Risk Factor 9 05 Issue


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Risk Factor 9 05 Issue

  1. 1. Volume 1, Issue 6 September 2005 Basel II Compliance: Are You Ready? by Lori Widmer In This Issue: New banking compliance measures are set to be announced by the end of next year. While Basel II committee members hail the new regulations as Basel II Adoption positive, businesses aren’t so sure. Emerging Issue: Timing is everything. The Basel II framework—the new compliance Mold Claims in the measures that revamp and enhance the monitoring and risk control Big Easy measures of the financial market—will not be available until the end of ______ 2006. And according to a recent poll by Accenture, only five percent of Side Issue: top-tier banks in North America and Europe have actually imple- Flood Cleanup mented one or more components of the new framework. ——— Basel II measures were created in order to “to promote the adequate Plus: capitalisation of banks and to encourage improvements in risk manage- • News Briefs ment, thereby strengthening the stability of the financial system”, says • Moves & Notes the Basel Committee on Banking Supervision (BCBS). The Basel II Capital Accord is based on “three pillars” as outlined by the BCBS— Quick quote: risk appraisal and control, supervision of the assets and monitoring of the financial market. The measures, says BCBS, will complement each “You wanna other while creating incentives for banks to enhance their control proc- change jobs, esses. man?”—New Or- Yet so far, the majority of financial institutions have yet to act on leans Mayor Ray Basel II compliance. Perhaps it’s the lack of confidence in the effective- Nagin’s offer to To- ness of the regulations. The Accenture study shows that only 25 per- day Show host Matt cent of those surveyed believed there would be enhanced process effi- Lauer regarding ciency thanks to Basel II. That number is down from 43 percent a year cleanup and facing ago. another possible The concern is not unwarranted. A recent report by Fitch Ratings storm. finds that banks could decrease their capital charges dependent on how “To be honest with they invest. “We may see banks looking for opportunities to reduce you, no.”—Lauer’s their Basel II capital measures by investing in the credit card ABS, response. CMBS and RMBS markets,” according to Stuart Jennings, managing director of European Structured Finance for Fitch Ratings. According to Accenture’s managing partner, Andrew Wilson, a Copyright 2005, LDW Publishing. All rights reserved. No reprints without permission.
  2. 2. 2 company’s IT function accounts for 60 percent of Basel II Basel II’s Three Pillars compliance costs, as many companies must build data ware- houses. These costs are proving to be much more than banks first anticipated, he says. “Banks are truly seeing the costs Pillar One—gives guidelines for measur- now that they are in the resource-intensive phase of imple- ing credit risk more precisely. It also out- mentation,” Wilson says. And of those polled, 45 percent lines precise operational risk standards to are expecting to shell out more than $61 million for compli- be followed that the BCBS expects will in- ance through 2007. crease risk sensitivity. The guidelines call for greater risk differentiation and a more Approaching Basel Compliance detailed plan for the treatment of credit Experts are still trying to sort out the best response to Basel risk mitigation techniques. II, yet some have gone on record with recommendations. PriceWaterhouseCoopers suggests splitting the financial de- Pillar Two—sets up the supervisory re- partments of one’s firm so that one team can devote them- view process, including four key principles selves to the “routine data processing” and the other can be of supervisory review: responsible for the compliance and risk management strate- 1. Banks should have a process for assess- gies of the firm. That should bring the “clarity of focus” that ing their overall capital in relation to PwC’s head of financial services advisory in London Pat their risk profile and a strategy for Newberry says is necessary to bring Basel II compliance is- maintaining their capital levels. sues under control. 2. Supervisors should review and evaluate Still others believe breaking down silos will allow for a banks’ internal capital adequacy assess- smoother adoption. A white paper from the Economist Intel- ments and strategies, as well as their ligence Unit sponsored by Oracle suggests that managing ability to monitor and ensure their risk across categories is the best approach to Basel II compli- compliance with regulatory capital ra- ance. Also, the paper suggests creation of a “firm-wide cul- tios. Supervisors should take appropri- ture to manage risk” to ensure successful adoption. ate supervisory action if they are not Despite the approach taken, all agree that increased and satisfied with the results of this process. improved communication across the company is necessary 3. Supervisors should expect banks to op- in order to tame the Basel II beast. erate above the minimum regulatory capital ratios and should have the abil- Is Basel II Right for You? ity to require banks to hold capital in If you’re not working with the current Basel I requirements, excess of the minimum. chances are you may not need to heed the Basel II compli- 4. Supervisors should seek to intervene at ance issues. However, if your business plans include taking an early stage to prevent capital from on more overseas business, Basel II may indeed be called falling below the minimum levels re- for. An easy way to determine if your company should com- quired to support the risk characteris- ply is to compare your current business financial structure tics of a particular bank and should re- with the proposed Basel II requirements, a.k.a. the “three quire rapid remedial action if capital is pillars (see sidebar) . Also, look at your current compliance is- not maintained or restored. sues—Sarbanes-Oxley, for example. Are there processes within that compliance that you can map over to Basel II Pillar Three—deals with market disci- compliance that would alleviate some of the compliance pline, calling for banks to follow strict gen- costs and headaches? eral disclosure requirements and requires What about your current risk management model for fi- banks to adopt an “adequate bank man- nancial areas? Is your company due for a revamp anyway? If agement process” that includes a formal so, Basel II compliance could help to bolster or replace exist- disclosure policy approved by the board of ing risk management processes. And compliance is an op- directors. portunity to build a team approach to risk management, as well as a company-wide adoption of risk management tech- For more information, visit www.bis. org. niques.
  3. 3. 3 Advocates for Change By Lori Widmer Dwayne Jorgensen says that when people hear about Basel II requirements, they begin to stress about the new onslaught of regulations. Jorgensen, the global practice leader for Sar- banes-Oxley services and IT governance at Computer Task Group, Inc. (CTG), Duluth, Ga., cautions against a “ready-fire-aim” approach that was witnessed best during Y2K. Instead of putting thought and planning into solving the problem, he says management spent millions of dollars before de- termining the scope of the risk exposure. And he says risk management is well positioned to change that mindset. “With the timing of Basel II after Sarbanes-Oxley, organizations, even those under the original drivers of Basel I, need to ratchet down further.” That’s where he says risk management comes in. “Risk man- agement can no longer be viewed as an ancillary function sitting somewhere calculating numbers, report- ing to someone and saying ‘my work is done.’ Risk management has to become an evangelical post within an organization that uses its expertise and starts to exhibit a stronger link to the internal audit function.” Jorgensen, who is well versed in SOX compliance, says throwing Basel II into the mix should not be the cause of great stress and anxiety. To the contrary, he believes that risk management has the tools in place already to tackle yet another set of regulatory requirements. In that respect, he contends, risk management can utilize current best practices for other areas as models for Basel II. In fact, if folks are paying attention, it may just start a trend in thinking. Early adopt- ers of Basel II have the opportunity to push the concept of continuous monitoring of all regulatory func- tion. Basel II, he says, “is just another iteration of HIPAA and Sarbanes-Oxley.” He likens all regulatory issues to an iceberg with several tips. “Regardless of the space you’re in, be it Basel II or HIPAA or SOX, no matter which iceberg you’re staring at, it’s merely the tip. And that’s been the difficulty. People all think they’re looking at different icebergs because they’re all staring at different tips. When you go below the surface, it all becomes the base common denominator of the risks associate with your organization. It’s still the same iceberg.” It all sounds good, but any risk manager understands that changing mindsets is difficult within an or- ganization. Jorgensen agrees, and says that change must first come from risk management. The hardest part of a risk manager’s job, he believes, is becoming the advocate for change. “It’s one of those para- doxes where by definition these are not the people who would normally grab the banner and surge for- ward into battle. They’re the ones in the background doing the logistics. Yet if risk managers are going to be most effective, they need to learn to charge. They need to get in front of management and help these people become educated on risk factors that are driving business.” Perhaps the first sell is that in the end, management owns the ultimate company risk. Risk managers looking to sell Basel II compliance to management must first educate management on the importance of the requirements. More to the point, he says, risk managers need to show management why they should care. “It’s the Inspector Clouseau approach—you educate them until they’re the ones telling you where the risk is and where you need to focus. It now becomes less of a ‘how much is this going to cost’ ques- tion and more of a ‘what’s it going to cost if we don’t’ question.” What tools are needed? Software, certainly. But Jorgensen cautions against applying software with pre-loaded templates. “What do we know about human nature? We follow the path of least resistance. If you give me something preloaded, do you honestly think I’m going to spend any of my own time trying to figure out if it maps up with what my risks are?” He suggests using software that has already been mapped to fit the risks of the organization, and can easily be updated as the organization or the require- ments change. He also advocates a corporate-wide education on risk exposure. “The role of risk management has to be education of all corporate management. Whether you’re an accountant or in IT is irrelevant if you ap- proach business from the universal lexicon of risk.”
  4. 4. 4 The Cost of Basel II Compliance By Lori Widmer As the day nears when Basel II guidelines will be released, experts can do nothing but sit back and guess at the cost. And the guesses are many. Early reports show costs similar to those experienced with Sarbanes-Oxley compliance. One estimate by Accenture has just the IT portion of Basel II compliance will cost companies an estimated 50 to 60 percent of their budgets. For the most part, banks are remaining quiet about what they expect to pay. But a recent Forrester benchmark study shows that large European banks may be shelling out euro $115 million for compli- ance. HSBC has determined that its costs had reached $400 million in 2004 for various cumulative com- pliance costs, including Basel II. Vendor estimates for compliance solutions fall somewhere between $300,000 and $1 million, and that’s just for banks that have proper infrastructures already in place. Those who don’t can expect a $2 to $3 million price tag. Domestic banks are going to be the most affected by Basel II, say experts. A recent white paper pre- pared by the Economist Intelligence Unit, sponsored by Oracle, says the choice to adopt Basel II will hit the largest mid-tier banks within Canada and the U.S. Pressure to compete will drive these decisions. Can they afford it? Many believe they can’t afford not to. The white paper reports that 41 percent of respondents expect to come under pressure to adopt Basel II. Of those respondents, 54 percent believe the pressure will come from regulators. That same study showed that 31 percent believe the high cost of compliance is their largest obstacle, and 25 percent believed it was a lack of consistent, standardized data. Still, many see the benefits of compliance. Fifty-two percent said that they expected better risk management to be a benefit of Basel II adoption. News Briefs A new FM Global study of financial executives at the world's top companies, finds supply chain risks pose the top threat to companies' revenue. At the same time, close to half of all respondents say risks associated with globalization and outsourcing are only a low priority or concern for their organiza- tions, potentially leaving their supply chains vulnerable. The study, "Managing Business Risk in 2006 and Beyond," is available online at www.protectingvalue.com. Premiums in the commercial insurance industry continued along the path of an 18-month long down market, according to the RIMS Benchmark Survey, a survey of current policy renewal prices as re- ported by corporate risk managers. However, mixed signals from the market suggest that it may be poised for a change. Renewal prices stabilized, or even slightly increased, for some lines of business, but some leading indicators of market direction signaled further declines. For example, general liabil- ity, a line typically responsive to changing market conditions, showed clear signs of firming, while property, often a leading i ndicator of market conditions, fell a further 4.3 percent in the latest quarter. The Hartford is once again bracing against another round of inquiries from New York Attorney Gen- eral Eliot Spitzer. Spitzer is now concentrating on information related to the company’s sale of annu- ity products and its reporting of workers’ comp premiums. The Hartford announced its full cooperation with the latest subpoena. A former Prudential Securities broker pleaded guilty to charges he executed improper mutual fund trades on behalf of hedge fund clients, federal authorities said on Monday. Martin Druffner was charged with four counts of wire fraud and four counts of securities fraud for his involvement in a trading scheme of mutual fund shares between 1999 and 2003.
  5. 5. 5 Who Needs Compliance? By Lori Widmer So it costs a lot. But do you need it? That’s the question risk management should be asking before sell- ing the company on spending millions to comply with Basel II. It goes without saying that large financial corporations are hard-pressed to avoid compliance. Yet smaller financial entities need to determine what competitive advantage is being gained by the cost of compliance, if that advantage is large enough to warrant the added costs, and if noncompliance will hamper future business. The Economist Intelligence Unit interviewed risk managers to determine what benefits Basel II was expected to bring to their companies. • Better risk management— 52 percent • Better competitive position —16 percent • Less volatile earnings — 9 percent • Higher profits— 8 percent • Better credit ratings—28 percent • Higher share price— 4 percent • Pricing of products to reflect risk better—23 percent • Lower capital levels—4 percent • Greater transparency—25 percent • Improved efficiency—12 percent • Not applicable: I do not/would not expect any benefits—33 percent • Other—1 percent (Source: “Weighing risk: Basel II and the challenge for mid-tier banks.” Economist Intelligence Unit, sponsored by Oracle.) Moves and Notes Lawyers and Professional Liability coverage is the latest offering from The Hartford Financial Services Group, Inc. and Target Insurance Services. The coverage is customized to fit the broad coverage require- ments within a law firm as well as the more specific needs. PMSI-Tmesys, a provider of workers’ compensation services, has introduced a Web Portal Reporting service that provides instant, self-service reporting capabilities to its clients. Willis Group Holdings Ltd. announces the appointment of Andy Pearce as Head of Claims within Global Operations UK. Pearce will be focusing on further developing the delivery of market leading claims service to Willis clients, with responsibility for the end-to-end delivery of Claims service across the UK. American International Group, Inc. (AIG) has announced that Elias F. Habayeb will join AIG as Chief Financial Officer of the Financial Services Group. Mr. Habayeb succeeds Ronald A. Latz, who has been named a Vice President at AIG Financial Products Corp. (AIGFP). RIMS will sponsor the Bermuda Market Symposium, November 16-18, 2005, near Hamilton, in Ber- muda. Located at the offices of XL Capital Ltd and ACE Ltd., this event presents networking oppor- tunities and education from the basics of entering the market through more complex topics of captives, casualty, liability, property and reinsurance. Risk Factor is a monthly publication of LDW Publishing. Lori Widmer, Publisher. To subscribe to Risk Factor, please visit www.ldwpublishing.com, or e-mail ldwpublishing@comcast.net. Mail to: LDW Publishing, 1465 Tullamore Lane, Phoenix- ville, PA 19460. Phone: (610) 933-7980. Fax: (610) 917-0636. Copyright 2005. All rights reserved.
  6. 6. 6 Side Issue Lessons Learned: Katrina By Lori Widmer Toxic soup, mold, death, storm damage, water damage—and that’s just the known issues. Even with rough estimates at $100 billion, the final toll from Katrina has yet to be determined. Add to that growing list the environmental cleanup costs. As cleanup crews worked endlessly to pump water out of New Orleans, they also were adding to the crisis. The water being pumped back into Lake Ponchartrain was quickly polluting everything it touched. “It goes against what normal environmental risk management practices would dictate,” says David Bennick, environmental expert with AON Environmental, Philadelphia. “The pyramid is upside down. Usually, one would go in and treat the water before pumping it back into the lake or river. In this case, there was a need to protect life and property first and address the environmental concerns on the back end.” Cleaning up after Katrina may prove to be an environmental nightmare. According to the EPA, the water being removed from the city contains elevated levels of arsenic, chromium and lead. E coli is pre- sent in the soil and residents are being advised to avoid drinking, standing or touching the water, and to avoid contact with the soil. Under normal circumstances, water with that much contamination detected would not be allowed to be released into another body of water. But Bennick says these are unusual times. David Dybdahl, founder and principal of American Risk Management Resources Network, sees mold as a huge factor in the environmental remediation of the area. “There will be significant amounts of mold in the buildings. And to dry those buildings out, you need power. There isn’t any. Even if there was power, there isn’t enough drying equipment in the country to handle the job.” Mold issues aside, the main area of concern for businesses could turn out to be what contamination exposures they face. As insurers respond to claims, they’ll be looking for the source of contamination. If a company has experienced a flood-related spill, the result could be years of litigation. But good luck trying to figure out what contaminants belong to which companies. Bennick says that the known releases to date “are roughly half of what the Exxon Valdez release was.” Even Superfund sites are exposed. Bennick says one site in particular did “everything right” in terms of qualifying for Superfund. In one storm, all that was wiped out. Will the site be denied coverage? With- out knowing all the particulars, Bennick cannot speculate. However, he anticipates the environmental markets will see more clarification in coverage terms going forward. The Effects on Coverage While the environmental issues in New Orleans and downstream are expected to be expansive, the over- all effect on the market may be nil. “I don’t anticipate that this will have a significant impact on environ- mental insurance,” says Bennick. “Having underwritten the coverage, I think the event will be seen as somewhat fortuitous by the underwriters. I don’t anticipate a hardening of the environmental insurance market. It may, in fact, create a lot more awareness of the environmental insurance products.” The awareness may be coming at just the right time. In the past, flood issues were not tied in with en- vironmental insurance, but were covered by traditional insurance policies under water damage and flood exclusions. Dybdahl says that’s all changed. “Mold exclusions have brought water damage into the realm of environmental insurance. This is new. The insurance industry hasn’t had to deal with widespread wind-driven water damage in the face of mold limitations.” Managing environmental risks requires a healthy dose of common sense, says Dybdahl. “There are six steps to management: identify, measure, prevent, control, finance and monitor.” And the financing of risk is the part most often overlooked. “If this happens, how am I going to pay for it?” That figure should be revisited often, as prices go up and conditions change, says Dybdahl. And things do change. Mold ex- clusions, for example, went into effect just two years ago.
  7. 7. 7 Emerging Issue Mold in New Orleans: Covered? By Lori Widmer As the water is pumped from New Orleans and the city begins to dry out, the real challenges start to take form. Sitting in toxic water for over two weeks wreaks havoc on a building long after it’s dried out and the occupants return. Just ask David Dybdahl, principal and founder of American Risk Management Re- sources Network, an environmental wholesale insurance broker in Madison, Wis. Dybdahl is less con- cerned with the effects of the storm damage on the environment than he is with the effects of the water on all that construction. “Biological materials will generally break down with some adverse consequences to the environment, but not long-term,” says Dybdahl. The more worrisome part for Dybdahl is the condition of the build- ings—the mold, to be exact. “Mold is everywhere,” he says of the flood zone. Though he’s not visited the area himself, he says the recipe is perfect for mold. “The food source for mold is carbon, which is in wood. All it takes is humidity to set off mold growth. If water gets into a building, you have to get it out within three days to keep mold from growing. For New Orleans, it’s been more than three days.” If that’s not enough to cripple the city, just wait until you try to make a claim for mold damage. Says Dybdahl of the coverage: “Something that is untested in this economy is the effect of mold exclusions and limitations that were universally added to insurance policies in 2003-2004.” Translation: if you didn’t buy mold insurance, you’re not covered. And that could be an expensive mistake. In August 2003, the Insurance Information Institute that mold remediation for homeowners alone can reach $100,000. National figures for mold are difficult to determine since until now, mold and water damage claims were not separate. Nevertheless, the III says that insurers paid out a minimum of $3 billion in mold-related claims in 2002. Dybdahl believes the industry will see less of an attempt to remediate mold and more of an attempt to replace structures. “Something change in New Orleans. Mold exclusions went into effect. Very few peo- ple purchased insurance covering mold. Now we’ll see the effects of those exclusions.” David Bennick, environmental expert with AON Environmental, agrees. “The sleeping giant when you look at the estimated damages may be the mold issues. Those structures may not be physically dam- aged to the extent that they’ll have to be torn down. In the environment there with the intrusion of water, I fully expect in three to six months a huge amount of mold issues.” Bennick also says that the jury may still be out regarding whether mold claims will be covered. “In the past year or two, mold has really come to the forefront from a litigation standpoint and from a coverage standpoint. There will be the immediate damages from the property and environmental issues, and you have lingering damages which will emerge from the mold. “Because there’s alleged ambiguity about what’s flood and what’s wind, the courts may rule that poli- cies should respond despite the lack of flood coverage.” So how will insurers respond to Katrina flood and mold claims? Bennick sees no problem in getting a claim processed—if the insurer can tie the contamination back to a specific entity. While he says this may occur, he agrees that it’s a tough row to hoe. “It generally may be problematic. We have a tremendous commingling of a lot of different contaminants.” Tying that back to one or more sources, he says, could prove to be impossible. Even with the questions of coverage and of court decisions soon to come, one thing is quite clear— Hurricane Katrina will prove to be another testing ground for an often-overlooked area of coverage. And it’s only recently that mold became part of the environmental insurance coverage. Says Dybdahl, “The environmental impacts of a flood in the past were not environmental insurance topics. Those were cov- ered under traditional insurance policies under water damage and flood exclusions. Mold exclusions bring water damage into the realm of environmental insurance. This is new. The insurance industry has- n’t had to deal with widespread wind-driven water damage in the face of mold limitations.” Lori Widmer is publisher of Risk Factor. She can be reached at ldwpublishing@comcast.net.
  8. 8. LDW Publishing Valley Forge, PA www.ldwpublishing.com Conference Calendar October 2-5, 2005 Federation of European Risk Management Associations (FERMA) Risk Man- agement Forum 2005, Lisbon, Portugal. Titled “Europe, the World and the Future: Opportunities for Risk Management.” For more information, visit www.ferma-asso.org, or email a. gigon@colloquium.fr or s.ashton@colloquium.fr October 2-5, 2005 NAMIC Excellence in Leadership convention. J.W. Marriott Desert Ridge Resort & Spa, Phoenix, Ariz. NAMIC's 110th Annual Convention featuring networking, education, and learning the latest in insurance-industry trends and issues. www.namic.org; (317) 875-5250 October 16-18, 2005 National Risk Retention Association’s 2005 Annual Conference, The Fairmont Hotel, Washington, D.C. www.nrra-usa.com Telephone: 952-928-4656; Toll Free: 800-999-4505; Fax: 952-929-1318 October 11, 2005 Captive Insurance Companies Association (CICA) 6th Annual Fall Meeting, Westin Airport, Atlanta, Ga. In-depth discussions on captives, risk retention and alternative risk fi- nancing. Free to CICA members. Online registration at www.captiveassociation.com October 24-26, 2005 Society for Human Resource Management (SHRM) Workplace Diversity Con- ference & Exposition, Caesar’s Palace, Las Vegas, Nev. Guided dialogue sessions, pre-conference workshops and exhibits. To register, visit www.shrm.org