Insight

Charles Nortjie, executive director of risk finance at Alexander Forbes Risk Services, provides some background about the ever-changing insurance sector.

The field of insurance and risk management has seen a number of fast-unfolding developments in recent years.

There has been some decline following recent large-scale negative events, such as September 11 and the failure of Enron, Worldcom, Parmalat and others.

The industry is still experiencing high prices and shortage of capacity for some types of insurance. Some of the bluest of blue chip insurers and re-insurers have suffered unprecedented credit-rating downgrades.

But there have also been several positive advances, notably in the field of risk management.

Risk used to be handled by companies on a departmental basis. Internal audit looked after financial risks, Treasury looked after treasury risks, business units looked after project risks, and someone else was designated to take responsibility for the insurance programme for hazard and liability risks.

In the last few years companies have taken much more of an enterprise view of risk. Risk has always been centre stage in risk intensive industries such as banking.

Only comparatively recently has an enterprise risk view been adopted by companies operating in other sectors such as manufacturing, mining and government.

Against this background, new accounting standards are emerging at a breathtaking pace. Few understand the scope and intent of the new standards such as AC133, much less how to apply them in a risk management and insurance context.

Many companies have come to appreciate that in order for them to insulate themselves from fluctuations in the insurance market, they have to retain more risk and build a measure of self-sufficiency.

Captive insurance facilities have become a popular way of setting aside risk capital to finance retained risk. Insurance premiums paid to captives worldwide is estimated at $90bn, yet some auditors continue to view captive insurance with suspicion.

Take the hypothetical example of two healthcare providers, both with a conceivable exposure to medical malpractice liability risks. These are long-tail claims which might take several years to materialise, or not at all.

The first, a well risk-managed organisation, carefully assesses its potential exposure to claims and makes use of a sufficiently funded captive insurance mechanism for the financing of the retained portion of any claim.

The second organisation gives little thought to retained risks, taking such losses as a direct hit to the income statement as they arise. In applying the new GAAP standards, captive insurance mechanisms are effectively unwound.

The first organisation is portrayed as if no formal capital reserving against retained risks has taken place. The balance sheets of both providers are presented in exactly the same way!

This lack of differentiation is clearly nonsensical. Investors no doubt find it useful to understand which companies have a structured approach to the financing of risk, and which do not. In their haste to apply the new accounting standards some auditors seem to be missing the point.

The preparedness of the organisation to face a crisis and meet any calls on its retained risk capital is really valuable information to stakeholders. Arguments about the veracity of captive insurance mechanisms are energy-sapping without providing any true value to the organisation.

There is another foreseeable development from a corporate governance point of view.

Most companies were prepared to rely on their brokers for advice as to how - and to what extent - their insurance programme would respond to a loss. Audit committees of the future are very unlikely to continue to accept this as greater assurance regarding risk protection is needed.

A greater degree of transparency and disclosure regarding the retained risks of the organisation seems inevitable. Accountants and insurers have a great deal to learn from one another.

The efficacy of risk transfer can no more be judged by an auditor with limited insurance exposure, than the usefulness and protections offered by new accounting standards can be judged by an insurer.