Risk Management in the New Economy

Per J. AgrellCenter of Operations Research and Econometrics (CORE)

Catholic University of Louvain

© Per Agrell, SUMICSID 2

Outline

The New Economy– Business environment– RM environment– Insurance environment

Business strategiesThe if.. competitive advantage

© Per Agrell, SUMICSID 3

Presentation

1991 civ. ing. Linköping Institute of Tech, Sweden1991 M.Sc (OR) Univ of Massachusetts, USA1995 tekn. dr. Linköping Institute of Tech, Sweden 2000 docent Linköping Institute of Tech, Sweden

1991- Linköping Institute of Tech, Dept of production economics assistant professor of production economics

1995/96 IIASA, Vienna research scholar

1996/97 University of Georgia, Dept of managementvisiting professor

1997/98 University of Copenhagen, Operations researchvisiting associate professor

1998- Royal Agricultural University, Dept of economics, associate professor of managerial economics

2000- Catholic University of Louvain, COREvisiting professor

© Per Agrell, SUMICSID 4

The New Economy

Lower transaction costs– Lower cost to enhance services– Lower cost to reach the market

Constant production costs– Fewer advantages to commodity providers

Information driven– Changes in the Value Chain

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Theory of intermediation

PROVIDERPROVIDER CLIENTCLIENTGEOGRAPHICAL,

CULTURAL, ECONOMICAL;

LEGAL BARRIERS

INTERMEDIARYINTERMEDIARY

HIGH TRANSACTION COSTS

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Disintermediation

PROVIDERPROVIDER CLIENTCLIENT

INFORMATION TECHNOLOGYEDUCATIONKNOWLEDGE

INTERMEDIARYINTERMEDIARY

LOW TRANSACTION COSTS

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Intermediaries?

Disintermediation– Demise of the Middleman

Reintermediation– Birth of marketplaces

“Disinterremediation” Saffo (1997)

– Death of non-value added services

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Example 1: Automotive

Old Economy:– Car (product)– Maintenance (service)

Now– Car + Maintenance (product + service)

New Economy – Transportation (multiple products,

services)

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Example 2: Home Appliances

Old Economy:– Refrigerator (product)– Electricity, maintenance (service)

Now– Fridge + maintenance (product +

service)

New Economy – Food Management Services (product, multi-service)

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Example 3: Electricity market

Old Economy:– Energy + distribution (monopoly product)

Now– Energy (competitive product)– Distribution (monopoly service)

New Economy – Heat, Light and Comfort (competitive

service)

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Common traits?

Slow movers become commodity providers– tough market, low loyalty

Fast movers become service partners– through focus on core needs of client

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Two Generic Strategies

Low-cost leadership– Domination due to technology, skill or

source

Differentiation– Domination due to unique and lasting

partnership with clients

Porter (1980)

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Your turn...

Postal servicesCommercial TVHigher education

BankingInsurance...

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Critical Questions

Who are our clients?What is on his agenda?

What is happening to the RM profession?What is the state of the insurance

market?

How can we move forward?

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Managerial focus

OPERATIONSMANAGEMENT

RISKMANAGEMENT

STRATEGICMANAGEMENT

-Mission-Objectives

-Risk-Uncertainty

-Goods-Services

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The Executive’s Risk Agenda

Occupational hazards (stress)Loss of reputation/brand valueCopyright infringementE-commerce exposure

– Technological risks– Dispersion of knowledge– Impediments to growth

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Enterprise Risk Management

Focus at value-adding processes– Financial operations– Technological processes– Operating practices

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RM development

Risk ManagementRM

Uncertainty ManagementUM

Strategic Importance

Complexity

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Professional trends

Higher entry levelBroader scopeCertificationStandardization

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Risk manager revival

Industry interest– One of 21 Top Jobs in USNews

Educational – RM replaces actuarial sciences programs

Reimbursement– Growth of salaries and benefits

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Risk manager’s credo

Consistency– Organizational objectives

Proactivity– Taking the initiative

Comprehensiveness– Addressing the true risks

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Proactive management

REACTIVE MANAGEMENT“never happens again”

PROACTIVE MANAGEMENT“it must never happen”

BUSINESSBUSINESSCLAIMS,

ANALYSES,TRENDS

PLANNING,INFORMATION,

READINESS

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Risk manager’s evolution

Insurance Purchaser

Risk Controller

Risk Manager

Uncertainty Manager

Complexity

Manageriallevel

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Summary: Business changes

Global, demanding, changingInformation intensive: new exposuresManagement of Risk acknowledged

However:– Short span of attention– Very specific requirements for services – No loyalty in trading commodities

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RM actions

Systematized RMIncreased ART (alt risk transfer)

– 1. Flexibility– 2. Non-traditional risks– 3. Price

Competitive purchasing

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Insurance market

How will the insurance industry meet the challenge?

– Product provider?– Service provider?

What is the current basis for change?

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Client satisfaction

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Insurance market

Disintermediation– Only the value-added survives

Commodization– Standardized, competitive products

Innovation in finance– 49% of PC insurers diversify in finance

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Insurer’s survival strategies

Commodization may be met with– Low-cost leadership

Volume

– Differentiation: BundlingBlended programs

– Differentiation: ServiceFinancial servicesConsulting services

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Volume strategy

Expected, but– IT has reduced processing costs– Decreasing marginal revenue

What did you make on your last contract?

– New risks -- new expertise– No lasting advantages

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Product revamping

Short-term response to competition, but– Blended contracts have lower margins– Simplification accelerates commodization– Needs close financial ties– No comparative advantage

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Service provider

Financial products– Synergies with life, pension, etc.– Strong competition from banks

RM Consulting– Cultural change– Competition from consultants– Needs a comparative advantage

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RM Consultancy market

Growing outsourcing budgetsComplex task -- Higher marginsScattered market -- Low trust

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Future actors

Insurance companiesBrokersManagement consultants

– Who will take the most profitable market?

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Management Consulting

Ernst & Young Enterprise RMArthur Anderson Integrated RMArthur D LittleCoopers & Lybrand Generally Accepted

RPTowers Perrin Enterprise RMKPMG Boston Consulting Group

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Ex: RM at Ernst & Young

Enterprise RM– Strategic RM support– Maximize return/RM-investment– RM Performance benchmarks

Key angle: Pre-merger RM assessment

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Industry response

Insurance Purchasing

Risk Controller

Risk Manager

Uncertainty Manager

Complexity

Manageriallevel

Agent

Safety specialist

Broker/Consultant

RM Partner

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RM partnership (1)

RM Partner offers the client– Professionalism– International network access– Superior risk assessment through data

analysis– Superior risk transfer access– Single account manager at insurer

© Per Agrell, SUMICSID 39

RM partnership (2)

RM Partner gains– Higher value-added to client– Higher billing marginal– Lower dependency on insurance products

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if… Comparative Advantage

Insurance theory revisitedJumping over the fenceSung (1999)

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Principal-Agent Theory

AGENTAGENTTASKPRINCIPALPRINCIPAL

VERKSAMHETVERKSAMHET

RESULT RESULTACTION

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Two Problems

The insurance contract puts the client as agent– Moral hazard– Adverse selection– Contractual excesses

The quality of insurance is not assessable– Impediment to partnership

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Jumping over the fence!

What does the client really want?– Peace of mind

How can we give him that?– By sharing his agenda – By working with him, even after the contract

© Per Agrell, SUMICSID 44

The Winner Insurers

Sung (1999):The insurance contract is the optimal incentive contract for a consultant-investigator and the client.

Competitive advantage !

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Barriers to development

Cultural differencesEducational diversityIndustrial structure and inertiaConflicts of interest and loyalty

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Cultural change

YESTERDAY TOMORROW

Salesman, distrust Partner, trustReactive ProactiveNarrow specialist Holistic analystUnknown quality Certified qualityCostdriver Profit drivenProduct focus Client focus

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Change enabler

if… Educational Program– RM Academy

Academic entry to contemporary RM discipline

– The ARM diplomaCertificate of excellence in industrial RM

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Summary

Market drives for changeLooking for prosperity, insurance turns

– Knowledge industry– Information intensive– Delighter!

Jump the fence!