PETER HARMER SPEECH - A QUESTION OF RELEVANCE
Introduction
The world of risk is becoming increasingly challenging as the business world
itself is buffeted by an ever-widening range of complex issues. These include:

Globalisation – of markets, of supply chains, of communication and the
creation of a new generation of global giant corporations.

Energy supply and demand and the consequent pricing volatility and geopolitical plays.

The rapid industrialisation of China and India and the consequent changes
in the balance of economic and potentially political power.

Continuing and rapid developments in technology enabling new ways of
doing business, reconstruction of value chains and the emergence of new
businesses and even new industries.

Changes in developed country demographics as the baby boomer bulge
moves into old age and retirement, coupled with what appear to be
fundamentally different values and expectations of the younger workforce.

And it would be remiss if I did not mention anthropogenic climate change
and its affect on a wide range of business and societal risks.
Not unsurprisingly this environment has driven a rapid growth in the importance
of risk management – particularly over the last 10 years. Risk management is
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now recognized as an essential component of good management and corporate
governance from the Board of Directors down.
To amplify:

The UK Combined Code on Corporate Governance says that the Board
‘should satisfy themselves that financial controls and systems of risk
management are robust and defensible.’

A global risk briefing report conducted by the Economist Intelligence Unit
in 2007 (sponsored by ACE) found that
Risk management is now seen as a key contributor to a company’s
source of competitive advantage. The research also showed that
companies worldwide are planning to increase their investment in most
areas of risk management over the next three years including improving
the quality and reporting of data, training and strengthening risk
assessment processes.
So I find it ironic when I hear commentators suggest that insurance is becoming
less relevant to our major customers.

Less relevant in a world of growing risk, growing risk complexity and
heightened awareness of the importance of good risk management?

Less relevant in a world of increasing global trade and commerce? – trade
and commerce which gave rise to the first forms of insurance and its rapid
growth from the 18th century.
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Less relevant - this is a view I fundamentally disagree with – and I hope not
only from a position of conflicted interest. In putting my case, I want first to
explore what might be driving this perception of reducing relevance. Then I want
to look at what I choose to believe is the reality. Finally I want to identify what I
see are some of our major challenges and opportunities if we are to beat the
nay Sayers and to continue and grow our relevance.
Perceptions of reducing relevance
Commentators raise a number of issues to illustrate what is seen as reducing
relevance. I want to dwell on three of them today starting with the growth of the
derivatives market.
Growth of derivatives market
The insurance markets dominated the financing of risk throughout most of the
last two centuries. However that domination has been challenged and arguably
lost in the last two decades with the growth of the derivatives market.
In December 2007 the Bank of International Settlements published its Triennial
Central Bank Survey on Foreign exchange and derivatives market activity. It
found that the over the counter derivative market had continued to rapidly
expand between 2004 and 2007. The total amount of OTC contracts rose 39.5
percent to $415 trillion, the biggest jump since the BIS began compiling the
data. Converted into US dollars at constant 2007 exchange rates turnover
increased by 50% between 2001 and 2004, and by 65% in the more recent
period.
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The UK remains the leading derivatives centre worldwide with a 43% market
share. The US is the only other major location with 24% of trading.
This is a market that was started just over 25 years ago – when in 1981
Salomon Brothers arranged a swap transaction between IBM and the World
Bank!
In comparison the insurance markets have been relatively static. International
Financial Services London tells us that global insurance premiums grew by 8%
in 2006 to reach $3.7 trillion. This includes both life and general premiums.
Net worldwide premium income of the UK insurance market totalled £193.9bn in
2006, of which £41.4bn is general insurance or P&C.
Premium income,
however, has changed very little since 2000 due to stagnant and falling prices.
The difference in the two markets is now vast. While the derivatives market
continues to rapidly grow the insurance market is relatively static. This, say our
critics, is evidence of our increasing irrelevance. By way of example, look at the
weather derivatives market they say. This market is still very young – just 10
years old – but managed to attract $19.2 billion in terms of the notional value of
weather derivatives traded in 2007 – and this was down from a record in the
previous year of $45.2 billion.
Another indication of reducing relevance is reflected in perceptions that
insurable risk is not what keeps members of the C-Suite awake at night.
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Insurable risk not what’s keeping organisations awake at night
Aon’s 2007 Global Risk Management Survey found that the top 10 risks that
organisations worry about are:
1. Damage to reputation
2. Business interruption
3. Third party liability
4. Distribution or supply chain failure
5. Market environment
6. Regulatory/legislative change
7. Failure to attract or retain staff
8. Financial market risk
9. Physical damage
10. Merger, acquisition, restructuring
You could argue that insurance only adequately responds to five of these risks.
In 2003, it was 7 out of the top 10. In 1999, it was 9 out of the top 10.
The clear message here is that insurance is playing a decreasing role in helping
companies manage and finance their risks. This is in part because companies’
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revenue and profit generation reliance has shifted from tangible assets to
intangible assets, and the insurance industry has not been able to keep pace.
In my experience this has led to confusion and even frustration about the
insurance product and its value.
Let me illustrate with business interruption.
When organisations think about business interruption risk they probably think
about supplier risk, utility risk and technology viruses as key sources of that risk.
They are likely to identify and quantify risk in this way.
However BI insurance has never managed to cut the umbilical cord that
attached it both in policy and conceptual terms to property insurance. With the
result that some sources of BI risk can be insured in some circumstances – and
other sourcees not. This leaves an organisation with a very ambiguous view of
how well its business interruption risk is really protected.
A third issue that challenges the relevance of insurance is the perception that
we retreat from, rather than embrace, risk.
Retreat from risk
There is undoubtedly a tendency to avoid risk that is not well understood. New
or emerging risks are particularly prone to this treatment. Y2K, Terrorism and
more recently the risk of a pandemic are all examples of where the industry has
hastened to exclude rather than take on risk, at least as a first response.
And while this causes concern for our clients who are left holding the risk come
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what may, it is not illogical when you remember that insurance is founded on the
law of large numbers – and the inability to quantify risk excludes it from this
concept. But of course customers are not concerned about the logic behind our
products.
There is another kind of retreat from risk that also causes customers to question
our industry. That benignly named but devastating family of Dennis, Emily,
Katrina, Rita and Wilma led to a massive retreat from risk as insurers cut or
excluded cover or, in some cases, exited entire regional markets in the US.
While this kind of response does cause considerable grief to our customers – or
former customers - it needs to be put into a broader context. In some cases
regulators are driving the exit of insurers – for example the Florida market,
which is so heavily regulated that insurers are finding that they cannot charge
sustainable premiums (although this is beginning to change). Indeed you could
argue that the weight of prudential regulation generally distorts the market by
making certain classes comparatively less attractive.
The other context that sits behind a lot of post catastrophe suffering –
particularly in developed countries – is that governments at all levels have
unnecessarily contributed to reducing insurability – for example by allowing the
development of flood prone land and by evading the need to take mitigating
action, such as investing in flood defenses in line with climate change forecasts.
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Summary or perception of reducing relevance
So in summary the evidence that supports the proposition that insurance is less
relevant is:

It’s lack of growth particularly when compared to the derivatives market.

The mismatch between the way an organisation sees risk and the way our
products are structured.

The tendency to retreat from new or increased risks.
And while all of these are important issues that we should not lose sight of, I
suggest that they are not conclusive evidence of our reducing relevance. And I
would now like to lead the case for the defense.
The reality of continuing relevance
I am sure that many of you in this room have excellent real examples of our
continuing relevance to our clients.
In the time I have I would like to talk about three examples:

Our response to the UK floods

Catastrophe payouts generally

Our capital leverage
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Response to the UK floods
The brand of this august institution, arguably of non-marine insurance itself,
owes a considerable amount to Cuthbert Heath and his response to the 1906
San Francisco earthquake catastrophe. And while I am sure as an industry we
did not ‘pay all claims’ the amounts paid following the 2000 and 2007 floods
were significant amounts - approximately £500m and £3bn.
I quote from the ABI’s Summer Floods 2007 – Learning the Lessons

Insurance companies are proud of their response to this year's devastating
summer floods in the UK. And rightly so.
Homeowners and businesses in the UK benefit from an almost unique
system of flood insurance. In other European countries, protection against
the costs of flooding is not a standard part of property insurance, leaving
taxpayers to pick up much more of the bill. This is reflected in the enormous
impact of the June and July floods on Britain's insurers.
ABI member companies have dealt with around 165,000 claims, and will
pay out approximately £3 billion. With the average cost of a property flood
claim running at £20,000, it is clear that Britain's homeowners and
businesses are benefiting from a unique and extremely valuable service.
As well as paying out on policies, insurers and brokers have become
increasingly better at disaster response. This was illustrated by the responses
to the 2007 UK floods.
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But the story does not stop with the amounts paid out – amounts that enabled
people to rebuild their homes and their businesses. The industry has shown
what I believe is outstanding resilience and good sense by engaging with
government to maintain flood insurance for most of the UK. Its approach in
being prepared to continue providing flood insurance in most cases while
attempting to drive flood mitigation spending and other risk reducing actions is
exemplary.
I believe it is indicative of the kind of approach we should be taking - and will in
an increasingly complex risk world need to take. An approach that sees the
industry influencing risk management practices not only indirectly through risk
pricing but more holistically and directly by engaging governments on better
policy and risk mitigating expenditure.
So ……… I think that the way we have dealt with flood in the UK is highly
illustrative of an industry that has continued to be very relevant to its customers
and is successfully striving to further build on that relevance.
And this proposition is supported by the ABI’s Summer Floods 2007 – Learning
the Lessons’ where it records that 65% of SMEs believe they received most
help after the flooding from the insurance industry.
Not from Government.
From the Insurance Industry.
Amount paid out by industry
My second point for the defense is the cash regeneration by the industry
following catastrophes.
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The amounts paid out for major catastrophes over the last 10 years is hardly
indicative of an industry that is not relevant to the broad community. For
example

In the US in 2007 dollars: Katrina and other 2005 hurricanes - $60bn, World
Trade Centre - $22bn, 2004 hurricanes - $21bn.

In the UK: 2007 summer floods - £3bn.

In Europe: 2007 Kyrill storms - US$6bn.

Another way of looking at it is Munich Re’s estimate that for the period 1950
– 2005 US$340bn has been paid out in 2005 dollar values. And as many of
you know the last 10 years has seen increasingly large and frequent
catastrophe payouts. This is an enormous amount of money, redistributed
to those in need at critical times.
(So while we are not growing at the rate of the derivatives market, we have and
continue to return a significant amount to clients to compensate them from
losses and enable them to continue in business).
Our Capital Leverage
Insurance continues to work on the law of large numbers. The premise is the
premiums of the many pay for the losses of the few. The portfolio construction
of most (not all) insurers imputes a diversification benefit, which in turn, is
applied to the benefit of policyholders.
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The capital adequacy or solvency requirements of most regulatory regimes
creates an enormous amount of capital leverage, that cannot be replicated by
other products, or clients themselves.
If clients, by way of prudential management, had to reserve capital against
otherwise insurable losses, commerce would grind to a halt.
It is difficult, if not impossible, to quantify the amount of capital leverage we as
an industry generate. Given that we said earlier worldwide premiums have
reached over $3.7 trillion one might argue that something in the order of $4,000
trillion is thereby released for reinvestment in the global economy.
Summary of the case for continuing relevance
We do continue to adapt and innovate our products; we do provide financial
certainty for major risks that allow the world to continue its development; we do
release an enormous amount of capital back into the economy; we do pay out
vast amounts following many major catastrophes allowing people and business
to continue in existence. Finally we are learning to work proactively with
governments and other stakeholders to drive better long-term risk management.
Major challenges to maintaining relevance
Introduction
And so clearly I would conclude that our industry does remain relevant. But that
is not to say we should not acknowledge relevance will be an ongoing issue;
one that we must continually seek to address. And this brings me to the final
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part of this talk – some of what I see as our major challenges and opportunities
if we are to continue and, even, grow our relevance. I will examine three key
challenges – namely around clients, capital and competence.
Better understanding our clients’ risks and needs
Our first challenge (and opportunity), and one particularly for our part of the
industry (the brokers), is to get far better at understanding customers’ risks and
needs and using our skills (both brokers and underwriters) to design solutions
that demonstrably match those needs.
This must start with segmentation based on a deep understanding of client
need.
While the industry has adopted various forms of segmentation, it is
invariably not based on client needs. More often it is size or current levels of
remuneration or product type – which are not good proxies for client need.
Much better proxies are the complexity of clients’ risk profile and their level of
risk sophistication.
Too often we begin the annual renewal process with the client from the
presumptive position that they will have to buy (at least from someone) again
this year.
A risk review is often confined to revaluing assets to be insured, establishing
estimated turnover and wage roll etc.
This reactive, static approach, coupled with the continuing shift in emphasis
away from the risks insurance has historically handled well, leaves the average
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CEO or CFO rather skeptical of the real value of insurance, (even more so if he
has had a poor claims experience), ultimately viewing insurance as just another
commodity purchase.
When we look at a major listed corporate entity, we should remind ourselves the
CEO has only 3 prime concerns. All other concerns trace their roots back to
one of these.
They are:
1. How to manage and finance the risks of growth?
2. How to improve earnings predictability? and
3. How to increase return on capital?
Everything we do by way of risk management or insurance responds to one,
two or all three of these needs.
Equally, for a small commercial business at the other end of the spectrum, the
needs might be defined as:
1. How do I protect my cash flow?
2. How do I satisfy my banking covenants?
3. How do I manage wealth succession?
When you start the discovery process from this perspective, you must have a
greater certainty that the risk management advice, and the resulting suite of
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recommended insurance transactions, will actually meet the need ie: be
relevant!
At Aon, for our major clients, we are meeting this opportunity by taking a very
robust approach to matching advice and transactions to need.
It starts by ensuring we have an extremely good understanding of the sector in
which our client operates.
Is it high growth or, low growth, what are the
regulatory or competitive pressures, what are the specific risk characteristics of
the industry, is it asset or knowledge intensive. etc? This begins informing the
risk profile.
We follow with a detailed and thorough review of the client specific insurable
risks in the context of their business objectives. These are ranked by probability
and severity to create a risk matrix.
Against this matrix we map effectiveness of controls and mitigation actions, and
the responsiveness of current and/or proposed insurance coverages, and
create a gap analysis.
We then conduct a probalistic loss forecast (if appropriate), analyse the
company’s risk appetite and financial tolerance against their own financial
metrics, and design the optimal risk financing programme – all predicated on
the objective of selling risk to the insurance market – not simply buying
insurance coverage.
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The outcome is simple.
The client knows what all of their risks are; the source, and potential of financial
consequence, extent to which these are financed by insurance; the extent to
which they are relying on their own capital or profits to fund risk; and the
risk/reward result they are targeting through the risk financing / management
strategy.
Simple – but by our findings not always common.
I would like to conclude this point that you can probably realise we are
passionate about at Aon, by referring again to the global risk briefing report
conducted by the Economist Intelligence Unit in 2007 which I mentioned at the
beginning.

The survey found that the majority (97%) of senior executives and risk
professionals surveyed said that good risk management is an important
source of competitive advantage. There is a growing consensus that risk
management is now expected to be more than just a tool to protect a
company from losses.

Commenting on the results Andrew Kendrick, ACE European Group
Chairman and CEO said: “Risk management has come of age. But with
this maturity comes responsibilities. More than 60% of respondents to the
research said that over the last three years the commitment of their
company’s board to risk management issues had increased. But, as a
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result, there is a greater expectation that the operation will make a
measurable return on the investment it receives.”
And so that is our first and biggest challenge going forward – to be responsible
for showing how our risk and insurance advice and products deliver a
measurable return and ideally assist the company in pursuing its competitive
advantage. And we won’t do that unless we and our clients, working together,
truly understand their risks and needs.
Risk and capital innovation
Another challenge to maintaining and improving our relevance can be
summarized as risk and capital innovation.
I would like to return to the subject of the dramatic growth in the derivatives
market for a moment. One of the enablers for that success has been the
development of sophisticated financial engineering skills and tools. These have
allowed banks and other product providers to slice and dice the risks inherent in
supplying that product and on sell these as ‘derivatives’ to an ever-widening
class of investors. In turn this has allowed banks for example to sell on assets
and risks derived from their retail activities and vastly increase their product
origination capacity.
Arguably it has also enabled the dramatic growth of hedge funds who have
played an increasingly important role in at least creating liquidity for these new
classes of derivative assets.
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If we turn back to our own markets we see that the risk has largely remained
‘locked’ within the insurance and reinsurance market.
While arguably
reinsurance is a form of derivative, we had until more recently not developed
the ability to break up the risk from originating insurance into derivative asset
classes that could attract alternative capital. The best we had done was to slice
and dice the risk within our own markets through retrocession – but that is a
limited game as we are relying on the same capital to invest in the risk – and it
can actually increase systemic risk as those with memories of the London
market in the latter part of the 1980s will testify.
In the mid 1990s following Hurricane Andrew and the Northridge earthquake,
we took the first tentative steps in trying to attract alternative capital to support
the insurance markets with the development of cat bonds.
During the ensuing decade we have seen good growth in the cat bond market
as we, and the potential new investors, have developed our understanding, risk
modeling sophistication and confidence.

The total value of bonds outstanding has grown from US$4.9bn at the end
of 2005 to US$8.5bn at the end of 2006 and US$14bn at the end of 2007.
Increasing sophistication in financial modeling and engineering, allowing
for the development of an increasing range of derivative investments, has
helped.
The market is destined to continue to grow aggressively. John Seo [pronounced
So] the US hedge fund manager who has made a name investing in cat bonds
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as well as foreseeing the possibility of the kind of catastrophe that eventuated
with Katrina, recently gave evidence on this subject to a sub-committee of the
House of Representatives. He said

‘Looking forward, even with things cooling down a bit, we might still
reasonably forecast another tripling in size to 50 billion dollars in liquid cat
bonds outstanding in 5 years and another tripling in size to 150 billion
dollars in liquid cat bonds outstanding 10 to 15 years from now. Here,
again, I will mention that the entire cat bond market is 2 to 3 times the size
of the liquid market, so the original expectation that the cat bond market
would become a trillion dollar market should be realized within a couple of
decades, which is probably par for the course when one looks back at the
history of the mortgage-backed securities market or even the options and
derivatives market.’
As an industry we must embrace and aggressively drive this growth because it
will enable much better and more extensive insurance product origination.
But dramatic growth will be a challenge because many of us still think in product
silos without seeing the possibilities to develop broader more valuable products
that can be sliced and diced and re-packaged to create a range of derivative
products for the wider capital markets to invest and trade in.
And one thing that will permit this kind of wider thinking is the further
development of our financial and risk modeling.
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Arguably we have for too long lived in the world of historical loss models which
are of course limiting by only allowing us to model a future that has the same
structure as the past. We are now beginning to see the development of more
creative modeling particularly driven by climate change which is of course
making historical loss data increasingly redundant.
But I think we have to do a lot more in this area. We as an industry have got to
actively promote and be prepared to invest in new modeling and risk
engineering tools and skills.
And I would like to take this opportunity of endorsing Vinay Mistry (the Manager
of Exposure Management at Lloyd’s) in his promotion of a move towards open
source cat modeling which should allow more rapid development of modeling to
incorporate scientific and engineering advances in finding proxies to better
estimate the future.
Improving the industry’s skill base
The final challenge for future relevancy I want to touch on today is our skill
base. For example we will not meet the other two challenges I have commented
on, namely understanding clients’ risk and the need for capital innovation, if we
do not have the requisite skills. And I do not think that looking at the industry as
a whole we are presently attracting the requisite skills in any kind of systematic
way.
We will not be able to engage our clients in a way that helps them analyse and
understand their risks and needs unless we have good diagnostic skills. These
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would, for example, include a good understanding of risk and a good
understanding of finance – after all insurance is a financial product.
We will not be able to develop new ways of analyzing and predicting risk to
enable the development of new original and derivative products without topflight risk modeling and financial engineering skills.
And we face this challenge at a time of increasing demand for these types of
skills by other parts of the financial services sector. And at a time when the new
employees with these kind of skills are highly mobile and driven by different
gods.
I don’t have the answer to this challenge but it is probably our most significant.
For without the requisite intellectual core we will struggle to face our many
challenges and opportunities in continuing to retain, let alone increase our
relevance. We need to start looking seriously at what we have to do to attract
the right talent for tomorrow in a highly competitive environment.
Conclusion
So in summary I hope that I have convinced any of the nay Sayers that as an
industry we remain very relevant to our clients and stakeholders.
There are however, fantastic opportunities to improve our relationship with our
clients and it is the challenge of exploiting these that gives me personally the
excitement and passion for my job.
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While we can exploit some of these opportunities individually within our own
competitive domains, there are many more opportunities to work together,
collaboratively, as an industry. The good news is there is a pretty good track
record in this regard.
Thank you.
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