Edition

Editorial: Back to the Basics

Editorial

Back to the Basics

By Ronald Poon-Affat

WITH ALL THAT the insurance industry has been through lately, isn't it surprising that the cable news reporters have zeroed in on the payment of bonuses for executives? Well not really, when you think about the complexity of credit default swaps, variable annuities product design and the mark-to-market accounting treatment when embedded options are out-of-the-money. Focusing on the bonuses was an easy option.

So what happened? How did we get in this financial crisis? It's my personal view that there were three contributing factors.

  • The first was strategic. It included the error of explicitly or implicitly adopting the concept of stretch management. This is the celebrated GE concept that "essentially means using dreams to set business targets with no idea how to get there." This issue contains an excellent article on this topic by James Ramenda, (FSA, CERA).
  • The second error was technical. It included aggressive accounting, policy design, underwriting (both asset and liability), and inadequate risk control procedures.
  • The third, of course, is with HR, for having compensation incentives that encouraged short-term tactical thinking.

With the benefit of hindsight, the creative designers of variable annuities, the chief investment officers and the infallible heads of the financial products division, were encouraged and celebrated by the insurance equity analysts, stockholders and the rating agencies. They were sometimes left alone by the regulators, valuation actuaries and the external auditors who were all unable to keep up with the frenetic pace of new risk products and credit derivatives.

With all of that cheering going on, no one dared challenge the stretch strategies; investors rewarded growth with little concern if it was sustainable; and bigger bonuses were paid. With so many people to blame, no one is to blame and life goes on. The lone voices that dared to raise any questions (Warren Buffett and Eliot Spitzer) were drowned out for raining on the parade.

I once attended a presentation by the head of a global reinsurance giant who was lamenting his company's poor underwriting results for the last few years. He confessed that he wished that he had hired underwriters who were maybe not so creative. He followed that surprising comment by saying it takes a really bright underwriter to challenge the guidelines and see the positive side of even the worst risks. He argued that less gifted underwriters would have declined such risks and stuck to accepting the plain vanilla variety. In the end it was the risks that should have been passed over that got the reinsurer into trouble.

This is not to say that creativity should be abandoned. But we also need to step up our existing risk models to accompany such creativity. Nassim Nicholas Taleb (author of The Black Swan) summarizes successful risk management in two steps. Number one, take the maximum amount of risk and other forms of exposure to positive black swans when this costs you very little if you're wrong and earns you a lot if you're right. Number two, minimize your exposure to negative black swans. According to Taleb this is exactly the opposite of what the banks did.

It's only in the financial markets that we spend so much time analyzing the fallen. In sports, the trophies and postgame interviews are reserved for the disciplined victors. Thankfully there are still many unglamorous but successful risk carriers who have stayed the course, kept to the basics, recruited experienced executives, delivered steady and incremental back-office efficiencies, installed rigorous risk controls and designed products that clients, brokers, equity analysts, regulators and rating agencies could actually understand.

So will the insurance industry change? Should the insurance industry change? What needs to be changed? The view from many thousands of miles away in Sao Paulo would appear to show that there are still many well run U.S. and European risk carriers. We need to celebrate those companies with clear unstretched vision, values and principles, and start to give them some well deserved space on the podium. The inclusion of Travelers Companies, Inc. in the Dow 30 on June 8, 2009, would appear to be a strong signal for the comeback of the insurance industry. Yes, we can!

The views of this editorial are attributable solely to the author and in no way reflect the view or opinions of his employer or the Society of Actuaries.

Ronald Poon-Affat, FIA, FSA, MAAA, CFA, can be reached at poolside06@yahoo.com.