Can Risk Framework ‘Assurance’ reduce Insurance Costs? Yes, but will CROs pay for it?

I've long believed that effective Risk Management delivers tangible benefits to organisations. Ray Flynn, a risk expert with decades of real experience, shares his attempts to sell Risk Framework Assurance to reduce Insurance costs. Ray is a former Director of the IRM and independent Risk Consultant. 

Could an independent review of a professional service company’s risk framework result in it paying reduced Professional Indemnity Insurance premiums?  Probably.  Is it an easy sell?  No!

I was once on a management course where we started by listing things we would like to achieve from what we learned, detailed as a value to the company (additional revenue or profit).  It had to be something you wouldn’t have aimed for otherwise, so it could be directly attributed to the training.  Anyway, 6 months later we had to report on how well we had done in achieving these goals, again putting a value on them.  I think one of mine was to develop a new ‘product’ that would generate £X in revenue in the months following the course and I had achieved my objective.  Anyway, it turns out that this is how the training company sold their services to new companies.  They were able to list ‘testimonies’ from previous clients about how much the training had added to their bottom line.  In other words, the course more than paid for itself.

Whether this was in the back of my mind, or if through pure genius, I developed a plan to get companies to invest in an independent review of their risk management framework, in a way that would more than recover the cost of our consultancy work.  The focus was on professional service providers that paid huge amounts of money every year for Professional Indemnity Insurance coverage.  I remembered hearing that the company I once worked for had reduced its PII premiums by $millions by demonstrating to its insurers that it had implemented a robust system of risk management for its projects.  I figured that this could be taken further.  If these companies had their existing risk management processes and procedures reviewed by independent risk experts, would the insurance companies be even more comfortable in providing PII cover, to the extent that they would charge even lower premiums?  I checked with a contact I had in a broker specialising in this type of cover and the answer was that, as a general rule of thumb, an independent review by a reputable risk consultant could generate about a (once off) 20% reduction in annual premiums.  I asked if companies paying for other insurances, such as third-party liability, defamation, kidnapping, etc. could expect to see the same benefits, if they were to demonstrate some level of verification of their approach to risk, and the answer was a resounding ‘yes’. 

So, there it was: all I had to do was to team up with an established, reputable risk management consultancy (which I did) and target companies providing professional services (architects, engineering firms, law practices, hospitals etc.) large enough to be paying millions annually for their PII coverage and show them the sums: ‘Pay us £100,000 for an independent review of your risk management framework and, of course, implement our recommendations, and you will save yourself £1,000,000 or more on your PII insurance’!  Apart from that, you might actually improve your Risk Management performance.  The problem of in-house risk management teams not seeing the wood from the trees would be mitigated. It was a sort of Risk Management Framework Assurance certification, and it was a “no brainer”!

We started with engineering consultancies, which is where my background was, with a plan to bring on board legal, medical and other experts to ease ourselves into doing the same thing for other professional service providers.  The world was our oyster (I can’t think of a vegetarian equivalent of that one).  Everyone we spoke to in the companies we targeted was interested.  Some thought it was a brainwave.  “Why hasn’t someone come up with this idea before” and similar responses were heard.  Did we get any work out of it?  Nope, not a single paid hour!  Why not?  Well, I think there were a few reasons:

1)  We often ended up in front of the Chief Risk Officer (CRO) or equivalent, who, while agreeing with our approach, felt that the exercise could expose them in some way. Even though there was a chance that we would, independently, confirm that they were doing everything perfectly well, there was a risk that we would highlight some weakness, and that was a risk, I believe, some CROs weren’t willing to take, at least by voluntarily subjecting their ‘babies’ to scrutiny.

2)  Even when we got in front of CEOs, or other decision makers, I believe the worst enemy of risk management kicked in: Complacency!  “We’re fine on our own”.  “We can sort this out ourselves”.  Maybe they contacted their insurance brokers and were offered the ‘equivalent’ from their in-house consultancy arm?

3)  We ran out of time.  We were operating out of an office that was short of commissions and, with no easy wins, other things took priority, so we couldn’t sustain the campaign.  Maybe it needed a more global approach than we were doing at a local level.  We thought we’d be able to develop a successful template that could be taken and used in every country in which the parent risk management consultancy operated.  It might have been better to persuade the bosses in the US HQ to adopt it and develop it as an approach with existing clients in other sectors.  Perhaps we needed a bigger “name”. There used to be the phrase “no one ever got fired for buying IBM”. In the 1980s, IBM figured that their name was worth an additional 18% on the cost of their services. As long as their price came in ‘only’ 15% higher than the competition, there were assured of the sale. In a similar way, given the choice, most companies would engage a “Big-4” consultancy over any other.

I guess I’ll never know if this would have, or even has, in the meantime, succeeded.  Maybe someone reading this will think it’s still worth trying and message me from the Cayman Islands, in a few years’ time, to let me know how well it all went?  Go for it!  

-------------------

Ray Flynn

Ray is a semi-retired independent Risk Management consultant, with a focus on bribery and corruption.  He has carried out risk framework reviews and fraud risk assessments & investigations. He has also run two businesses and carried out interim management assignments, in 4 different countries.  He has worked extensively throughout Europe, the Middle East, the Americas, Asia and Africa and was also a key member of a team investigating corruption in the engineering industry with the World Bank over a two-year period.  He is currently based in Brussels.

 

Ray was a board member of the Institute of Risk Management for 3 years and Chair of the institute’s Investment Committee.  He also sat on the IRM’s Education & Standards Committee and spent 5 years on the Audit and Risk Committee.  He has contributed to, and authored, two of the Institute’s publications

Greece - Covid-19 fatigue is real

This is what Lockdown Fatigue looks like. When we walked to the car last night around 7:45, the streets were full of people. People sitting together on walls and benches, drinking beer, smoking, talking and laughing. Glory Be! The pandemic is done, lockdown is lifted, immunity is achieved, Covid-19 is not really that bad. I have to say it was just plain strange. Friday evening, and let's all get out there and party, even if we can only party outside. Well, okay, not exactly “partying”, but maybe “let's meet up for a drink, it’s been a while”.

The city had a strange feeling of "normality" about it. The groups of people, the spring air, new leaves, and shops open, though with people only standing at the entrance in most cases, not entering. Except for the bread and confection stores which had gentle queues outside and strict limits on the numbers allowed inside. The café-bars were open with people taking drinks away. Not seating was set up, but that didn’t stop anyone, with all the city planter boxes serving as benches.

Had all these people sent the mandatory text messages to receive proper authorisation to be out? I've not seen any code for "meet friends, drink beer, talk". The closest might be a Code 6, used for "personal exercise". We were out on Code 1, "trip to a doctor". All pretty standard if prescriptions need to be renewed.

The seven-day moving average case count in Greece continues to be over 2000, though it does seem to be moving downward. A few days ago, it reached 2652. The highest seven-day moving average reached in November 2020 was 2673. We were less than 1% away from breaching the highest peak of the pandemic, but everyone is out in the streets.

The 9pm curfew also seems to be a bit of a moving feast. Francoise’s doctor’s appointment was at 8:30, hence our early departure, to walk to the car and to make sure we had enough time to start it with the booster battery if necessary (it started right away, good news). That meant that she finished with the doctor at about 8:50, which put us back on the road at almost 9pm, the start of the curfew. Nope, the roads at 9pm were full of traffic, and stores were still open.

The crowds of people across the park from us were still sitting outside the bar, and everything was good with the world.

Meanwhile, Francoise’s doctor was on the verge of tears with her, talking about how difficult it is treating the Covid-10 patients, and the emotional toll of dealing with trying to save people. The numbers of people coming into hospitals is not quite overwhelming the system yet, but it is putting a real and lasting strain on the healthcare professionals. Greece has drafted private doctors to help, as the public system has reached capacity and has taken over some private clinics to use as overflow wards.

Out in the streets, the age range of most people was in the 18 – 30 at a guess, but that doesn’t mean there weren’t plenty of older people, and certainly, there were plenty of children out with their parents. Mask discipline is better but not stellar. And when groups are sitting together along a wall, their masks just get in the way of the drinks and fags and talking. And there seems to be scientific evidence that wearing a mask also impacts your hearing, to judge how people don’t wear their masks even when just listening.

The doctors are suffering mental trauma from dealing with the flow of patients, and the potential patients are ignoring the basics required to keep themselves and their friends out of the hospital. But only the old die from this. Oh well, I guess a drink is worth the potential for a year or more of symptoms and a probable lifetime weakened immune system and damaged lungs, to name just a couple of possibilities.

The "good news" from the doctor was that this peak does not seem to have the same level of deaths (yet). This may be because therapeutic responses are better or that cases are being identified earlier through testing and, therefore, easier to treat. Or it could be because the death rate trails the new case rate by two weeks. We will not know for a couple of weeks. But we are only looking at the chart through today, and it doesn’t look too bad. Maybe it has peaked.

The charts are there. The data is there. And the history is there. 

When I shift the deaths backwards by two weeks or so to overlay the previous peaks in cases and deaths, the picture does not look very appealing for the next couple of weeks. The total cases may have peaked (I certainly hope, but again it is too soon to say that), but deaths certainly will not have peaked for this wave. Again, all that can be said that we will wait and see and hope that the numbers come down.

But Greece is not vaccinating people quickly enough. Most of the over-80s have been vaccinated, and the 60+ cadre is in process. But the total percentage of the population that has had its first dose is still around 10%. There will need to be a significant increase in the pace to be able to really open the country.

 

(Charts from Worldmeters: https://www.worldometers.info/coronavirus/country/greece/)

Inflation, Default, or Super-Twist

The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default. Inflation vs default.

The “New Normal” is evolving, and we do not yet know what it will look like, or fully how the transition will happen. We do know that governments are printing massive amounts of debt to attempt to save what they can of their economies, with the hope that post-pandemic growth can accelerate and recover economies to pre-pandemic ‘health’. But that growing debt is a burden on countries and will stay as a burden for some time to come.

I keep reading that there are two options to deal with debt growth; inflation or default. I’m not sure that either is the actual ‘end game’. Certainly, a huge amount of money is being conjured out of the air and being pumped into economies. In the US Congress has just approved a $1.9 Trillion spending package, on top of a $2 trillion spending package last year, all on top of existing government expenditure. The UK government has been paying salaries at 80% since last April or so, and will continue to do so until September or later this year. That is effectively paying 80% of a huge number of Britons' salaries for over a year.

Not surprisingly, but seemingly strangely also we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of 6.5% or whatever they are saying it is, those numbers are fantasy).

But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates). 

Inflation

Inflation has been the tool for managing down large debt for centuries, and there is an expectation that this is what will happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly is true at the higher end, with inflation in luxury goods, art and property (higher end). But that means that the excess money is in relatively fewer hands. “The rich get richer” argument. Well, if the rich are getting richer, than the products and assets that the wealthy are purchasing must either expand in quantity, or those products and assets will increase in price. Classic supply and demand pricing.

But if the income levels at the ‘not rich’ end of the economy are not increasing, and the quantity of products, services, and assets are remaining constant, then there should be little inflation at that level. In fact, prices in many cases are increasing while incomes remain stagnant or increase at a pace slower than the cost of those goods and services. But there has been creeping inflation underway for decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.

There are numerous examples of the management of inflation figures in developed countries, driven by the use of ‘hedonics.’ for the calculation of inflation. If you get greater functionality from a smart-TV and pay more for that TV, there has been no inflation because you are getting more for your money. Therefore, the increased ‘hedonistic’ value of the greater functionality offsets any increase in the price paid. The fact that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer electronics, this generally is true. But when it comes to higher education, it is impossible to apply hedonics to a 500% increase in the cost of a four-year university education in the US.

The average cost of attending a four-year college or university in the United States rose by 497% between the 1985-86 and 2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)

That is twice the rate of the underlying inflation figure. Yet, the underlying inflation figures have been manipulated to ensure an overall lower figure. Why? There are several reasons, but a primary reason is the pegging of some national benefits (such as Social Security, the US national superannuation scheme) to the “Consumer Price Index” (CPI) measure of inflation.

In the UK, the introduction of a £9,000 per year tuition fee for almost all universities has certainly ‘inflated’ the cost of higher education to little or no additional benefit for students.

So there has already been ongoing inflation. The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.

For inflation to be the tool of choice to reduce the debt it will require policies that alter the distribution of income or constrain the quantity of goods and services available. The classic way to accomplish this is through changes in the taxation system, shifting the tax burden toward higher incomes while reducing the tax burden on lower incomes, and/or through employment policies that encourage unions and mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.

Increasing wages without increasing the stock of goods and services will drive up prices, based purely on the increase in money chasing the finite goods and services. Classic supply and demand at the middle and lower income levels. There will be inflation in areas such as housing (in the suburbs and ‘country towns’ and zero, limited or even negative inflation in cities) because the population continues to rise at a rate faster than additional housing stock is being built. That is classic supply and demand inflation, and until the housing stock (in the US and in the UK, for example) has grown – in the places people want to live – the unit price of housing will increase to meet what the market will accept.

But general hyperinflation needed to devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime soon. The (policy) conditions to allow this are not in place yet and will be avoided until there is no other option.

In the US (and in some other “capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and shareholders; the managerial and rentier class that are the beneficiaries of lower wages. These people (as a group and as individuals) control government policy through the economics of the American electoral system, and policies that will boost individual incomes at the expense of the wealthy will not be acceptable (even under a Democratic administration).

Default

The alternative being discussed (in speculative writing) is a default in portions of the debt. Of course, this has never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the last refuge of countries that cannot continue to access international financial markets and therefore no longer able to finance their debt. But there are countries for whom international markets for their bonds are an “also” and not an “only” option.

For countries such as Argentina, default has been a strategic tool used once access to international markets becomes impossible based on existing government financing capacity. Other countries such as Greece have used “debt restructuring” to avoid any overt default.

The default route, including debt restructuring, comes at a terrible cost, with countries finding themselves cut off from financial markets, and being unable to meet obligations to their own populations.

Economies are destroyed. Banks are destroyed, companies cannot access revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during the borrowing and spending years (if some of that borrowing actually funded capability creation) are wiped out, and the entire economy performs a “hard reset”. Deflation across the board results in economies that, eventually, restart at a lower cost base, impacting profits for corporations and tax income for the government. Infrastructure project come to a halt, and social support networks collapse.

Argentina, Venezuela, Zimbabwe and Greece are examples, each responding in different ways. Argentina is the serial offender of Latin America with a cycle of recovery and exuberance, followed by over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they converted national productive assets into social programmes to buy the support of the masses, only to ultimately “run out of other people’s money”, yet still not learn and restructure their economies for recovery. Both remain mired in poverty and hopelessness.

Greece has restructured its economy, and until the pandemic hit, the economy was growing again, within a huge debt overhang that was being managed.

Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.

And as the wealthy control the setting of policy and the justification of policy, and as they wish, first and foremost, to protect their own assets and interests, we can be confident that policies that may lead to default in the shorter term (3 – 5 years) will be avoided.

But what if these policies will result in a future potential default situation? Almost any policy will be acceptable if expected to preserve wealth in the short to medium term. Stimulus spending is meant to ensure the preservation of wealth by reducing the risk of a systemic collapse or a market implosion. To avoid those, ongoing imbalances are acceptable, because the alternatives are so frightening.

That is where we are now. The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default.

Another Way – Super-Twist

Do not expect the Fed or the Bank of England, or any other central bank that can, to either stop funding stimulus, to allow their currencies to collapse, or to default on sovereign bonds or gilts.

Any increase in inflation will convert into an increase in rates (the assumption is that rates provide a view of future inflation) and a corresponding increase in funding costs for governments. That vicious cycle results in governments being unable to fund their debt, and are the hilltop of the slippery slope to hyperinflation or default. Therefore, rates must and will be managed.

The provision of guaranteed liquidity under any circumstances is the bedrock of managing the markets. Too much liquidity and the markets turn into bubbles, while too little liquidity and the markets could collapse. So central bankers must send the message that there is unlimited liquidity, while at the same time drip-feeding that liquidity into markets is required, all the while “ignoring” the fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to come from somewhere.

Instead of borrowing solely from the markets, governments purchase from themselves (and from other governments in the process of spreading their risk and helping to prop each other up). The debt is purchased with varying maturities.

In 2011 the Fed implemented Operation Twist, with the objective of reducing the yield curve and extending duration of the Fed’s debt. Buy short duration debt to take it off the table while selling longer duration debt at the same or similar rate, pushing the debt out and reducing the yield curve, pushing down inflation expectations.

There has been speculation about a “Century-Bond” in the UK before, with questions about who would find such a gilt attractive. The basic answer would be the government itself. Any government that can issue debt in its own currency and purchase it from itself at such a long duration would be well incentivised to issue such debt. Of course, long-duration gilts and treasuries will not go away, nor will they be paid off. But at 1% interest the burden of debt required to impact annual budgeting would need to be multiples of total GDP and the tax take. And such gilts or treasuries held in ‘public’ hands would retain value and still be available for exchange.

How long could the UK or the US continue to issue such long duration debt (and purchase it from itself)? As long as the markets will purchase that debt. And when purchasers disappear, they can purchase it from themselves knowing that they will be making debt payments to themselves at 1% per year.

But Bubbles?

As long as governments are purchasing the debt at a rate that provides liquidity to the governments, they will retain the monetary policy tools to add or remove liquidity to external markets. As bubbles expand, excess liquidity can be drained off by shifting purchasing of the long-duration debt to themselves, and likewise, liquidity crunches can be avoided (or mitigated) by releasing funding to stabilise markets.

Will they be able to destroy “boom and bust”? I highly doubt it. But they will have the policy tools (and the cash) to smooth the busts and rein in the booms. Boom too fast, and liquidity will be removed. Likewise, the busts will see floods of liquidity to stave off systemic collapse or depression.

Of course, we should trust that those different governments will fail, increasing the potential for a pan-economy systemic crisis. But coordination between Central Banks should reduce the likelihood.

Am I placing too much faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of success will lead directly to excess risk-taking by governments and Central Banks resulting in instability. Will the system be self-correcting? Probably, up to a point.

But there will be bubbles, and policy-makers will accept those as the cost of stability. Squeeze a balloon, and it will pop out somewhere else. Release the pressure, and the balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst. Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to squeeze within boundaries, until they don’t.

But we are still ‘early’ in the process of managing financial stability and growth through unconstrained government borrowing and expenditure. There will be many years to run before a real bursting of the balloon.

  

Inflation, Default, or Super-Twist

The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default. Inflation vs default.

The “New Normal” is evolving, and we do not yet know what it will look like, or fully how the transition will happen. We do know that governments are printing massive amounts of debt to attempt to save what they can of their economies, with the hope that post-pandemic growth can accelerate and recover economies to pre-pandemic ‘health’. But that growing debt is a burden on countries and will stay as a burden for some time to come.

I keep reading that there are two options to deal with debt growth; inflation or default. I’m not sure that either is the actual ‘end game’. Certainly, a huge amount of money is being conjured out of the air and being pumped into economies. In the US Congress has just approved a $1.9 Trillion spending package, on top of a $2 trillion spending package last year, all on top of existing government expenditure. The UK government has been paying salaries at 80% since last April or so, and will continue to do so until September or later this year. That is effectively paying 80% of a huge number of Britons' salaries for over a year.

Not surprisingly, but seemingly strangely also we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of 6.5% or whatever they are saying it is, those numbers are fantasy).

But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates). 

Inflation

Inflation has been the tool for managing down large debt for centuries, and there is an expectation that this is what will happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly is true at the higher end, with inflation in luxury goods, art and property (higher end). But that means that the excess money is in relatively fewer hands. “The rich get richer” argument. Well, if the rich are getting richer, than the products and assets that the wealthy are purchasing must either expand in quantity, or those products and assets will increase in price. Classic supply and demand pricing.

But if the income levels at the ‘not rich’ end of the economy are not increasing, and the quantity of products, services, and assets are remaining constant, then there should be little inflation at that level. In fact, prices in many cases are increasing while incomes remain stagnant or increase at a pace slower than the cost of those goods and services. But there has been creeping inflation underway for decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.

There are numerous examples of the management of inflation figures in developed countries, driven by the use of ‘hedonics.’ for the calculation of inflation. If you get greater functionality from a smart-TV and pay more for that TV, there has been no inflation because you are getting more for your money. Therefore, the increased ‘hedonistic’ value of the greater functionality offsets any increase in the price paid. The fact that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer electronics, this generally is true. But when it comes to higher education, it is impossible to apply hedonics to a 500% increase in the cost of a four-year university education in the US.

The average cost of attending a four-year college or university in the United States rose by 497% between the 1985-86 and 2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)

That is twice the rate of the underlying inflation figure. Yet, the underlying inflation figures have been manipulated to ensure an overall lower figure. Why? There are several reasons, but a primary reason is the pegging of some national benefits (such as Social Security, the US national superannuation scheme) to the “Consumer Price Index” (CPI) measure of inflation.

In the UK, the introduction of a £9,000 per year tuition fee for almost all universities has certainly ‘inflated’ the cost of higher education to little or no additional benefit for students.

So there has already been ongoing inflation. The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.

For inflation to be the tool of choice to reduce the debt it will require policies that alter the distribution of income or constrain the quantity of goods and services available. The classic way to accomplish this is through changes in the taxation system, shifting the tax burden toward higher incomes while reducing the tax burden on lower incomes, and/or through employment policies that encourage unions and mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.

Increasing wages without increasing the stock of goods and services will drive up prices, based purely on the increase in money chasing the finite goods and services. Classic supply and demand at the middle and lower income levels. There will be inflation in areas such as housing (in the suburbs and ‘country towns’ and zero, limited or even negative inflation in cities) because the population continues to rise at a rate faster than additional housing stock is being built. That is classic supply and demand inflation, and until the housing stock (in the US and in the UK, for example) has grown – in the places people want to live – the unit price of housing will increase to meet what the market will accept.

But general hyperinflation needed to devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime soon. The (policy) conditions to allow this are not in place yet and will be avoided until there is no other option.

In the US (and in some other “capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and shareholders; the managerial and rentier class that are the beneficiaries of lower wages. These people (as a group and as individuals) control government policy through the economics of the American electoral system, and policies that will boost individual incomes at the expense of the wealthy will not be acceptable (even under a Democratic administration).

Default

The alternative being discussed (in speculative writing) is a default in portions of the debt. Of course, this has never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the last refuge of countries that cannot continue to access international financial markets and therefore no longer able to finance their debt. But there are countries for whom international markets for their bonds are an “also” and not an “only” option.

For countries such as Argentina, default has been a strategic tool used once access to international markets becomes impossible based on existing government financing capacity. Other countries such as Greece have used “debt restructuring” to avoid any overt default.

The default route, including debt restructuring, comes at a terrible cost, with countries finding themselves cut off from financial markets, and being unable to meet obligations to their own populations.

Economies are destroyed. Banks are destroyed, companies cannot access revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during the borrowing and spending years (if some of that borrowing actually funded capability creation) are wiped out, and the entire economy performs a “hard reset”. Deflation across the board results in economies that, eventually, restart at a lower cost base, impacting profits for corporations and tax income for the government. Infrastructure project come to a halt, and social support networks collapse.

Argentina, Venezuela, Zimbabwe and Greece are examples, each responding in different ways. Argentina is the serial offender of Latin America with a cycle of recovery and exuberance, followed by over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they converted national productive assets into social programmes to buy the support of the masses, only to ultimately “run out of other people’s money”, yet still not learn and restructure their economies for recovery. Both remain mired in poverty and hopelessness.

Greece has restructured its economy, and until the pandemic hit, the economy was growing again, within a huge debt overhang that was being managed.

Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.

And as the wealthy control the setting of policy and the justification of policy, and as they wish, first and foremost, to protect their own assets and interests, we can be confident that policies that may lead to default in the shorter term (3 – 5 years) will be avoided.

But what if these policies will result in a future potential default situation? Almost any policy will be acceptable if expected to preserve wealth in the short to medium term. Stimulus spending is meant to ensure the preservation of wealth by reducing the risk of a systemic collapse or a market implosion. To avoid those, ongoing imbalances are acceptable, because the alternatives are so frightening.

That is where we are now. The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default.

Another Way – Super-Twist

Do not expect the Fed or the Bank of England, or any other central bank that can, to either stop funding stimulus, to allow their currencies to collapse, or to default on sovereign bonds or gilts.

Any increase in inflation will convert into an increase in rates (the assumption is that rates provide a view of future inflation) and a corresponding increase in funding costs for governments. That vicious cycle results in governments being unable to fund their debt, and are the hilltop of the slippery slope to hyperinflation or default. Therefore, rates must and will be managed.

The provision of guaranteed liquidity under any circumstances is the bedrock of managing the markets. Too much liquidity and the markets turn into bubbles, while too little liquidity and the markets could collapse. So central bankers must send the message that there is unlimited liquidity, while at the same time drip-feeding that liquidity into markets is required, all the while “ignoring” the fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to come from somewhere.

Instead of borrowing solely from the markets, governments purchase from themselves (and from other governments in the process of spreading their risk and helping to prop each other up). The debt is purchased with varying maturities.

In 2011 the Fed implemented Operation Twist, with the objective of reducing the yield curve and extending duration of the Fed’s debt. Buy short duration debt to take it off the table while selling longer duration debt at the same or similar rate, pushing the debt out and reducing the yield curve, pushing down inflation expectations.

There has been speculation about a “Century-Bond” in the UK before, with questions about who would find such a gilt attractive. The basic answer would be the government itself. Any government that can issue debt in its own currency and purchase it from itself at such a long duration would be well incentivised to issue such debt. Of course, long-duration gilts and treasuries will not go away, nor will they be paid off. But at 1% interest the burden of debt required to impact annual budgeting would need to be multiples of total GDP and the tax take. And such gilts or treasuries held in ‘public’ hands would retain value and still be available for exchange.

How long could the UK or the US continue to issue such long duration debt (and purchase it from itself)? As long as the markets will purchase that debt. And when purchasers disappear, they can purchase it from themselves knowing that they will be making debt payments to themselves at 1% per year.

But Bubbles?

As long as governments are purchasing the debt at a rate that provides liquidity to the governments, they will retain the monetary policy tools to add or remove liquidity to external markets. As bubbles expand, excess liquidity can be drained off by shifting purchasing of the long-duration debt to themselves, and likewise, liquidity crunches can be avoided (or mitigated) by releasing funding to stabilise markets.

Will they be able to destroy “boom and bust”? I highly doubt it. But they will have the policy tools (and the cash) to smooth the busts and rein in the booms. Boom too fast, and liquidity will be removed. Likewise, the busts will see floods of liquidity to stave off systemic collapse or depression.

Of course, we should trust that those different governments will fail, increasing the potential for a pan-economy systemic crisis. But coordination between Central Banks should reduce the likelihood.

Am I placing too much faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of success will lead directly to excess risk-taking by governments and Central Banks resulting in instability. Will the system be self-correcting? Probably, up to a point.

But there will be bubbles, and policy-makers will accept those as the cost of stability. Squeeze a balloon, and it will pop out somewhere else. Release the pressure, and the balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst. Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to squeeze within boundaries, until they don’t.

But we are still ‘early’ in the process of managing financial stability and growth through unconstrained government borrowing and expenditure. There will be many years to run before a real bursting of the balloon.

  

Uncertainty, Emerging Risk, and our Blind Spots

Uncertainty in Emerging Risk. One question is "not if but when, and will we be ready”? Another question is “how are we blinding ourselves”?

Assumptions are deep-seated, institutional and cultural. These influence us, particularly when looking at Emerging Risks and expectations of our ability, collectively, commercially and personally, to assess and respond. The Covid-19 Pandemic should have stripped bare, but probably did not, the assumptions that we can respond effectively. Another lesson we should take is that hubris and myopic cultural confidence can cloud our vision when considering Emerging Risks. 

The 2019 Global Health Security Index ranked countries on a number of factors, coming up with a combined score. That score provides a surrogate for perceptions of countries ability to respond to a pandemic or other major health emergency. Of course, ‘rich’ countries scored better than ‘poor’ countries. Developed countries scored better. ‘Western’ countries scored higher. Every way you look at their data and estimates, the ‘Western’ developed countries come out ahead. 

The United States was ranked as number 1 overall, with the UK ranking as number 2 overall. China was ranked 51st. However, it seems that these two countries failed when confronted with the emergence of a risk that has been on risk registers for years, if not decades. 

The WHO, Bill Gates and others have shouted the warnings of the dangers of a pandemic, and even the CDC had a Pandemic Response team and plan before Trump dismantled it. In the UK, the 2017 version of the “National Risk Register Of Civil Emergencies” from the UK Cabinet Office, National security and intelligence, contains a section dedicated to Pandemic Flu. While Covid-19 is not an influenza virus, the principles and responses are the same. 

Why did Risk Managers miss this, and why were Western countries so, on the whole, ineffective in their response? What should Risk Managers take away from the events we have been living through, and hope will come out of this year?

Before going further I would like to remind any reader that this Pandemic is only one of the potential pandemics that could envelop our world. Pandemic influenza remains a real danger, even though the personal distancing, lockdowns and quarantines, and use of personal protective equipment (PPE) by most people has resulting in 2020 being the “Flu season that never happened”. 

What are some of the lessons that I have taken from this?

1. Assume a Western bias in all materials developed in, researched in, or presented in Western countries and media.
2. Accept that national hubris overestimates our governments' and societies' ability to identify the actual level of the threat.
3. Be confident that elected leaders will, in most cases, make the hard decisions too late, and in half-measure.
4. Do not accept that a “free society” is any more capable of an effective response. 
5. Reject the idea that we cannot or could not see this coming.
6. Be ready to be amazed by the resiliency of businesses of all sizes.
7. Finally, please agree that Capitalism is not the best system to allocate capital, and that government ‘guidance’, no matter how flawed, is required to save Capitalism from itself.

None of those is meant to result in or generate political arguments, though some economic discussions may result. There are no intended value statements about the moral, cultural or philosophical supremacy or superiority of any country or political system. Humans have a limited attention span, both in time and distance. The Strategic Planner’s, and I would argue the Risk Manager’s role is to inculcate a wider attention span. To look beyond the horizons that otherwise limit our ability to plan and respond.

1. Western bias. We’ve seen it again and again, in reports such as the WHSI referenced above. It is natural to consume information written by people with the same cultural and historical references, and living in the same economic (and in many cases) political structures. We read what they write because they write in our language, our culture, and we understand their references. If anyone writes about Enron or Parmalat, there is a good chance that an accountant, and auditor or a risk manager in a Western company will understand the references without having to learn an entire backstory.

We read and learn from the experiences of those around us, not from those in other cultures or in different continents. Because we speak the same culture and references, we take our lessons from those references. That makes it too easy to accept that ours is the one-true-way, and that we have the answers.

Yet look at the Middle East and Asia, and you will find that they have their answers, that work for them, and have worked for them. By Western measures, China should not be possible. Year-on-year 6.5% to 8% annual growth is not sustainable. And it isn’t. But that is only if we are looking at the Western experience and economies. The Asian economies have created that growth through a combination of public sector spending and private sector export-driven growth, founded on economies with large numbers of newly urbanised and well-educated workers. 

Can this continue in a straight line? Absolutely not. We’ve long bet the growth has been exhausted and that stimulus can no longer support that growth; a crash is coming. We’ve been mistaken thus far. How much longer will we be mistaken? And, while it hasn’t happened yet, an econcomic collapse with consequent social unrest in China remains an Emerging Risk, as does economic turmoil in Europe.

2. National hubris. The introduction to the “National Risk Register Of Civil Emergencies” mentioned above states:

The United Kingdom has an enviable reputation for resilience. In a rapidly changing world, we are at the forefront of embracing new opportunities and seeking innovative solutions to emerging problems. Our openness and integration of technological developments brings us huge benefits but also introduces risks and vulnerabilities. As such, resilience is crucial to protecting our people and businesses, and through them our society and economy.

These are the stories we tell ourselves, and these are the stories we believe. Each country has its reasons for pride, and is blind to aspects of its strengths and weaknesses. The British believe that the UK the Financial system is the best in the world. The Americans think they have a monopoly on “Freedom” (whatever that is) and that their capitalist system is the best at allocating capital, creating jobs and making money. Militarily they are unassailable, and from a technology perspective, they lead the world. France has culture (as does Italy), Greece has history, and Germany has order and discipline (translating into the best workforce globally).

Yet what about China and Japan? They have history that we know nothing about, and cultures that we do not understand. Therefore they must not be as advanced or as capable as “we” are. 

Why does this matter to Emerging Risks? We overestimate our ability to see the risks coming, just as we overestimate our ability to respond. If the USA has the greatest military and the ability to sail an aircraft carrier and support ships to respond to a disaster, then surely America can respond best to any disaster. If the UK Financial system is the best in the world, it will surely see financial crises developing and respond to such crises? If Asia (whatever that means) are not as advanced as the West (a badly flawed supposition), then surely we cannot rely on them to either see events coming, or to respond to them as effectively as “we” can and will. Our national hubris blinds us.

3. “Our” systems of democracy are superior, and our elected officials, supported by professional civil services, have the best interests of the people in mind, and will mobilise the resources required to respond to Emerging Risks effectively.

We might want to reconsider that, and remember that elected officials respond to what they believe is the “will of the people”, as manifest by what actions and programmes will ensure their re-election. The civil service's role is to implement the will of the people, as determined and funded by elected officials. This includes cadres of civil servants whose primary jobs are to scan the horizon for upcoming risks (and opportunities) and provide the elected officials with a foresight to craft policies and allocate budgets. 

But the Pandemic has taught us that our elected officials can fail, and do so spectacularly. The response from the major Western countries to the Pandemic has been one of gauging public perceptions of the risk and attempting to determine the level of response acceptable to the electorate, resulting in responses that have been too late and frequently too little.

Consider the potential contribution or impact of government support of intervention in the event of a large systemic event .

4. Freedom. Now we come to one of our worst blind spots. We in the West are free. And that means that we can choose what we want to do. I’m afraid we have lost sight of the two sides of the scale; Freedom is balanced by Responsibility. Responsibility as the counterbalance to Freedom has been subverted by using the phrase “Cancel Culture” to escape responsibility and avoid consequences.

AS Risk Managers we need to be looking at the responsibility side of the equation, and assessing what may occur if this is forgotten. The lack of responsibility felt by the “wage slave” works directing into the hands of the corporate leader and shareholder and into the hands of the fraudster. Too often “freedom” can result in the suppression of the sense of responsibility, resulting in individuals who feel no meaningful responsibility to the company, the customers or companies’ role or place in society. 

From an Emerging Risk perspective, we need to be questioning individuals’ and society’ perceptions of the role of Freedom and Responsibility. 

We also need to be careful when assessing the capability for an effective response to an Emerging Risk, and to consider the level of social and personal responsibly that will be required to deliver the response required. Where the response is top-down, there may be less risk of a Freedom/Responsibility gap. Command and Control is able to dictate responsibility. But not all situations are suited to such a response.

5. “Didn’t see that coming”. Please. We’ve seen every major crisis of the past two decades coming, and have ignored the signs, or underestimated the potential impact, with the exception of two major natural disasters; the Fukashima earthquake and associated nuclear accident, and the Boxing Day 2004 Tsunami.

The GFC (Global Financial Crisis) did not come as a surprise. Certainly, there were wailings of angst, many by learned or senior individuals all bemoaning how impossible it was to have seen what was coming. Yet we know from the literature that it was foreseen by those very leaders in business and government. 9/11 was a shock, but those with access to the intelligence reports knew that something was coming. The warnings were ignored. 

The Pandemic was foretold for years, and ignored. In late 2019 I was shown an Emerging Risk list, with estimated timeframes for the emergence of the various risks. Pandemic was on the list, but estimated to be in the 5 – 10 year range. I commented that, for all we knew, a Pandemic could already be underway, and that my own assessment of the emergence period for a Pandemic was “yesterday – 10 years”. I’ll hasten to add that this was before it did begin November or December 2019. I claim no unique insight or prescience. 

For most Emerging Risks, we can see them coming. What we cannot see is precisely when, and this makes planning difficult. It also adds difficulty to encouraging management to dedicated limited resources to prepare for a situation that may or may not happen (within the planning horizon). But not freeing resources is not the same as not seeing it coming. 

6. Corporate Resilience. All that being said, be ready to be amazed at corporates and peoples’ resiliency in the face of “the event”. I’ve seen companies go through existential events and come out stronger. Indeed, we hear of companies that fail (other than the great failures due to frauds as mentioned above), sometimes spectacularly. But so many companies recover quickly. Do not underestimate the human capacity for adaptability and perseverance, and when employees are part of a culture that empowers, the ability to rapidly respond to and recover during a crisis if phenomenal. 

7. Capitalism is the answer. When scanning for Emerging Risks, consider that the prevailing economic system may be a contributor to a coming crisis. We will ignore for a moment that Western Capitalism is, in virtually all countries, actually a form of Capitalist/Socialist mutant. An economic system that enables and encourages “moral hazard” exposes itself to greater systemic ecomonic risk. Conversely, Japan has proven to the world that it is possible to monetise debt for two decades (so far) and still have a functioning economy and society. Hyperinflation has not struck Japan, and the Yen has not collapsed. But Japan is not France or Greece, and it certainly it is not the United States or Great Britain. 

The greater the reliance on the state to maintain the economy, the greater the risk of systemic crises, or so we are told and expect. Yet we need to look deeper when considering Emerging Risks. Chinese government policy supports and encourages business growth, and through the GFC, was active in stimulating the economy and supporting businesses. While the Chinese economy may be rife with zombie companies, it is hardly alone in this. The major drag on Chinese growth in future may ‘consumption’ of the pool of under-employed labour as the working-age population shrinks.

There are too many biases and factors that influence our consideration of Emerging Risks, and I’ve not covered them all by any means. But what I have covered should be enough to demonstrate that we need to be aware of these factors. The Strategic Planner and the Risk Manager's role is to look beyond what is within our day-to-day sphere, and look beyond the prejudices that we take for granted. 

Doing so will help us to more objectively assess the Emerging Risks on our registers. Objective assessment is the first step to present the case as to why any Emerging Risk warrants attention. Sometimes a watching brief is all that is required. For others, a “plan” on the shelf will speed and simplify responses. I know a Risk Manager whose organisation had a “Pandemic Response Plan”. It wasn’t much, and was focused on the risk of an influenza outbreak that would stop staff from coming to work, while concurrently increasing customer inquiries. They were able to take that plan off the shelves for the first few weeks of the Covid-19 Pandemic. They were also ‘lucky’ in that their IT department had a large stock of laptops in the process of being refreshed or ready for disposal, so there was more stock than at a ‘normal’ time.

Still, it was an initial plan that enabled them to respond quickly. The plan did not take significant resources to develop, and since testing was not possible, it remained theoretical. Yet having a plan did enable a faster response.

Why did they have that plan at all? Because they recognised that a health event (such as a significant flu outbreak) would happen. There was (and remains) uncertainty as to when an outbreak would happen, but they had absolute certainty that there would come a day when it would happen.

Uncertainty demands that we scan the horizons constantly, and that we consider what will happen when, not if. It demands that we look past the natural and human boundaries and prejudices that shape our thinking. It also demands that we prepare, enough at least, to be ready to respond, and not to be taken by surprise. 

The SEC will take ESG seriously

Combined with a Final Rule Change in November, the announcement of Allison Herren Lee as Acting Chair of the SEC is excellent news from an ESG (Environmental, Social, Governance) and Sustainability reporting perspective. Rest assured, the new US administration’s acceptance of the science of Climate Change and stated understanding that there are already major impacts on the environment, are going to result in a major shake-up in corporate reporting.

For too many years the SEC has paid lip service to the need for ESG reporting.

No rule change will be needed

This means, finally, there will be real movement in requiring companies to provide ESG reporting. Way back in 2009, I wrote to the SEC in support of the Social Investment Forum (SIF) vision of what mandatory Environmental, Social and Governance (ESG) disclosure should look like. I pointed out there than the existing Reg S-K already mandated reporting on ESG in the MD&A.

Companies listed on the US markets are required to file various forms with the SEC, with the most notable being the Form 10-K, the annual filing that includes both financial information, and significant additional information included in the "Management Discussion and Analysis" (MD&A) section. The content of the Form 10-K is controlled by Regulation S-K, and there is some specific wording that applies to ESG and Sustainability reporting. However, it does not explicitly state ESG or Sustainability. 

I argued then, and still believe, that the "known trends" and "uncertainties" requirement was enough.

There is already the requirement under §229.303 for companies to "Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."

I believe that Climate Change and the wide range of potential negative impacts, raises to the standard of a "known trend", or at a minimum, based on the overwhelming amount of scientific research undertaken to date, an "uncertainty". Equally, Social and Governance issues have a significant impact on liquidity and operations, and therefore should rise to the level of "known trends" or "uncertainties".

The SEC has acted on the "known trend" or "uncertainty" clause before, when Y2K reporting was mandated. At that time the SEC also took the bold step of stating that boilerplate reporting would not be acceptable, and that filers had to provide detailed discussion of their plans, including potential impact on customers, and the cost to address. “No net impact” was not an acceptable response. The SEC's actions in relation to Y2K could form the basis for similar action in relation to Climate Change and ESG reporting.

Allison Herren Lee's appointment as Acting Chair of the agency will bring about a sea change in ESG reporting.

“During my time as Commissioner, I have focused on climate and sustainability, and those issues will continue to be a priority for me,”

Read those words again “those issues will continue to be a priority”. Finally, we will have some real reporting on ESG and sustainability in annual filings, and hopefully not the boilerplate. Investors and the public should begin to see what companies really think are the risks (and opportunities), and will need to say exactly what they plan to do to address the potential impact of Climate Change.

The Rules have changed

In November 2020, a Final Rule from the SEC strengthened the reporting requirement. In their Final Rule, they discuss the change from "will" have a material impact, to "reasonably likely" to have a material impact. 

"Item 303(a)(3)(ii) currently requires a registrant to describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material impact (favorable or unfavorable) on net sales or revenues or income from continuing operations".

The Commission's final Rule says:

"We are adopting Item 303(b)(2)(ii) with these amendments substantially as proposed, but with slight modifications to clarify that the “reasonably likely” threshold applies throughout Item 303. Furthermore, our amendments to Item 303(a) state that, as part of MD&A’s objectives, whether a matter is “reasonably likely” to have a material impact on future operations is based on “management’s assessment.”

I could contend that it will be the very brave, or very disconnected, company executive who, in "management's assessment", determines that Climate Change cannot be considered "reasonably likely" to have an impact on "continuing operations".

Preparing for the change

So with this change and increased reporting, what should reporting companies be doing?

First, consider a complete review of your CRS reporting. CSR has too frequently been seen as something owned by or shared with Marketing and Communications. The greater the ‘power’ in Marketing for the production of CRS reporting, the greater the risk that what you are reporting does not fully map to the reality of your operations or strategic expectations.

There is a risk of shareholder, regulator or customer sanction if your CSR reporting is not in sync with your internal strategic plans and the assumptions used to create those plans and, more importantly, with what you have been reporting in SEC other regulated filings. If there is a disconnect, then there is a risk to reputation and a risk that a regulator (or the markets) will respond punitively to a belief that the company has been ‘hiding’ information, or spinning and ‘greenwashing’.

CRS and Sustainability have just jumped to the top, or near the top, of the Internal Audit risk universe. What controls are in place over the production of the CSR report? What processes are in place to validate the information that is reported? Does management override play a part in the production of such reporting?

Instead of repeating myself, I’ll just point you to my post on the subject from all the way back in 2015; Why CSR is an important part of your risk universe.

Pick a Standard

There are several ‘competing’ CSR and Sustainability reporting standards. Do your research. Each has its strength, but so far we do not know which one will be the ‘one true standard’ the way COSO became the presumptive standard for internal control following SOX.

My own betting would be on either (or both) the SASB and the GRI standards. Both are comprehensive and established. SASB is modelled on the need for rules-based reporting and standards used in corporate financial reporting, and the very name pays homage to the FASB. The GRI standard, however, is global and has been around for close to 20 years. There may be some flaws, but it is a comprehensive standard for wider ESG reporting.

Plan ahead

Expect ESG reporting to expand, and expect scrutiny of reported information to increase. Mismatches between current and historical CSR and Sustainability reporting and corporate communications will come to light, so be prepared if you are concerned that there may have been mismatches.

With Climate Change on the agenda (finally) and with a new SEC Chair nominated (with clear views on ESG) there can be little doubt that ESG and Sustainability reporting will no longer be something for the marketing people; it is now center stage for regulatory reporting.