It is a real pleasure to be here at MIT Sloan. It is always valuable to talk to future business leaders about how they plan to manage risk when they reach board levels.
My perspective, I should say, is currently that of an insurer. But I have not always been in the insurance industry. My career has been varied. I started off in the defence industry before moving to a government position. I spent time working in transport, a year as Lord Mayor of the City of London and I also took over the running of the Canary Wharf property development in London, at a point when its prospects had been looking pretty grim.
As you heard, these roles were diverse. But they all required me to manage risk. And my aim today is to impress upon you the vital importance of boards examining risk carefully and appropriately. I also want to consider the regulatory response of governments around the world to the financial crisis.
One of the consequences of the financial crisis has been to treat risk as a dirty word. But businesses need to see risk as neither a negative nor a positive. Instead, they should see it as a reality. The world is full of risks which business cannot avoid. The volcanic eruption in Iceland is a case in point. A week ago I was sitting in London, unsure whether or not I would be able to speak to you this week.
And risks constantly evolve. When that volcano last erupted in the early nineteenth century, the most damage it did was to poison a few sheep and cattle grazing in the Icelandic countryside. The ships and cargo which Lloyd’s insured back then were completely unaffected. Fast forward a few hundred years and the same eruption of the same volcano erupting can cost the airline industry, at a conservative estimate, $200 million a day[1].
Iceland can also serve as a metaphor for the suddenness of the last financial collapse and how risks can spread from one realm, the financial to have political consequences. In 2007, Iceland was widely perceived as a prosperous, outward looking economy, one of the few remaining small European countries where a Prime Minister could afford to say, as Geir Haarde did in May 2008, that the costs of EU membership outweighed the benefits. By July of that year, the economy was one of the first casualties of debt and disaster and an application for EU membership had been sent to Brussels.
Iceland seems rapidly to have become a symbol for swift unpleasant surprises that unsettle the business community and cause governments to radically rethink their economic policies.
The key question we need to ask is, could we in business have foreseen these events, could we have managed them better? I am a strong advocate of the view that risk can be mitigated and can be reduced. But this takes foresight, planning, imagination, and– sometimes - courage. It also, of course, costs money. But the point is that the sums invested in risk mitigation are less than the cost of a rebuild. Hurricane Katrina caused over $100 billion in damage. But the levees are being rebuilt at a cost of $14 billion.[2]
Some of you may not be familiar with Lloyd’s. The first point which I would like to make is that our business is not banking. We are the world’s oldest and largest specialist insurance market and we are based in London. Hundreds of different insurance companies – ranging from large multinationals to smaller businesses – trade at Lloyd’s. Often they share the risk of insuring large, complex projects, such as satellites and oil rigs. And we also insure some highly unusual risks such as David Beckham’s ankle bone or the smile of television star Ugly Betty.
We have been in business for over 300 years. We started off as a coffee house in the City of London, where wealthy shipowners would meet to share the risks of their sea voyages between them. For several hundred years, we concentrated on the maritime industry, famously insuring the Titanic and indeed the tea chests that were tipped into Boston harbour, in this very city. But increasingly, and particularly in the 20th century, we diversified, insuring the earliest flights and the fledgling automobile industry. Much of this activity, was of course, happening in the United States, which today is our largest market.
The main point about Lloyd’s is that our development has largely been led by the development of industry. As industries have evolved, or declined, we have had to find new products, understand new innovations and crucially, price new risks.
Any form of innovation is risky. And insurance stands behind most of the great inventions of the modern era. The world class scientists at places like MIT need to be able to insure their products if they are to get them to market, and at Lloyd’s we have a team whose job is to chart emerging risks, such as nanotechnology, or even renewable energy – a quarter of the world’s wind farms are insured in the Lloyd’s market.
So what risks are businesses most concerned about?
Well, last Summer, with the Economist Intelligence Unit, we surveyed board level executives across the world and asked them the same question. The answer was overwhelming, and predictable: financial risks, and regulatory risks. But perhaps what was more telling was what came at the bottom of the risk league table. Earthquakes came 36th out of 41 risks, yet we have experienced devastation in Haiti, Chile and China already this year. Drought was 37th out of 41, yet a recently study which we published with the World Wildlife Fund suggests that the world may face severe shortages in global water supply in the next 30 years.
The problem with many risk management strategies is that they focus on the current risks and not the future risks. Boards should be developing plans to deal with future energy shortages, or water shortages, or looking at the low probability-high impact events – the volcanos – to establish what their exposure might be, and what are their mitigation plans.
That, to my mind, is a primary weakness of the debate on how to address the risks taken by the banking sector which led to financial meltdown. Of course, these need to be addressed, but perhaps it would have been better to do this before the collapse, rather than after.
Hindsight is not necessarily the ideal viewpoint for risk management – because the risk landscape is constantly evolving, so we need to focus on the future, not the past. The current myriad of proposals to fix banking regulation is a case in point. In the UK, we have seen report after report, academic viewpoints and newspaper punditry on what is the best solution to redress a crisis which has already occurred. And politicians around the world are feeling the enormous weight of public expectation to do something. But it is not enough just to do something. You have to do something good. Something worthwhile. Above all, something that will fix the problem. That doesn’t mean more regulation, it means better regulation.
The latest proposals coming out of the International Monetary Fund (IMF) seem to suggest that the IMF may recommend that the payment of a “Financial Stability Contribution” to government coffers could be applied to insurers.
It is worth quoting Robert Peston, the BBC Economics Editor. “Although insurers, hedge funds and other financial operations were relatively uninvolved in the causes of the financial crisis, the IMF has argued that they should pay the tax anyway because, otherwise, activities currently carried out by banks might be reclassified as, for example, insurance services[3].”
Any decision to link insurance to banking is wrong. Insurance has performed well in this crisis. Our risk management facilities are not the same as the banks and neither is our remuneration. Lloyd’s made a record $6.2 billion profit this year. And who was our highest paid member of staff? The person who had the job of monitoring the market’s exposure to risk.
That isn’t to say that insurance companies have all escaped involvement in the recent calamities. The near-death experience of the world’s largest insurer AIG should act as a warning to us all about the dangers of getting involved with products that you don’t fully understand. But the AIG problems did not originate in their insurance business.
Over the last few years, Lloyd’s has built up a solid capital base - money which is there to pay out claims. During the recent boom years, we stuck to a cautious investment strategy, much to the amusement of some competitors. And over a number of years, we have made a number of fundamental and far-reaching changes to almost every aspect of our operations – improving the quality of our business procedures and the stringency of our oversight and supervision.
A basic rule of any regulatory practice should be not to punish those who have showed good behaviour. Or where is the incentive for careful risk management?
If the governments of the world want to create effective risk management for the financial sector, as a start, they need to look at where those risks lie. I do not believe they lie in the insurance sector. Insurance is a means and a method to manage risks. If we were not there, how would people construct new buildings or develop new products or travel from continent to continent?
One of the features of risks in this century is that they are increasingly interconnected. The volcano eruption demonstrates this. An eruption in Iceland has led to British holidaymakers stranded in Florida. The financial crisis demonstrates this. Decisions on US mortgage applications led to Iceland applying to join the EU. I hope that global governments will not now try to demonstrate how regulations designed to curb banking excesses can create a negative impact on insurance.
[2] Insurance Journal 2009
