Monthly Archives: May 2011

How Energy Companies Reduce Risk

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Risk is always a double-edged sword; the greater the exposure, the greater the risk — but also the greater the opportunity for profits. Some prefer conservative operations, expecting continual, long-term profits to grow the organization. Others choose to embrace the risk, believing that their ability to avoid it better than others will lead to a short-term windfall and a quickly expanding presence in the marketplace.

Where a company falls on that sliding scale depends on its risk appetite. (Unfortunately, too many companies never clearly define exactly what their risk appetite is … but that’s a whole other story for another post.)

Energy companies often embrace risk.

In the video below, faculty from Harvard Business School discuss this fact and professor Forest L. Reinhardt sums up the general attitude that those in the sector have towards risk. “The fundamental question for energy leaders is what risks they confront and how they can most cheaply reduce the exposures that they don’t want while getting compensated for bearing exposures that they want to retain.”

Of course, in energy, an industry whose risks are often — literally — volatile, failures of risk management stand out gravely when they occur. Lives can be the collateral damage. There has been a rash of high-profile catastrophes related to the energy sector of late: Gulf oil spill, Massey mine collapse, the Chilean mine rescue and the San Bruno explosion, to name just those that made major headlines. The contentious safety and environmental debates over deepwater oil drilling (and the equipment used), hydrofracking for natural gas and extracting crude from tar sands have opened other worm cans.

Meanwhile, energy companies are among the most profitable in the world. Three of the top four companies on this year’s Fortune 500 list, for example, make their money off of energy. (Exxon is second after Walmart, followed by Chevron and ConocoPhillips.) Seven others whose operations focus on petroleum or pipelines appear in the top 100. (#24. Valero. #29. Marathon Oil. #68. Sunoco. #74. Hess. #80. Enterprise Products Partners. #99. Plains All American Pipeline.)

Does the recent wave of disasters represent unlucky streak that will inevitably happen from time to time in any industry that faces such extreme risks? Or are perhaps too many companies within the energy realm being too cavalier with their risk appetite?

I’m not qualified to answer that question. And any company is of course entitled to shower its shareholders with wealth if they can make it while obeying relevant laws and regulations. But it seems as though, even in a sector as competitive as this, companies could re-invest a larger percentage of the profits into loss prevention without significantly hurting their quarterly results.

Talking Insurance With Wells Fargo Insurance Services CEO Neal Aton

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At RIMS 2011 Vancouver a few weeks ago, I got the chance to speak with Wells Fargo Insurance Services President and CEO Neal Aton to discuss the current state of the market and his company’s expansion over the past decade, something accelerated by the Wachovia merger at the end of 2008. Much like most other insurance executives I have spoken with over the past several months, he believes that the confluence of catastrophes and other market realities have led to a bottoming out of premium pricing for the P/C market.

“It seems that from a pricing standpoint, we’re finding the bottoms in the market,” said Aton. “There are a couple things I think are happening. We see global events that are going to drive reinsurance costs. You see local events which will drive direct losses in the marketplace. I think the property market is a place where there is … a sensitivity to events.”

In addition to the many, many loss events that have battered insurers, he sees a reactionary mentality developing across the industry. And he thinks that once pricing starts to go in the other direction, many carriers will follow suit.

“I think the psychology of the market is such that it seems to me that there is a willingness to follow a price leader,” said Aton. “While the facts may refute that, I think there’s just a mentality that the market’s finding a bottom. I wouldn’t call it a hardening of the market but I think there’s a firming of the market.”

Of course, the P/C industry is not some monolithic collection of policies all moving in unison. Different market segments will continue to behave differently. He doesn’t see the same level of firming in casualty as with property, for example. And he certainly doesn’t see it in D&O. “There’s still plenty of capital running around,” he said.

As for workers comp, he expects a drastic change.

“However, in workers comp, it’s hardening,” he said. “Clearly.”

For Wells Fargo, this will be the first major market shift that the company has undergone as a major player in the insurance market. It  jumped into the business with its acquisition of Accordia in 2001, and while it did navigate through the ensuing market cycle, it did not have nearly the same scale of operations as it does today. Its subsequent acquisition of ABD Insurance & Financial Services (in 2007) and merger with Wachovia (in 2008) have changed the game, turning it into the fifth largest brokerage in the world, according to Business Insurance.

While Wells Fargo Insurance Services is headquartered in Chicago, this growth has caused it to remain a very decentralized operation with 6,000 employees spread out in 200 offices. For Aton, that is a good thing, since the different offices can maintain “a deep commitment to a local market” but also retain “a window into a national resource.”

But you can be too decentralized to an extent that the mothership loses track of what each location is doing. So Aton thus spends a lot of his time trying to devise ways to maintain a good balance between a vast, dispersed network of employees who can reach all segments of the market and ensuring that the whole team remains connected with a common mission. Keeping this connectivity between company resources and the insurance buyer is not easy, but it is the goal.

“It’s hard to deliver, but when you deliver it, boy, it’s magic for a customer,” said Aton.

The main reason the company sees insurance as such a good area of business is that its banking operations allow different units to “cross sell” very easily. It already has so many corporate clients receiving financial services from other parts of the company that adding insurance to their portfolios seems like a natural fit. Right now, about 25% of the insurance side’s business comes from such cross sales with the remaining 75% coming from the market. “I aspire to have that grow to about half-and-half…not by shrinking that side but by making the pie bigger,” said Aton. “We’re on track to do that.”

Currently, Aton’s team supplies one out of every 13 to 15 of those customers who already do other business with Wells Fargo. Aton wants that number to be one out of every five. “That would imply somewhere around tripling our business,” said Aton, later adding that “getting to that is as much about marketing ourselves not only in the marketplace [but] marketing ourselves within Wells.

As the insurance side becomes more a core piece of Wells’ overall business, this will become increasingly easy, he believes.

“We start a conversation with another business [unit] not by saying ‘should we work together?’ It’s ‘how do we work together?’ It’s assumed that we’re working together. That’s the culture—we share our toys. That has taken building muscle memory.”

When I asked him if increasing revenue on the insurance side will also entail expanding through acquisition, he was unequivocal. “Absolutely,” he said. “Absolutely. I think it’s a good time to continue to acquire.”

Integration is never easy, but the Wachovia experience has left Aton optimistic for future opportunities. “In the insurance space, I don’t want to say [the Wachovia merger] was easy, but I wish they all worked so perfectly as that one did,” he said. The key benefits, aside from the integration ease (something they finished on the insurance side in 15 months) were the greater market reach the merger gave Wells Fargo into the Southeast and the complementary risk management and employee benefits talent that Wachovia brought.

Right now, 20% of Aton’s company’s business is in the employee benefit space. He wants to double that over the next five years. This is something that was evolving naturally on its own. And then health care reform came around and provided an even larger impetus to expand in the benefits area. “Number one, it’s a good business,” said Aton. “But the major driver is that our customers need help. There are just so many questions in flux in the health care space.”

So in health care, as in insurance and risk management services, he doesn’t see any end in sight to his company’s expansion.

“There is just a huge demand as customers, from small business owners up to CEOs and CFOs, say that the relevance of insurance and risk management is huge — huger than it’s ever been,” he said.

Excellence in Risk Management

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The Great Recession is not known for inspiring great things, but it did spur the creation of the Dodd-Frank bill, which, among many things, created the Financial Stability Oversight Council and the Federal Insurance Office. And the near-collapse of the U.S. economy did wonders for the discipline of risk management.

As a result, according to a new survey from Marsh and the Risk and Insurance Management Society (RIMS), executives in the C-suite are expecting much more from the risk managers at their company.

Below are a few of the key findings from the report:

  • An overwhelming majority of respondents said that senior management’s expectations of their organizations’ risk management departments have grown over the past three years. Senior management’s list of desired changes from risk managers includes integrating risk management deeper with operations, executing daily risk management activities more efficiently, providing improved analysis and quantification, and leading enterprise risk management (ERM) activities.
  • The most common focus area for 2011 is strengthening strategic risk management, which was cited by more than half of survey respondents. For the second year, this area came out on top, although barriers to doing so remain.
  • The top barrier cited to senior leadership understanding of the risk landscape was silos within the organization. This is the same answer given in prior years, and is something that organizations should begin to confront if they have not already done so. One way to tear down the silos is to create or strengthen cross-functional risk committees.
  • As the role of chief risk officer (CRO) continues to develop, we are beginning to see some differences in how they view and prioritize the issues. For example, CROs were much more likely than other risk managers to categorize senior management’s change in expectations a “very significant.” CROs said strengthening ERM capabilities and integrating ERM into strategic planning were focus areas for 2011.
  • Economic conditions ranked as the number one risk among respondents, and was also the risk that they were least comfortable with their organizations’ ability to manage. In other areas, such as business disruption, risk managers and the C-suite are not as aligned in their views of how prepared their companies are to manage the risk.
  • Nearly 60% of companies said their use of data and analytics has changed over the past three years. This is likely a reflection of leadership’s desire for there to be more transparency and quantification around risk decisions, particularly the economic implications. Despite the stated changes, however, there appears to be a need for companies to better use the available tools and analytics.

And let’s take a look at the areas in which senior management’s expectations of the risk management department have grown:

It seems the financial crisis continues to shine a light on the importance of risk management as a whole and, more specifically, enterprise risk management and strategic risk management.

Survey Says? Risk Management Raises Profitability

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A new report from the Economist Intelligence Unit and Oracle Financial Services sheds further light on the elevation of risk management since the financial crisis. The general conclusion is similar to the one we have been hearing ad naseum since a failure of risk management tanked the global economy.

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As stated in “Transforming the CFO Role in Financial Institutions:  Towards Better Alignment of Risk, Finance and Performance Management” (PDF):

In such a challenging environment, financial institutions must now devise a sustainable growth strategy and be better protected against new or emerging risks. To do so, many finance departments are recasting their business processes in an effort to provide better access to information for internal decision-making, risk management, financial reporting and regulatory compliance.
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Blah blah blah. Same ol’, same ‘ol. Rhetoric and platitudes.

Right?

Maybe not.

This report, in addition to re-stating the need for better risk and finance alignment is actually speaking about evidence directly rooted in the bottom line. The execs surveyed are reporting that financial firms are more profitable when these two departments are in sync.

Financial institutions that benchmark themselves well on aligning their risk and finance functions also say they are doing better financially. Among survey respondents, of those who rank themselves much better than their peers at alignment between risk and finance, 60% are also much better at financial performance and 92% are above average. The equivalent figures for those who are average or worse at alignment are 8% and 32% respectively. The benefits are both specific, such as identifying potentially profitable clients, and general, such as providing a greater understanding of the global context in which major strategic decisions are made.

Those numbers seem substantial.

And this is not just a reality in 2011; this was the case all along. Those firms that prioritized risk management the most — not just rhetorically, but by paying big bucks for talented risk managers with decision-making insight — fared much better in 2008 than those that didn’t.

Research shows that at the 15% of US banks where the chief risk officer (CRO) was among the five highest-paid executives in 2006, the proportion of total assets made up by mortgage-backed securities at the time of the crisis was one-fortieth that of banks where the CRO was less well paid.

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There is even a correlation between higher CRO pay and lower stock volatility.

One-fortieth. That’s 1/40th. Or 2.5% if you prefer.

So you’re telling me that companies that committed to paid risk managers who they valued as decision makers to foresee, navigate through and mitigate pitfalls did much better in avoiding risks than those that didn’t? You don’t say?

For the past three years, we have repeatedly been saying that if this financial meltdown isn’t enough to move the needle on pushing risk management up the corporate hierarchy, nothing will be. But as more and more insight like this in unveiled, it’s hard to believe that companies can continue to ignore the obvious: risk management saves — and makes — money.