a quick and broad contraction of capacity for exactly the type of loss that insureds most need coverage for.

Likewise, after a bad hurricane season in 2005, many in the insurance industry, though not all, suggested that windstorm should be covered by the federal government.

California quake coverage falls into the same category. California quake is not a newly emerging hazard, having been widely acknowledged.

George Redenbaugh, assistant treasurer, enterprise risk and cash management, at eBay, even sees insufficient capacity in errors and omissions, directors' and officers', and intellectual-property lines as well.

The trend seems to be for the insurance companies to pull capacity out of the high-risk areas where they could suffer very large losses. Because this is precisely where large companies want to apply risk transfer, there is a discrepancy between market demand and supply.

Terrorism coverage was virtually unobtainable for the recent FIFA World Cup, for example. FIFA was able to obtain a CAT bond for a fraction of the cost that the sole insurer was willing to provide coverage.

There is also a tremendous discrepancy between capacity and need. In large part, this is driven by the widening chasm between the value of the markets and the amount of total global capacity. For example, it is widely accepted that total global capacity in the property/casualty markets is somewhere between $300 billion and $400 billion. By contrast, the Economist puts the total value of the derivative market at just under $300 trillion. BusinessWeek recently published an article stating that the total value of private homes in the United States, excluding mortgages, has increased $1.5 trillion in the last year alone, and that the value of the taxable mutual fund markets alone is $1.7 trillion.

Insurance might very well be unable to cover catastrophic losses, not because of a loss of appetite for risk, but because business, and often personal exposure, is growing faster than global insurance capacity.

In this environment, risk managers are forced to look elsewhere for solutions to the exposures they face. "For a small but growing number of companies the risks are evaluated, analyzed, modeled and all alternatives are sought, including, but not limited to, insurance," says Lance Ewing, vice president of risk management at Harrah's Entertainment. "These companies have or are coming to the realization that insurance may not protect as well as other options, including self-insurance, risk retention groups, captives, derivatives, hedging or other risk alternatives."

Fancy the contradiction: While carriers are shrinking from the marketplace, their market could be turning away from insurance permanently.

As insurance carriers pull away from the markets with the highest exposure, the issue of capacity has become an issue in regard to the materiality threshold. Insurance limits are becoming immaterial in relation to the size of the risks faced.

For example, if a company has a $2 billion exposure to loss from product liability, but the market capacity is only $250 million, purchasing insurance coverage might not make any sense.

Likewise, if the company considers losses under $500 million to be below the materiality threshold, insuring the exposure makes no sense. "The key question is what financial result is now 'material' to an organization," says Felix Kloman, retired partner with Towers Perrin. "If what insurance offers is less than that number, then why waste the time involved to arrange these policies, most of which are inefficient (less that 65 percent of premium goes to claims payment), and slow/no/partial payment devices that seldom meet current conditions."

Materiality tends to go up over time. If capacity is going down, then insurability matters less to senior management.

A PRECEDENT

There is precedent for this type of shift in the market, according to Pat Gallagher, CEO of broker Arthur J. Gallagher. "In 1960, Bill Karnes, founder of Beatrice Foods, realized that if he gave the insurers $100, they could only pay back $65 and remain profitable," says Gallagher. "So he asked us to create what was really the first large retention of $100,000. It was a radical solution at the time, but now it is the norm for large companies. In essence, the market for the first-dollar coverage all but disappeared."

The same shift could come about with large insureds. "When you get to be a certain size, risk transfer requires a whole different way of thinking, and there is not enough capacity," Gallagher says.

The value of insurance to publicly traded companies is diminishing in another way. Insurance was supposed to prevent a market capitalization decline. The theory was that a large uninsured loss would send a message to the market that the company was not run well. The thinking was that every prudently managed company insured all of its big risks. That's not the case today. The market has changed its mind. Companies are no longer getting punished for one-time events with uninsured losses. Bill Kelly, past president of the Risk & Insurance Management Society and president of WJK Advisory, recalls an example from his days in the banking industry.

"The company I worked for talked about CAT losses as being $500 million. However, in one day we wrote off $2.1 billion in Latin American debt. The stock went up. The Street was just glad that the risk was gone," he says.

But the shrinking insurance market doesn't affect just the Fortune 500. Smaller companies are starting to abandon the market as well. Conventional wisdom would have you believe that large companies have the financial wherewithal to create captives and to self-insure. Smaller companies, so the argument goes, must buy insurance because they lack the resources to create alternatives to pure risk transfer like insurance. A Fortune 500 company can put $20 million dollars into a captive while a five-person company cannot.

This conventional wisdom might be inaccurate, though. "The low end of the market has already stopped buying insurance," says eBay's Redenbaugh. According to him, price pressure is the main driver of the smaller company's choice whether to purchase insurance or not. In today's global market, that price pressure is so fierce that "faced with pricing pressure from low-cost suppliers in India and China, small companies often have no choice but to cut their insurance spending just to remain competitive on price. Their overseas competitors are not buying insurance; how can they compete?"

They only have two choices: pass the costs on to the customer and become less competitively priced, or simply go uninsured like the competition.

But it is not just the size of the insurance-buying market that is at stake here. The buyers of insurance might also find that they are on a sinking ship. The forces that cause a decline in the perceived value of insurance as a risk management solution also erode the value of the insurance-buying risk manager.

"Insurance will play a smaller role and, as that happens, insurance-oriented risk managers will be seen as a clerical function," Redenbaugh says. "If the value of the product continues to narrow, so will the value of the person who buys it."

For the executive level of management, the big risks are increasingly operational and strategic. The introduction of enterprise risk management has redefined the types of risks that risk managers must address. This environment demands a change in the role of the risk manager.

"Many times, in our profession, we not only resist change but run away from it. The paradigm is changing as to how the role of the risk management professional evolves. Those that rely too heavily on their broker for insurance purchasing only, or cannot provide new ideas to meet the changes, are doomed to the fate of the dinosaurs," says Ewing.

If risk managers do not begin to better align themselves with the demands of business and the expectations of senior management, they might not have a position for long.

Risk managers must look at the entire portfolio of risks that face their companies and also consider all of the potential solutions available. This requires closer and more frequent contact with senior leadership and an up-to-date knowledge of what obstacles lie in the road to successful completion of corporate objectives.

Insurance is only one such solution, so a working knowledge of the financial and operational risk treatment alternatives--such as business-continuity planning, risk quantification and analysis, self-funding, captives and capital markets--must become part of the risk managers toolbox.

In the face of large catastrophic losses, the instinct is often to seek safety; for risk managers, this often comes in the form of insurance. For insurance carriers safety comes by pulling capacity out of high-risk areas. Risk management has reached a sufficient level of sophistication that there are readily available solutions to fill the gaps left by the fleeing capacity and the lack of appetite to cover certain risks. Once these solutions are established, they could prove to be a more efficient use of capital than insurance risk transfer.

A captive can pay close to 100 percent of collected funds and remain viable, while an insurance carrier can't pay much more than 65 percent of collected premiums without risking its financial stability.

If a hard market or period of shrinking coverage or capacity drives companies to seek solutions such as captives, CAT bonds, self-insurance or risk pooling, or to implement mitigation strategies that satisfactorily reduce the risk, they will likely not want to consider insurance when the capacity coverage or price returns to an acceptable level. For example, if the captive is fully funded and generating savings, the captive owner will be loathe to dissolve it in order to re-enter the insurance market.

This all might be for the best. Old institutions rarely change unless forced to do so. While any change might be painful, there is a likelihood that the changes will benefit the market as a whole.

HUNGRY CAPITAL MARKETS

Already the capital markets are looking toward the insurance industry for opportunity. Hedge funds are injecting capacity into the market, and some insurers, American International Group Inc., for example, have created teams dedicated to capital market solutions that fall outside of the traditional insurance coverage. Corporations are being forced to look at new methods to identify and manage their large risks--hence the emergence of ERM.

If insurance carriers learn to better use the size and efficiency of capital markets and risk managers learn to mitigate and manage the largest risks of their companies, the changes, painful as they might be, will benefit the entire market.

While insurance has remained remarkably unchanged over the past few centuries, some changes, such as the move to large retentions, are actually evolutionary shifts that stick. The current forces at work seem to be driving a similar change.

If insurers decide that they can take a vacation from the market in certain areas, they may find that their market is permanently gone by the time they decide to return.

BEAUMONT VANCE, senior risk manager for Sun Microsystems Inc., is a columnist for Risk & Insurance®.

September 1, 2006

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