Risk Management for Insurers: Lessons Learned From The Crisis Michael A. Cohen 3 rd Annual Risk Management Insurance Conference September 16, 2009

“The future is impossible to forecast. Why, it is even difficult to predict the past.” Ancient Chinese Proverb

Introspection by Insurers: “What Happened?” “Was it something we did”? “Was it something we didn’t do”? Q: What are the root causes of the crisis, and what roles did insurers play?

Dislocation dis-lo-ca-tion (\,dis-(,)lō-’ka-sh ə n): a disruption of an established order

Dislocations in History Economic Military Societal Political

This Dislocation Was A Massive Failure of the World’s Financial System; Fortunately It Seems To Have Been Only Temporary

How Did We Get To Where We Are? (and who was ‘minding the store’?) Unjustifiably easy credit was offered to homebuyers with inadequate assets and earnings … our real estate industry concussed (arguably the most important industry in our economy) - Q: Would you lend money to someone if you weren’t sure they could pay you back? (limited documentation, weak debt coverage)

How Did We Get To Where We Are? (cont’d) Banks, insurers, investment bankers and others facilitated transactions built on elements that had not been properly vetted … vast, unforeseen and ill-understood financial liabilities were exchanged Asset managers made ambitious claims about the prospective investment returns they said they could achieve (but couldn’t), and others committed outright fraud... huge amounts of value were wasted Rating analysts did not adequately analyze securities, causing them to be overrated and underpriced … risks were not understood and consequently were undervalued on an enormous scale

Macro Issues Were Overwhelming The banking system almost collapsed The financial markets ‘froze’ Complicated financial instruments confused and overwhelmed the system The real estate market plunged into its worst cycle in decades Ratings, and the rating process itself, were called into question Consumer attitudes became more negative than ever (over the 40 years they have been tracked), and buying of almost all products has declined precipitously

Questionable Business Practices Abounded Greed Fraud Poor analysis/narrow perspective Nonchalance Many similarities to “The Seven Deadly Sins”

Business Psychology (many thanks to Mark Griffin) People work on problems they think they can solve, and they avoid those they don't think they can solve. Therefore, if the elements of risk are in the latter category, they won't be addressed. They are slow and cautious in reacting to new information. Solutions to risk reduction may exist, but they might not be implemented without an inordinate amount of study, or possibly not at all. They are reluctant to admit ignorance or mistaken assumptions and tend to forget misassumptions that have been made. An ill-conceived initiative can be expected to have additional risk, and if learning doesn't follow, further mistakes may be made.

Business Psychology (cont’d) They are inclined to be risk averse when they have made gains and can be risk seeking when they have incurred losses. This leads to a strategy basically opposite of what should be pursued, which is to invest more when gaining and less when losing. They look at fewer as opposed to more perspectives, possibly missing a better solution. They do not realize when they are at an information disadvantage. They are inclined to blame others for poor results, as opposed to studying the causes for their own mistakes and fixing them. They frequently place greater value on what they have created than on what others have done, either individually or collectively, and may well miss out on higher-order thinking generated by a group and on critical perspectives of others.

Insurers’ Difficulties Investment losses: Diversified, investment grade bonds portfolios had massive unrealized capital losses Capital erosion: Losses (primarily but not exclusively investment related), greatly diminished access to capital (and liquidity) Vanishing profitability Decreased sales: Consumers significantly curtailed their expenditures in the face of the recession Q: Could these difficulties have been averted?

Precedent – A Life Insurance Dislocation: Interest Spike of the Early ’80s Guaranteed interest rates offered by whole life products became uncompetitive Bonds values were far ‘under water’ Cash flow was leaving companies in substantial amounts, and many companies made crippling decisions Distribution expenses were then seen as way out of line Result: The life insurance industry had to completely reevaluate the way it managed its business

What Do Insurers Need To Do To Succeed? Satisfy their customers’ needs and wants, more effectively and efficiently than their competitors can; provide quality advice Manage their asset, capital and profit dynamics well, for themselves and their customers Understand the underpinnings (especially the risks!) in their enterprises, especially strategies and key elements, and ensure that the interests of all of their stakeholders are addressed Operate with integrity and transparency … internally and externally Have contingency plans

Lessons Learned Responsibility and trust Be ‘students’ of what we do; know the fundamentals; analyze carefully and expansively Know your counterparties (partners) Communicate! Plan and execute; have contingency plans Anticipate the unthinkable (tail risks) Don’t ‘bet the farm’ Don’t be defensive

Risk Management Lessons Learned - Companies Focus on the most important risks (many are asset related), but don’t ignore the tail risks, either Establish risk thresholds/appetites, and manage to them Analytics must support decision making

Risk Management Lessons Learned - Regulators What type of oversight for the financial services industry should be established … without stifling innovation? What structures/mechanisms should be in place to prevent a systemic meltdown when a major institution fails?

Conclusion - Introspection by Insurers: “What Happened?” “Was it something we did”? “Was it something we didn’t do”? Many more perspectives will emerge over time (and the view of history will be impacted by who is writing it!)

Recommended Reading “The End of Wall Street” by Michael Lewis “Billion-Dollar Lessons” by Paul B. Carroll and Chunka Mui “A Sense of Urgency” by John P. Kotter “Dislocations” by Michael A. Cohen

Contact information: Michael A. Cohen Cohen Strategic Consulting (215)