Category: Risk

Announcements in Coming Events are run free of charge as a service to the industry. Items should be submitted by the first of the month prior to the month in which the announcement is to appear.

Canadian Insurance Accountants Association: Seminar & Luncheon. Contact the CIAA at 905-274-2422. Toronto Hilton Hotel, Toronto, ON. Mar. 10.

Ontario Insurance Adjusters Association: Dinner Meeting. Contact OIAA at 905-542-0576 for information. Toronto Colony Hotel, Toronto, ON. Mar. 10.

Speakers Club of the Insurance Institute of Ontario: “Final Encounter (Wrapping it up)”. Contact Rejeanne Dorion at 416-350-4137. Toronto, ON. Mar. 15.

Blue Goose Luncheon. For information, call 416-665-1311. Royal York Hotel, Toronto, ON. Mar. 15.

Ontario Risk & Insurance Management Society: Monthly Business Meeting and Breakfast. Contact Marlene Jones at 416-215-4288. Toronto Marriott Eaton Centre Hotel, Toronto, ON. Mar. 29.

Institute for International Research: Year 2000 Liability and Contingency Planning. Contact Institute for International Research at (416) 928-1078. Holiday Inn On King, Toronto, ON. Mar. 29-31.

Women in Insurance Cancer Crusade: Fundraising Dinner. Contact WICC at 416-366-7600. Sheraton Centre, Toronto, ON. Mar. 31.

Risk and Insurance Management Society: Annual Conference & Exhibition. For more information contact RIMS at 800-713-7467. Dallas, TX. Apr. 11-16.

Blue Goose Luncheon. For more information, call 416-665-1311. Royal York Hotel, Toronto, ON. Apr. 19.

Speakers Club of the Insurance Institute of Ontario: “The Great Debate”. Contact Rejeanne Dorion at 416-350-4137. Toronto, ON. Apr. 19.

Bugs, big deals, bad spills and a certain public official’s sexual high crimes and misdemeanors were all key factors driving the corporate insurance market throughout 1998.

And the same scary financial exposures will likely be very much in the minds of Canadian risk managers, their insurers and intermediaries for much of 1999, key industry players say. “Ask any underwriter on the street and Y2K was an issue in almost everything they did in 1998,” observes AIG’s Lynn Oldfield.

The millennium bug “added a layer to every insurer’s, broker’s and client’s due diligence,” she added. In mergers and acquisitions especially (in what Fortune magazine describes as yet another “record M&A year”), buyers were looking for coverage that would shield them from liability-minefields buried in an acquired company’s non-compliant systems. And that caution isn’t expected to let up as the clock ticks down to 2000.

The whole Y2K liability area is “pretty dynamic,” one observer notes. Chubb Insurance Company of Canada senior vice president Udo Nixdorf says he’s heard of a few doomsayers, like the kind who have predicted that next January 1 will kick off a claims snowball which will gain size and power threatening enough to send fleeing before it all of the market’s current excess capacity. However, he does not believe that Y2K will become the insurance crises predicted. “I believe the widely exposed corporations … especially the big, public companies here with U.S. operations for instance… will be prepared. There’s been an incredible amount of due diligence going on around this issue, it certainly will have an impact but it won’t be cataclysmic. And the biggest exposures are in the high tech world itself … the consultants, software manufacturers and so on.”

Chubb caused a stir last year when it announced that it wasn’t excluding Y2K. “We never believed there was really a valid reason,” Nixdorf explains. “Y2K comes down to due diligence and proper disclosure, the same as any other financial or operational oversight duty.” Instead, he says, the company embarked on a process of personal interviews with insureds beginning in 1995, to make clear its due diligence expectations.

D&O and E&O liabilities

Laura Bruneau, vice president of claims with Encon Insurance Services in Ottawa, agrees with industry experts who say that D&O and E&O policies will be obvious sources of coverage for Y2K related claims. And she says she won’t be suprised to see Y2K claims prompting “serious coverage disputes” between insurers and insureds.

“Many experts believe that the day you have a claim is the day you’ll find out what kind of Y2K coverage you really have.” She also suggests risk managers ensure they’ve factored expenses for these kinds of disputes into their organization’s potential Y2K litigation costs.

All of the M&A activity in 1998, in Canada as well as in the U.S. (here, think cable TV and newspapers, theatrical production companies, grocery chains, telecommunications, oil and gas, mining, insurance and banks … well, almost …), as well as some scandal-plagued stock offerings stirred up a swarm of new exposure angles, especially in the ever-more litigious environs to the south. However, with a few Canadian names hitting the headlines over the past few years — notably Bre-X, Hamilton-based Philip Services Corp. and Livent — some spark was added to both D&O and E&O markets here.

New players boost

rate competition

When it comes to Directors’ & Officers’ products especially, last year brought new players to new markets, expanded coverages and producing fiercely competitive pricing. On the latter, Greg Winterson of Royal & Sun Alliance offered one strong adjective to describe the market: “Horrendous. Absolutely horrendous.”

Winterson took particular note of the “blended” corporate covers that some companies are offering for everything from D&O/fiduciary, E&O, employment practices and at least some Y2K protection — single-limit, single-deductible and single-premium packages (which Chubb, for example, is offering to mid-sized companies via its Forefront package).

Winterson believes it won’t be long before someone introduces complete indemnity packages. “And I’ll wave as they go down the dumper,” he sniffs. Observing that there are now more than a dozen companies in Canada chasing D&O business (a pie that represents only about $120 million in premium according to most estimates, compared to about $3 billion in the U.S.), he suggests all of the competitive thrust-and-parrying going on will catch up to the D&O combatants.

Bargain days are over

Chubb’s Nixdorf, who might be seen as one of those fisting it out, insists prices can’t go any lower. And, although, insurers always say that, he offers some reasons why risk managers and their brokers shouldn’t expect to find many bargains in 1999.

He notes that frequency and severity trends are both still headed upwards. He sees the year as a “pivotal year for D&O and other specialty lines, and not just because of Y2K”. Most businesses being indemnified today, especially by insurers without sufficient D&O experience, have “a loss lurking somewhere,” he observes.

And, Nixdorf agrees with Winterson that the size of the Canadian market can only support “a handful of players”. As such, he believes there will be a market shakeout within the next 18 months.

Bleeding flows into

commercial fidelity

Another area that’s hurting is commercial fidelity, where again, claim trends are up while rates and deductibles are down, insurers note.

White-collar crime is on the rise and all of the M&A and new-stock-issue activity has ripened opportunity for less-than-honest players. According to RCMP alerts, Asian and Russian organized crime gangs are moving in on legitimate businesses as investors and jockeying those investments into seats on board of directors. And, Canadian companies venturing into foreign markets and projects are also vulnerable to ingrained local habits of bribery and corruption.

According to Bruneau, Canadian companies don’t have to venture all that far afield to get into trouble: just the other side of the 49th parallel is plenty far enough. For many growing, cash-hungry Canadian concerns, the deep pockets of American stock exchanges are too tempting. She urges them to proceed with caution.

Comparing the still relatively young civil Canadian securities law scene with the U.S., with all of its predatory plaintiffs lawyers, she says: “The differences are significant, namely U.S. SEC regulations, attorney contingency fees, trials by jury and the huge damage awards that U.S. juries often grant. Canadian Directors and officers often comment on their inexperience and their need to learn about it and their preference for getting this education before a claim and not during a lawsuit. You’re going from swimming with some smallish barracudas, who have a lot of sharp little teeth, to swimming with some big, hungry sharks.”

Bruneau adds that she’s “very concerned” over the lack of preparedness of many directors and officers of Canadian companies listing on U.S. exchanges. “There’s a huge need for education,” she adds.

Canadian twist

In light of the differences, Bruneau (who is also a lawyer) wonders if executives of Canadian companies with no U.S. exposure are being needlessly alarmed by some players trumpeting the dangers of increased Canadian based shareholder actions, as growth could be spurred by class-action legislation now in effect in B.C., Ontario and Quebec.

“An important distinction is that the allegation of ‘fraud-on-the-market’ is not available to Canadian shareholders when suing in Canada,” she explains. Normally, a U.S. shareholder class action will include allegations of fraud-on-the-market, as such conduct would be pivotal to the plantiffs’ case and the jury in assessing liability and damage awards. Without the right to claim damages for alleged fraud-on-the-market, it isn’t likely Canadian outcomes will match U.S. cases.

However, as Oldfield points out, the Bre-X case, which is now before a Te xas court, will decide whether Canadians may join U.S.-based class actions. And the more recent high-profile suits involving “accounting irregularities” (such as Philip Services and Livent), will keep this kind of exposure in front of risk managers for months to come.

Internet exposures

Oldfield warns that the Internet, especially the growing practice of posting prospectuses and other investor information on company Web sites, is also posing new exposure challenges for public corporations. For example, Internet service providers and their parent companies are under the gun after Philip Services won a dozen court orders in Canada forcing them to reveal the names of subscribers who had posted “defamatory” messages about the company on bulletin boards operated by America Online, PsiNet and others. (Philip Services, which restated up to three years of earnings last year after the discovery of what management insists were unauthorized copper trading, saw its stock drop from nearly $28 to $5. The company is now facing more than 20 shareholder lawsuits contending, among other things, that it artificially inflated earnings.)

Environmental exposures

Risk managers should have also taken note of two Canadian-managed companies at the center of toxic spills in other countries last year.

Damage and clean-up costs are still mounting from a toxic-waste spill from a burst reservoir on the site of the Los Frailes mine in southern Spain last April. The mine was owned by Toronto-based Boliden Ltd. The disaster, which occurred near Donana Park, the country’s largest nature preserve, has prompted demands from environmental and other groups for international monitoring of mining operations.

The second incident, which involved cyanide being spilled into a river in Kyrgystan in May, after a truck crashed while en route to the Kumtor mine operated and owned in part by Saskatoon-based Cameco Corp., turned out to have caused little lasting harm according to a report issued by a panel of international experts in September. Still, two such high-profile accidents in one year have further damaged the reputation of the Canadian mining industry, and are likely to increase risk management costs for domestic and foreign operations, experts suggest.

“Pollution is still a high-profile topic,” observes Bruneau. “Insurers walked away from it for a while but coverage for certain pollution exposures is now available. Still, we probably see more uncovered pollution claims than we see covered ones.” And there is a lack of understanding and clarity, she adds, partially caused by “some very tricky, specific wording”. She suggests risk managers review their pollution covers several times. “If it’s still not clear, call your insurer or broker and describe five or six examples of what could happen and ask if you’d be covered,” she suggests.

Her colleague, Encon’s vice president of professional indemnity Mark Reszel, notes that current dilemmas for risk managers around policy language and reliability of coverage in areas like pollution and Y2K “is probably a function of the current marketplace. If you remember there’s too much capacity right now, which has led to lower premiums, then competitively, you next have big pressure to expand coverage. There will be a natural tendency for insurers to want to appear as though they’re giving something more. But, more often than not, that won’t really be the case,” he comments.

Other exposures

When asked about other recent trends and developments likely to be shaping the Canadian corporate insurance market, such as several high-profile employment practices/sexual harassment suits and awards in the U.S. (President Clinton’s troubles chief among them), Laura Bruneau says: “In the strictly Canadian context, issues such as employment discrimination or sexual harassment are nowhere near as expensive as their U.S. equivalents. What can be frustrating is that a lot of these trends that originate in the U.S. aren’t all that significant for Canada while we have other, unique issues. Take bankruptcy claims for instance. They don’t even exist in the U.S. but they can be monsters in Canada.”

That’s because Canadian governments have generally adopted the view that directors can be held personally responsible for unpaid taxes, such as GST and PST, and employee wages, liabilities that can easily amount to millions, she points out. Recent cases have also seen creditors successfully sue for recovery of credit extended after they had been assured by a director or officer that the company’s balance sheet was a picture of health.

At the time, it captivated Canadians across the country and even today is at the top of book best seller lists. The raw power of nature displayed by the ice storm which paralyzed south eastern Ontario, Quebec and parts of the northern U.S. in January last year continues to attract public attention. However, the experience of the ice storm offers more than just a fascination value, it provides the insurance industry and emergency support services the ability to learn from the past to ensure against future destruction.

What has been dubbed “Ice Storm ’98” was truly a remarkable event. At its peak more than five million people were without power in the middle of winter, some suffering for more than four weeks. Twenty-eight people died. And, insurers continue to work in partnership with many others to accelerate the recovery from the worst storm ever to strike Canada, northern New York and Maine.

There are several lessons to be learnt from this storm and the important role of mitigation as a tool to better manage risk. These include:

Ice storms are common in Canada and the U.S., yet many people believe they will never be victims of a severe storm. Ice Storm 98 crippled homeowners and businesses in Montreal and the surrounding area, and a similar storm could strike other cities such as Minneapolis, Winnipeg, Chicago, Toronto or even New York City.

We now know that a massive power failure in the middle of the winter can lead to a tremendous loss. Despite the magnitude of the challenge, insurers continued to provide the quality service that consumers appreciate during difficult times. There was never any concern about an insurance company failing, all legitimate claims continue to be paid and during and following the storm, the image of the industry continued to improve.

The response-and-recover effort due to the storm was very effective, but there remains tremendous opportunity for mitigation investment needs to anticipate and reduce future losses. Continued on page 26.

Coming in from the freezing rain

Freezing rain started to fall in the evening of January 4 and continued for almost a week. The storm struck a wide area including Ontario, New York, Quebec, Vermont, New Hampshire, Maine, New Brunswick and Nova Scotia. At its peak more than five million people were without power, some for weeks. Many died. The damage was extensive.

Large ice storms are unusual. They can happen in the winter when a layer of warm moist air becomes wedged between cold air. Snowflakes fall through the warm air, melt into raindrops, and then fall through the cold air to freeze on contact with cold objects like trees, power lines and buildings.

Warm moist air from the Gulf of Mexico travels north and east in the winter at higher altitudes, while cold air travels south and east from the Hudson Bay at lower altitudes. If both of these systems are blocked from their normal migration across the continent, an ice storm can form. This year the Bermuda High was particularly strong in early January, so the warm and cold systems remained locked together.

Some experts speculate that El Nino caused this blockage, but others strongly disagree. The scientific debate continues about the role El Nino played with respect to Ice Storm 98 and with previous ice storms across Canada and the U.S.

The center of the storm was located near Montreal, one of the largest urban centres in North America. In some areas 80 millimeters of ice accumulated, more than twice the previous record high. The build up of ice led to a power failure over a large area. Trees fell on power lines, hydro poles were pulled down and transmission pylons were crushed. In the middle of winter the lights went out.

Ice storms have been experienced across much of North America from the mid-west through to the Atlantic. Some large communities in this area include Minneapolis, Winnipeg, Chicago, Detroit, Toronto, Buffalo, Ottawa, Montreal, Boston and New York City. The first lesson of Ice Storm 98 is that all of these communities are vulnerable to a large ice storm and power failure in the middle of winter.

The Lessons

Many people experience a loss when the power goes out in the middle of the winter. This is an important lesson about the damage that an ice accumulation can cause.

A useful point of comparison is Hurricane Andrew, which triggered the largest loss ever experienced by the insurance industry. The value of claims incurred due to Andrew was US$15.5 billion, a total more than 10 times that of Ice Storm 98. There were 700,000 claims filed because of Andrew. More than 840,000 claims were filed from Ice Storm 98 – 20% higher than that of Andrew.

Although the value of claims from Andrew was greater, the claims volume resulting from the ice storm was much higher – the highest ever experienced by the insurance industry for one event. The ice storm was the largest loss ever to hit Canada. By value, it is one of the 30 largest losses recorded by the insurance industry.

Less than 10% of the ice storm damage involved vehicles. Some trees fell on cars and trucks. Since the average claim was around $1,400, few vehicles were severely damaged. Nevertheless, there were more than 75,000 vehicle claims. In addition, almost 30% of the claims were paid on commercial coverage, of which the average claim was over $8,000 – this, however, is a much lower average than what is found in most other severe events.

Two thirds of the total claims were paid to homeowners. Almost 700,000 claims were filed, the highest total ever. The average claim was $1,400. The most common loss was due to food spoilage resulting from power failure.

There were, however, some large personal losses as families desperate to keep warm were forced to light fires that destroyed their homes – fortunately these losses were few in number.

We have learned that sustained power failures during the winter over a large geographic area cause a lot of people to experience losses. Homeowners are the most vulnerable, yet the value of the losses generally can remain low. Efforts to educate homeowners about safety during the storm were effective in managing the risk of severe loss.

About 80% of the storm’s losses were recorded in Canada. This reflects the higher concentration of people and property in the Canadian areas affected by the storm. Canadian insurers made payments of $1.44 billion, more than three times higher than for the 1991 Calgary hailstorm, the previous record high catastrophic loss in Canada.

While Hurricane Andrew was about 10 times larger in terms of its impact on the US insurance industry, the U.S. is also about 10 times larger than Canada in terms of population and economic resources.

Clearly the ice storm was a major challenge for Canada and our insurance industry. At no point has there been any discussion in Canada about the risk of an insurance company failing as a result of the storm. The industry is in excellent financial health, and the prudent use of reinsurance is an important tool to manage this risk. Indeed, about two thirds of the cost of the storm was covered by reinsurance. All legitimate claims continue to be paid in full and no companies were at risk because of the event.

Public response

Public opinion polling confirms that the community appreciated the active role of the insurers. Measures of public trust and respect for the industry increased during the storm, and are now highest in the regions hardest hit. Montreal is an important centre for the insurance industry, and many companies and insurance professionals were directly affected by the storm. Most were without power. Working conditions were difficult. It was critical throughout to ensure that families were safe and warm. The storm highlighted our growing dependence on electricity to heat homes, operate computers, prepare meals and perform so many other essential activities of every day life.

The payments by insurers accelerated the recovery process, stimulating economic growth and job creation through the regions that suffered the most during the storm. Many areas now appear to have fully recovered, and a ll areas show progress toward recovery. Some challenges take longer – for example the damage to the forests in the region will take decades to heal, but we are on the road to recovery, and insurers have helped along the way.

Mitigation investments

Ice Storm 98 demonstrated the strength of several elements of the disaster management systems in North America. In particular, the response and recovery efforts were effective. Millions of people were affected over a large area in several jurisdictions, yet most losses were small, perhaps much smaller than they could have been.

There was an immediate effort, for example, to restore power through the involvement of specialists and repair crews called in from across North America. Power generators were brought and assigned to the most deserving including hospitals and emergency shelters. And there were many remarkable stories where volunteers worked to reduce suffering and loss.

An effective disaster management process should also include a strong commitment to mitigation. Often small investments before a storm can significantly reduce suffering and damage during a storm. The communities affected by Ice Storm 98 were poorly prepared for a major ice storm and the loss of power in the middle of the winter.

Public awareness of the threat was low despite regular minor ice storms in the area. Building codes do anticipate many risks but do not specifically account for the threat of ice accumulations, including the threat to the hospitals and schools used as shelters during the storm. There was little information about the availability of large generators. Since the utilities’ actions to anticipate the risk were not effective, the vulnerability of electrical power distribution will now be subject to extensive public review.

The area was not prepared for a significant loss of power in the middle of the winter, and other vulnerable communities are unlikely to be as prepared as they should be.

With most insurance claims the paper trail starts with an incident report. The incident report is then prepared as a claim report by the internal claims handler who in turn creates a paper track process. A third party adjuster then creates a file and, with larger claims involving risk managed environments, the broker and the insured also generate paper-tracking files. All these parties need to communicate the results of the adjudication which adds to the growing paper pile. And, despite the fact that we exist in the “technology age”, the quantity of paper generated in claims handling continues to grow. However, it is maybe time to move to “advanced technology” to reap the cost efficiencies of a near paperless claims system.The technological advances of computers for claims handling began with the early calculators of the 1960s which automated recurrent tasks. In the mid 1960s mainframe computers made tracking of large amounts of data possible and continued the path of automation. The designing of software tracking programs to handle claims management began in the later 1960s. In general, these programs were user unfriendly, cumbersome and not very communicative to the outside world although to some extent the process of number crunching was accelerated.

Advances in computer technology through the 1970s and 1980s meant faster and faster processors but didn’t really affect the time that it took to handle a claim. A major impact was felt on the communications front with the introduction of the facsimile in the mid-1980s. This reduced the speed of transmitting information but didn’t reduce the paper handling.

Each handler of a claim, from insured to adjuster, continued to create a paper trail. Today, the adjuster may write a letter to the insured with a computer as opposed to typewriter, and the insured may fax a response instead of mailing it, but the paper still piles up.

The 1990s

With the arrival of the 1990s came another generation of computer software and hardware, with increased emphasis on graphical interfaces (windows) and more local content (personal computers). Local area networks (LAN’s) evolved from simple PC connections to complete systems with their own software and design considerations. In the mid 1990s email evolved enough to be made secure, but remained little more than a further automation of the facsimile process.

Then came wide area networks (WAN’s), also designed in the mid 1990s. Although they allowed for connections between a number of offices, it is only now that WAN’s are being implemented in the insurance industry with any kind of measurable success. As it stands there is still little connection between the parties of the claim and their systems, while the paper piles higher.

The future

To many users the Internet simply means email or web-browsing yet there is a revolution occurring in digital communication. Rapid advances in cellular phone, notepad and television technologies are all affected by the Internet. What has been ignored by many parties is that the Internet is primarily a communication tool, that the Internet permits a number of different levels of communication between parties beyond the historical phone and facsimile scenarios and today’s more vogue email. Some sectors however, have been paying attention — an excellent example being the banking industry. Personal and business banking can now be done with a fair degree of confidence and security over the Internet. By capitalizing on this opportunity, banks have managed to mediate the significant costs of person to person banking that existed only a few years ago, resulting in a substantial improvement in their bottom lines. The question then is, how can this technology revolution benefit the claims handling industry?

The Internet revolution

Let’s look to the future — say five to ten years from now. Density of web access will be 90% plus to all North American households (up from 46% in 1998) and virtually 100% of all businesses.

The methods by which claims handlers, and those in the insurance industry in general, increase their degrees of connectivity and reduce their dependence on paper will have great effects on the bottom line as well. As it stands there are three prominent scenarios to achieving this:

The Disconnected Interface Method. Each party to the claim maintains an internal WAN system (likely a client/server type model). Outside parties speak to the company through email or electronic data interface (EDI). For each party on the outside there is a separate interface or line — which creates a necessity internally to manage the variety of interfaces. The method is both extremely costly and cumbersome but remains the most prominent today. It does give companies the advantage of maintaining their own proprietary systems but to be truly Internet enabled (where others can view some of your information) is an almost impossible problem both from a security and design point of view. Fundamentally, to be paperless will be very difficult with this model.

The Proprietary, Managed Interface Method. A number of parties get together to develop standards to transfer claim information between their claims systems. An example of this model is the current estimating standards and point to point communications in auto appraisals and some auto claims used by companies like ADP. For large companies, these proprietary systems work well enough but most of the small to medium TPA’s, insureds, and others not party to the system’s business will be cut out of the loop. This model results in groups of tight collectives tied to specific vendors within the claim system. It is far less expensive to build and maintain than the first model due to standards and commonality of software but the static nature of these systems closes them off from new technologies and restricts acquisition capabilities.

The Coincident Interface Method. In this system a number of parties agree to use a common program to handle and protect the claims data as common information. For smaller TPA’s, insureds, and even larger parties who don’t have the desire to manage and maintain proprietary systems, this would seem to be the claims handling system of choice. In this model all data is held at a separate server for claim administration, and can be accessed instantly by interested parties upon request.

The example of Sabre, a ticket reservation system owned by American Airlines and used without conflict by most of its competitors, has proven data can be maintained separately in a common system to the benefit of all. Furthermore, when the Internet is used as the common path to the data, the systems flexibility becomes unparalleled. The clear advantages of lower up-front costs (no software, no network procurement and maintenance costs), as well as lower administration costs (no paper!) and instant response between parties, make the “coincident interface method” a likely candidate for an industry standard.

Technology objectives of claims handling

The objectives of technology in claims handling are simple: reduce retyping needs, speed up communications between parties to the claim data, simplify the process, and reduce the cost of maintaining the mountain of information, software and hardware.

The problem for most companies is how to achieve these goals while dealing with the sometimes complicated issues involved with outsourcing. Is in-house claims software an internal strategic asset or frustrating, revolving cost center? Can outsourced claims handling software be sufficiently flexible and secure to be considered a proprietary asset? And ultimately, how can those in the claims handling industry best capitalize on ongoing growth in information technology without the danger of costly commitments to systems that can’t grow with it?

These questions, and the issues raised within this article, are still being resolved throughout the industry. Over the next several years, with the increasing specialization of software handling and the rapid development of the Internet and global communications, many of these solutions wil l become available. Industry operators not ready to move with the times will find operating profits soaked up by their paper-intensive systems.

By Stephen Markson, a director of Forensic Systems Group and Craig Malcolm, managing partner of Forensic Accounting & Investigative Services

Regardless of whether the new millennium starts on January 1, 2000 or 2001, its advent will provide abundant opportunities for new and almost undetectable fraud schemes rising from the resulting disruption many predict will come about from the Y2K threat. And, while financial losses arising from potential “Y2K fraud” could prove substantial for the business community and government, the insurance industry faces the most significant risk consequences.

In fact, most frauds abetted by the so-called computer systems’ “millennium bug” will already be done deeds before the turn of the century. Fortunately, analysis of the characteristics of “fraud 2000” suggests strategic initiatives that can help to detect and prevent fraud as well as mitigating direct and indirect losses.

Contrary to popular belief, computer systems problems with the year 2000 were not caused by a need of computer programmers to store dates with six characters instead of eight to save storage space in primitive computers. A system to encode and decode a particular date using only three characters of information can last for over 45,000 years!

Rather, the date format decision was prompted by familiarity of the visual representation of dates with two-digit years. As time passed and the volume of data stored this way increased dramatically, the cost of changing data and systems became an unpleasant thought in the minds of information technology managers. Why not let some other manager take it out of their budget?

Fortunately, now that we have run out of time, software development costs have come down considerably. However, the cost of converting the old data to fit new systems is still prohibitive in most cases. The least expensive thing to do would be to abandon the old data which unfortunately would also mean shutting an important window on the past.

We need this “window” to discover and quantify the potential for fraud. In some instances, the window may be partially ajar, but the cost of opening it wide enough to mine the old data properly may be greater than the value of the fraud committed, account imbalance or whatever anomaly is being investigated.

Millennium fraud and insurance

In addition to a year 2000 conversion closing the window on a past fraud, there is the potential of fraud being masqueraded as a Y2K problem. Like the blame which is heaped on the conveniently “recently departed employee” or a popular problem-child for all ails such as El Nin, Y2K has the potential of becoming the next whipping-horse for everything that goes wrong.

If a fraud is successfully disguised as a Y2K problem, whether intentionally or inadvertently, it could be covered by a Y2K insurance policy even though the policy excludes employee dishonesty. Furthermore, the exclusion may even inhibit the search for fraud! This affects underwriters directly and stands to hurt brokerages indirectly through worsening claim ratios.

As a result, both underwriters and brokerages are vulnerable to internal fraud.

Underwriters also have some of the oldest, largest and most complex systems and therefore some of the most extensive Y2K conversion programs. This, coupled with the high incidence of fraud in large companies (62% in 1966 and 57% in 1997 according to the annual KPMG survey), raises additional cause for concern.

And, while smaller brokerages will be less concerned with internal fraud risk related to their own Y2K compliance efforts, they should be aware of problems in dealing with the systems of underwriters and other business support service providers. For instance, a typical case is highlighted in the “post-dated cheque lapping scheme” outlined below:

The red flags of Fraud 2000 are a combination of characteristics of Y2K compliance efforts/conversions and business operational/accounting procedures. If a brokerage uses post-dated cheques to collect premiums and its Y2K conversion (or its underwriters’) will obscure past post-dated cheque payments, then both the brokerage and underwriter are vulnerable to a simple lapping scheme using these cheques.

If Y2K conversion implies losing (electronic) details of sales transactions and/or bank deposit activity then it can become too onerous to manually sift through bank statements and sales slips to find cash flow irregularities which could be caused by cheque/cash lapping schemes or other employee defalcations.

If Y2K conversion entails losing or obscuring return/exchange data, inventory transactions, related sales and supplier accounting information, then the ability to investigate unusual inventory shrinkages, high returns/low sales, item substitution and supplier exchange anomalies is significantly hindered.

Detection and prevention

Watch for the red flags of fraud 2000: Y2K conversions that close the window on past information coupled with anomalies in business operations. Test for anomalies before conversion.

If these or similar anomalies are found then a more detailed fraud 2000 audit may be warranted.

Review your Y2K conversion plan with regard to fraud 2000 and fraud in general.

Open the window to the past by archiving old data in a format that can be mined in the future.

Review and test your new Y2K-compliant systems for fraud accessibility.

Implement anti-fraud measures in your Y2K-compliant systems

Develop a systems evolution plan and review it at regular intervals. Beware of system changes or enhancements that may provide the event necessary to close and restart or expand a fraud such as a lapping scheme.

Fraud beyond 2000

As systems become more advanced, as electronic commerce spreads, and with a major influx of new financial systems resulting from Year 2000 conversions, the opportunities for fraud are multiplying. Furthermore, the fraud incidences are also becoming more complex and difficult to detect and qualify. As such it is likely that fraud is going to become more difficult to prevent without pro-active intervention now.

Deployment of fraud detection, prevention and mitigation strategies and systems prior to Year 2000 conversions can not only alleviate some of these risks, but can provide a sound basis for fraud elimination in the new millennium as part of an integrated systems evolution plan.-