By Linda Chase-Jenkins and Samir Shah

Operational risks and related capital requirements have become a growing area of concern for regulators. U.S. regulators have tended to lag behind their European counterparts, but this may change in light of corporate-governance concerns and the occasional whiff of scandal.

In the United Kingdom, the Financial Services Authority requires insurers to consider operational risks as part of its Individual Capital Adequacy Standards regime. Operational risk is also expected to be an explicit component of the European Union's broader Solvency II initiative.

U.S. regulators worry about capital adequacy, of course, but in general have paid less attention to the underlying operational risks. One reason may have to do with the distinctive nature of operational risks - they are often hard to define and difficult to quantify. Operational risks sometimes fall into a gray area in which they are overlooked or treated as a "normal" risk, such as an underwriting risk. For example, how does an insurer classify coverage that it may not have intended to provide?

Even in the United Kingdom, the FSA continues to wrestle with the difficulty of quantifying capital for operational risk. David Strachan, the FSA's insurance-sector leader, once described this problem as "one of the most difficult" for both life and general insurers. In a challenge that applies on both sides of the Atlantic, he called on insurers to find solutions that are vital if risk and capital management are to be properly integrated.

We have no doubt that operational-risk identification and quantification will become a crucial competence for insurance company management into the future.

Defining the risk

Many of the most costly operational risks for insurers arise from how they generate business from potential customers.

A significant potential source of operational risk results from the use of third parties -- brokers, for example. Highly publicized investigations of bid-rigging and price-fixing, originally brought against insurance brokers, eventually swept up insurers and led to costly fines, reputational damage and changes in business practices.

In an earlier scandal, misrepresentation with regard to "vanishing premium" policies - where additional premiums were required when interest rates fell - cost the industry enormous sums in settlements. As the industry was reminded during the Unicover meltdown in the late 1990s, there also is a potential conflict of interest when managing general agents are paid commissions on the amount of business they write.

Much as industry management might wish to blame a few bad apples in their distribution force for all the problems, sometimes the CEO of the company is to blame. A common mistake is a decision to pursue a strategy of rapid growth in a soft market in which it is difficult for insurers to raise the price of policies.

Executives unfamiliar with a product line often exacerbate the situation. In the case of Unicover, for example, three of the reinsurers that acquired grossly underpriced workers' compensation business through MGAs were life insurance companies.

Reinsurance is a necessary and efficient method of spreading and diversifying risks. However, reinsurance can also be used to obfuscate and conceal, and because of that can be wrought with operational risk. Occasional reinsurance schemes can involve dozens of companies, as each block of business may be sliced up and sold many times over. If any of these companies are unwilling or unable to pay claims on time, all of the companies downstream in the reinsurance chain are at risk.

Often companies either don't, or are unable to, identify the other parties in the reinsurance chain on whom they are relying. Also, companies may not have a good enough knowledge of the business they are reinsuring to price and reserve properly against the risks of that business.

The tight link between the ratings that agencies such as Standard & Poor's, A.M. Best Co. Inc., Moody's Investors Service and Fitch Inc. give to insurers and an insurer's ability to write new business means that having a ratings downgrade can turn into a vicious cycle when ratings changes trigger lending covenants. Creditors demand payment, further hurting the company's creditworthiness and rating.

And then there are the lawsuits. Insurance is an extremely litigious industry. The terms of an insurer's promise are often interpreted and clarified in a courtroom, years after the promise was made. This gives rise to significant risk, including class-action lawsuits. Class-action lawsuits have been used for market misconduct, discriminatory pricing, denial of health coverage, managed-care incentives to doctors and auto insurance underwriting, to name but a few.

In addition, there is a significant risk of legal interpretation. It's difficult to predict how courts will interpret the terms of a contract and the actions of the insurer. For example, reinterpretation of contract language by U.S. courts in the 1980s as to whether environmental claims were covered by commercial liability policies led to the industry paying out billions of dollars that were not anticipated in pricing. The demise of Equitable Life in the United Kingdom, one of the country's oldest and most venerable institutions, turned on a House of Lord's decision about the company's liability under guaranteed annuity policies sold over a period of 30 years.

Losses due to operational risks such as lawsuits, reinsurance debacles and ratings downgrades eventually generate even greater losses due to impaired reputation. It is difficult for most companies that suffer these kinds of operational risks to get back on their feet because they are unable to sell new business. Most are rescued through acquisition and are reborn under a new name.

Will the future repeat the past?

The Financial Times once listed factors behind the demise of a U.K. insurance company - the dominant chief executive, heady expansion by an upstart company in a cutthroat market, self-delusion about the strength of the company and questionable accounting. It cited the factors in two insurance company failures separated by 30 years. These risks are systemic in the insurance industry, and they will surely present themselves again in the future.

Seasoned insurance industry executives are aware that their institutions are exposed to operational risks. However, they have been frustrated by an industrywide inability to put a number on these risks. If operational risks can be quantified, they can then be brought into the fold of traditional financial analysis to develop a more reliable combination of financial and operational strategies.

There are signs that the problem is becoming tractable using quantification methods borrowed from the engineering sciences, such as system dynamics, process simulation and fuzzy logic. These approaches are ideal when there is a need to supplement gaps in historical data with expert input and professional judgment.

But rigorous attention to operational risks can avoid losses that go beyond a one-time financial event. Writing a check to cover a fine may not repair reputational damage or cover the loss of management time and attention.

U.S. insurers should be clear: Operational risk management will become a more significant part of insurance company management into the future. Now is the time to get a grip with where your risks lie and what you can do about them.

Linda Chase-Jenkins and Samir Shah are principals at Towers Perrin and members of the ERM Practice leadership team for the firm's Tillinghast business. They can be reached at riskletters@lrp.com. This article republished with the permission of Risk & Insurance Magazine.

----------------------------------------

The views and opinions expressed by the author are not necessarily those of workcompcentral.com, its editors or management.