Three Steps to Better Risk Control

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Three Steps to Better Risk Control for Community Banks

Adopting a sound risk management strategy and appropriate risk management practices represent a beginning, but the ultimate armor is well-considered insurance coverages

By Mark Horton, second vice-president and national director for community banks for TravelersÕ Bond and Financial Products unit. He is responsible for managing and overseeing the companyÕs community bank business throughout the U.S. and has been involved with community bank strategy for 22 years.

A bank errs in its handling of a construction loan when it pays out sums directly to a general contractor, resulting in a lawsuit.

A board of directors has entered into an agreement to sell the bank, and its shareholders, unhappy with the decision, bring action against the board.

The theft of a laptop with account numbers and personal data puts a bank into damage-control mode and results in a regulatory fine.

These are just a few examples of exposures that any bank may face. However, for community banks, the exposure to such risks is likely to be more challenging than for their larger financial counterparts because smaller institutions often have fewer resources to cope with liability. In addition, , they typically have high visibility and pride themselves on their deep community connections—an asset that can be easily damaged by bad news or inept decisions.

These factors make it critical for community banks to adopt leading-edge risk management best practices across a range of issues, including careful selection of insurance protection that is designed to meet their specific needs in these difficult financial times.

Reducing risk where possible
The first step community banks should take in putting together a proactive risk management strategy is to understand their greatest areas of exposure.

While publicly traded financial institutions often face shareholder lawsuits over falling prices, privately held community banks are much more likely to be sued by employees, who may charge discrimination, harassment, or failure to accommodate disabilities.

In addition, as business models evolve, it is important to recognize how risk also changes. In the past, for instance, only the largest banks offered a variety of financial advice and investment-option services. Today, community banks are increasingly expanding their professional service portfolios, broadening their opportunities for profit—but also opening the door to liability that may not have been present before. A sound risk management strategy should incorporate periodic review to uncover new possible areas of exposure.

The second step in creating an effective risk management strategy is to identify best practices in each area of exposure; create policies aligned with those best practices; and then follow through with careful implementation.

An example of this is addressing issues of internet security and protection of private information. In this area, the risk management approach should require that a bank’s information technology department keep abreast of technology safeguards; upgrade systems when appropriate; and ensure adequate training and policy enforcement with employees.

The third step concerns the times when, despite the best efforts to carry out steps one and two, a bank faces a claim, and liability looms. Typical areas of risk that community banks should consider when designing their insurance package include:

Employment practice liability. Employee lawsuits concerning charges of discrimination and harassment are on the rise, and are also becoming more costly. The Equal Employment Opportunity Commission reported that the number of employment-related charges filed in 2007 grew 9% over the prior year, the largest percentage increase in seven years. And according to Jury Verdict Research, 42% of defendant-employers in employment-related claims were in the Service/Retail category (which includes financial institutions). Of reported claims, the median award—without taking into account legal fees—was $140,000.

Theft and fraud. With the poor economy, community banks may see an increase in theft and fraud, including bad checks, fraudulent loan applications, ATM robberies and employee dishonesty. Some of these issues are worrisome because of their frequency (for example, forged checks or checks that overdraw accounts), while others have an impact because of their potential severity (employee embezzlement of large sums over time, for instance).

Internet exposure. Increasingly, customers are demanding online access to their accounts and automated bill paying services. This opens the door to viruses, both those affecting the bank’s systems and those inadvertently passed on to customers in e-mails. It also leads to identity theft; unintentional release of confidential information; and claims for denial of access when systems go down. Areas of risk include hardware and software malfunctioning, external invasion by hackers, and laxity of employees, who may release private information, either purposefully or unknowingly.

Board member liability. Statutory and common laws impose specific standards of conduct on directors and officers, who must answer to the corporation’s shareholders and customers. Claims can come from several sources, including: past, current, or prospective employees of banks filing suit for alleged wrongful termination and discrimination claims, or customers and clients filing suit for disputes involving lender liability and debt collection, including foreclosure. A local competitor, supplier, or contractor could also file suit over a contract dispute, while government and regulatory agencies could sue.

For publicly traded banks, shareholder and investor lawsuits are another source of potential claims. The suits could involve inadequate or inaccurate disclosure resulting from financial reporting, a breach of fiduciary duty, or objections to merger and acquisition activity.

Professional liability. As loan defaults increase and credit terms tighten, there typically is a corresponding increase in claims brought against banks by borrowers. Claims may include negligence in lending practices; failure to disclose terms and conditions of loans; and unwarranted tightening of credit requirements.

Business operations. Like any other business, a community bank is subject to claims for operational mishaps or failings. These can include common issues—such as customer slips, trips, and falls, as well as commercial auto liability if employees drive during the course of business and are involved in an accident. Less-frequent issues may also arise, such as alleged competitor defamation in an advertisement or regulatory fines for violating process-oriented rules.

Picking the right insurer
When creating the insurance component of their risk management strategy, community banks should investigate with whom they are partnering and perform the same type of due diligence they would follow before entering any other long-term business relationship.

One of the first priorities should be selecting an insurer who can provide full coverage across a broad range of potential liabilities. By keeping purchases of policies with one insurer, there should be no gaps in coverage—and, therefore, no finger pointing between different insurers about who is responsible for coverage at the time of a claim.

Another aspect to consider is the local presence of the insurer. This not only provides some assurance of easy access, but also means that the insurer will be familiar with the community bank’s situation and challenges.

It also goes without saying that financial stability should be examined. The bank will want to see a top rating with A.M. Best or other insurance-rating agency, as well as a strong industry track record.

Finally, the quality of services should be examined. Does the insurer have underwriting expertise in the financial industry? Has the insurer set up claims handling in a way that inspires confidence, with ease of use, dedicated specialists, and demonstrated ability to produce speedy, fair results when claims are filed?

In today’s economy, everything feels a bit riskier than usual—but with careful planning to create an effective risk management strategy and smart decisions about insurance coverage, community banks will have a better chance to ride out the troubled times. BJ