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Old ideas can seem innovative after being shelved for decades in the risk management world. In 1752, Benjamin Franklin, a Founding Innovator, helped to launch America's first mutual insurance company, The Philadelphia Contributorship for the Insurance of Houses from Loss by Fire.

In the first year, 143 policyholders signed seven-year contracts. They paid premium into a pot, which any member could tap should their properties be torched. After the seven years, the company repaid the premium to policyholders. Perhaps ideas should be dusted off after centuries.

WEATHER CONTRACTS. Wouldn't it be nice if a contract existed to protect investors from the ravages of the subprime market? And wouldn't it be doubly so if the contract also allowed risk executives to hedge against the caprices of Mother Nature? No wonder the weather market has grown in this decade from $4 billion to $20 billion--it's all that.

The market started in 1997 with three temperature transactions between Koch Industries, Enron and PXRe, with Willis as intermediary, says Warren Isom, senior vice president at Willis Re Inc.

The market grew slowly at first, and it hit a rough patch at the turn of the millennium, with the "demise of the energy merchants," as Brian O'Hearne, managing director, capital management and advisory, at Swiss Re, puts it. Two El Nino-affected winters also chased insurers out, adds Isom.

Afterward, new energy firms, like Constellation and Centrica, and banks and reinsurers, changed the way the market had worked. No longer would deals be based like insurance transactions. They'd go the way of financial commodity trading, driven in the last few years by the Chicago Mercantile Exchange, and nurtured by the Weather Risk Management Association.

"Personally speaking, I see the growth and success of the weather risk market as part of a general change in the way business risk is measured and managed," says Isom. "We have seen the progressive quantification of risk in the banking, energy and insurance sectors and the development of quantatively-based risk management instruments."

What's now in place is a market that's all the more attractive to investors--"Weather risk is one of the few risks not correlated with general economic conditions," O'Hearne says. Indices are being invented and refined, based on rainfall, dry spells, the "misery" of humidity and heat combined, crop yield and anything else measurable in the natural world.

"In my view, the success has led to a further broadening of the weather market and markets influenced by weather such as energy, grains and construction risk, as well as increasingly utilization and growth of the insurance linked securities market," says O'Hearn.

Take that, Mother Nature.

TRANSPARENCY. Close your eyes and imagine a top-secret, member-only session at an industry trade event. The risk managers there join hands, light candles and sing like in those old Coca-Cola commercials. But instead of giving the world a Coke in perfect harmony, they wish for clarity and honesty, from their insurers and brokers.

Yes, the Spitzer Bomb blew up the whole broker commission system for all to see, particularly those who hadn't seen it before. Now, instead of compensation--an issue left for big and little brokers to bicker over--the catchword between client and consultant is "transparency." From the roundabout answers of some industry leaders, and the bold sound bites of others, all made during those 10-speaker executive roundtables at conference lunches, much more needs to be done on this issue than talk.

But transparency isn't just the Holy Grail in the broker-risk manager relationship. Risk managers wish the sun to shine on their insurance policies as well, where obscurity now often pervades.

"We have not seen much evidence of increased clarity or transparency in commercial policy wordings," says Thomas Reiter, partner in K&L Gates' insurance coverage practice group, which represents business organizations worldwide in connection with insurance coverage matters.

Sure, the courts let up the shades every once in a while. "In the United States, as a general rule, courts find in favor of policyholders where policy language is ambiguous," says Reiter. This Doctrine of Ambiguity is nothing new; it's been around for more than a century. But wouldn't you know it ...

"Insurers are increasingly attacking that doctrine," says Reiter.

OFFSHORE DOMICILES. Where would the industry be without offshore domiciles? It would all be onshore, that's where. Offshore domiciles were, in their day, truly innovative, perhaps too innovative as they sought to mitigate the impact of tax laws on premiums earned. Still, they allowed companies to transfer risk. When the industry needed capacity in a hurry, notably after Sept. 11, 2001, and after the 2004 and 2005 hurricane seasons, it was the offshore players who tossed overboard the lifeboats.

That capital is more important than ever. Despite U.S. regulations that require 100 percent collateral requirements of alien reinsurers, offshore companies and their U.S. subsidiaries accounted for 84.5 percent of the U.S. reinsurance market, according to 2006 numbers from the Reinsurance Association of America. That's down from the 2005 number of 85.4 percent, but the figures are still staggering.

More than 4,200 offshore companies ranging from 95 jurisdictions either assumed U.S. carriers' premiums or owed reinsurance payables in 2006. On top of the list of domiciles are United Kingdom, Ireland, Germany, the Caymans, Switzerland, Barbados--and at the very top--Bermuda.

"The spread of risk provided by Bermuda is critical to the proper functioning of the worldwide insurance mechanism. Additionally, the success of this marketplace has continued to attract capital from some of the most respected insurance, reinsurance and financial services firms around the globe," says Mark D. Lyons, president and chief operating officer, Arch Insurance Group.

Much of the same can be said of all offshore domiciles. Offshore capital is not about tax evasion anymore. It's about lubricating the global economy.

LLOYD'S. Lloyd's has served the industry well for more than 300 years, a scandal or two notwithstanding. But we all know it's time for the institution to change, and it has. The Names are far less prominent than they used to be, with corporate capital filling the gaps. And Lloyd's three-year plan toward greater competitiveness, announced last year, is well under way, according to its 2007 Mid-Year Progress Update.

The venerable house has increased its reinsurance capacity despite the hit it took after the 2004 and 2005 hurricanes. Recently, it raised nearly $1 billion (£500 million) of Tier-1 subordinated debt. It's trying its darndest to go electronic, and has seen moderate success with its Electronic Claims File, with 29 percent of all in-scope claims handled digitally in the second quarter of this year. And you want transparency? Lloyd's topped the FSA's contract certainty target of 85 percent in 2006.

What's more, the former coffee shop is a leader in pushing for reforms to U.S. alien reinsurer rules, has charged into emerging markets--see its new onshore reinsurance facility in China--and does not hesitate to take on global issues like climate change before they become fashionable.

In other words, it's on the way, finally, to modernizing. If Lloyd's can change, there's hope for innovation.

PARTNERSHIPS. There was a time when all corporations did was buy an insurance policy from an insurer and that was it.

"Risk management is much more sophisticated now than it was 20, 25 years ago, in the use of deductibles, captives, different kinds of loss financing techniques, structured reinsurance agreements, all kinds of things that just weren't thought of when the insurance industry was more of the driver," says William H. Rabel, professor, insurance and financial services, at the University of Alabama.

Rabel in part credits the excellent risk and insurance educational programs around the country. "You get people that come out of programs like that, they're not going to just leave things the way they are. They're going to change them," he says.

Tom Rodell, an Aon managing director and president of the Council of Insurance Agents and Brokers, attributes the change in risk management in part to technology and its power to unlock a company's exposure data.

"Now clients could say, 'Here's exactly what my profile is.' "

Of course, risk managers needed to be advanced enough to know what to do with the data, and Rodell says, in the early days, as with today, much of the cutting edge could be found in the Fortune 50.

This carried through to the '90s, with the emergence of companies employing their own actuarial resources to tame those data, and the rise of ERM and risk managers as vice presidents.

Another turning point, he says, was the rock-hard market in the mid-'80s, when even the most risk-intolerant companies realized they needed alternatives to insurance.

"The understanding that insurance is just one of the solutions was a big step forward," he says.

MODELING. Imagine if you took the top seismologists, geologists, atmospheric scientists and structural engineers and mashed them and their brains into a software program.

Not literally of course. That'd be messy. But figuratively, could software deliver their insight about your exposure to the worst earthquakes and hurricanes? That's CAT modeling.

As Paul VanderMarck, executive vice president, products, for Risk Management Solutions Inc., describes, a model is a "computer system that could replicate the decisions that experts would make"--consistently, repeatedly and at will.

Modeling is now "accepted as an absolutely core business process," says VanderMarck, but it wasn't always the case. In the late '80s, when models were being developed, underwriters and actuaries had to be convinced that they worked. They needed Hurricane Andrew and the Northridge quake to show that their old ways came up short in big disasters.

"It was very subjective, and there was no real science involved," says Karen Clark, founder of AIR Worldwide Corp. about the old way. "That's why, even at the time of Andrew, the big thing was companies didn't know how much business they were writing."

Of course, then came the flurry of storms in 2004 and Hurricane Katrina in 2005, which knocked the trust in models, revealing their weakness.

And that brings us again to the question: Does innovation really break from the past? Or do ideas evolve, regress, rebound?

For instance, Clark has founded a new eponymous company to help business clients grapple with the models' limits, by helping them merge the software with human-based quality-control processes.

Peter Yanev, who co-founded Eqecat Inc., now is a director at Global Risk Miyamoto, working toward a "modeling Renaissance"--especially for corporate risk managers who really want to know their property-CAT exposure.

In effect, Yanev argues that you need to "unsmash" some of those experts out of the software and then have a human structural engineer determine your loss probabilities at each of your properties at risk.

"I insist you cannot use the software without engineering," he says.

Humans are as retro as it gets.

If all insurance "innovations" come full circle like that, perhaps some day soon we will see insurance companies innovating in the ways of wily ol' Ben Franklin--and start giving back premiums to policyholders after the contract expires.

Right.

CYRIL TUOHY is Web editor/managing editor of Risk & Insurance®.

MATTHEW BRODSKY is Web editor of Risk & Insurance®.

ALSO: READ THE OTHER PARTS TO THE INNOVATION SHOWCASE ISSUE.

September 15, 2007

Copyright 2007© LRP Publications