As the global financial catastrophe continues to unfold 18 months after it started (and 1 year after the massive American meltdown – think AIG, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac), one has to wonder: what have we learned?
More specifically, to what reasonable standard do we hold our financial institutions, in the managing of risk?
Risk management is understanding, evaluating, quantifying and responding to the threat of risk. What we witnessed last year can be characterized as a fundamental – and deplorable – breakdown of risk management by many financial players and their regulators who should have known better.
We’ve witnessed:
- life insurers reeling from over-exposure to guaranteed investment products (including segregated funds in Canada).
- multi-line insurers hemorrhaging due to being over-exposed to derivative markets.
- turmoil among banks, investment management firms, and capital market advisors, who appeared blissfully unaware of the toxic nature of the collateralized debt obligations (CDOs) they were buying or recommending. (In simple terms, CDOs were home mortgages – some without down payments at sub-prime interest rates for more than the value of the home – packaged together with car leases, credit card balances, other consumer debt.)
- the resulting failure of 77 banks in the US so far in 2009.
However, the property-casualty insurance industry in Canada is somewhat unique, in that it largely escaped the carnage. Why? Here are 4 reasons:
1) a very conservative regulatory framework with strict protocols for investing;
2) conservative reserving practices for unpaid claims – including a series of modeling for worst-case scenarios, including 1 in 100 year events;
3) reviews by outside actuaries of reserving practices to ensure adequacy;
4) prudent reliance on reinsurance to spread risk of catastrophe.
This does not mean, of course, that no general insurer in Canada will fail; in fact some are being carefully monitored by government regulators. However, the Canadian industry’s general framework, together with specific advice from a knowledgeable broker, should provide a strong degree of confidence.