What has the global crisis taught us about risk management?

John Verry lays out the lessons that, if not already learnt, should be top of the 2010 to-do list.

Expect the unexpected. While most foresaw a recession coming, it had been talked about for months in the press and elsewhere, there are very few that would have predicted the depth and severity of the recession. Few also would have foreseen the almost total collapse of the banking system. Are some risks impossible to predict? Probably not, what is impossible is to believe that they might happen. This emphasises the need to ensure that your risk function is involved in the strategic planning and horizon scanning within your organisation.

Many risk functions focus mainly on operational and business interruption risk. Operational in the sense of having systems to ensure that work is done in an error-free manner on behalf of a client. File audit checks, effective diary systems, supervision of fee-earners and the work that they do to give some examples. Business interruption to keep the business going in the face of adversity This is not a criticism. These are key areas that need to be effectively managed. But what of strategic risk, another key area? How many organisations involve their risk function in the firm’s business plan, or in assessing the risk in entering into a new field of work, mergers or acquisitions, lateral hires of senior personnel and so on? Very few.

In order to make the right decisions, the decision makers need to have all the relevant information to consider so that they may make informed decisions. Without the involvement of risk, a key element of the decision-making process will be missing. While the risk team may be regarded as the business interruption unit in some firms, it is very important that proper consideration is given as to what may go wrong, and, if it does, the impact that it may have on the business.

Hindsight is an exact science; however some firms may well be regretting strategic decisions made at the height of the ‘boom’. A particular danger area is focussing on the ‘big earner’. Without a doubt, the start performing areas of recent years have been property and corporate.

Many firms invested substantially in these areas in terms of money and people to the detriment of other core work areas. Even where such core work areas had been the mainstay of the firm for many years and upon which the firm’s strength and reputation had been built. Private client groups, insolvency and litigation all became the poor mans relation in so many firms.

However, with the advent of the recession, the rapid growth in the ‘boom towns’ came to a sudden and abrupt halt. The tumbleweed started to blow aimlessly through the corridors of corporate and property departments. Over staffed and under resourced, these areas suffered the brunt of the redundancies. Those firms that spread their risk over a number of work areas have tended to fare better in the recession. Insolvency work and litigation especially have come to the fore. Those with professional negligence teams are particularly busy. With a recession, come claims. There is nothing new in this, it happens on a cyclical basis. Come the good times, property and corporate boom; come the bad times, it is the insolvency and litigation that come to the fore, which perhaps makes it all the more surprising that firms failed to plan for such a contingency.

Another problem with the good times is that many firms pay less attention to risk and governance. Risk tends to be used as a reactive tool as opposed to proactive, which is not an effective use of the function. The good times are when effective risk management is really important. It is in the good times that the mistakes are made that lead to claims in the bad times. Horizon scanning is an essential tool in the risk management tool kit.

A strongly recommended publication for any risk director is the HM Treasury Orange Book. Published in 2004, it is still a highly relevant source of information and guidance to the effective management of risk. Horizon scanning is identified as a tool to identify potential problems. But risk is not all about problems, it is also about positives. An identified risk may well present a business opportunity, it is the unidentified risk that is the real danger, or the identified risk that is not managed effectively or at all.

Again, this emphasises the need to ensure that the organisation has a robust risk identification process, to enable the inherent risk in any situation to be identified. This then enables the inherent risk to be managed effectively and results in a residual risk. It is for the board to identify its risk appetite and whether a residual risk is worth taking. Remember risks must be taken for a business to be successful. Many firms failed to adopt this simple process when making key business decisions in recent years, and are now paying the price.

So, enough of what should have been done – what does the future hold. It does not take much thought to come up with a number of issues.

The legal profession is facing enormous change in terms of how they are to be regulated, the way in which legal services are to be delivered, the amount that the customer will be prepared to pay for those services and the manner in which the services will be delivered. What might be on your scanning list that may need to be carried over on to your risk register?

Some thoughts:

The Legal Services Act 2007

This introduces the alternative business structure (ABS). Threats and opportunities must be identified. What sort of corporate vehicle will you be using to deliver legal services? Will it just be legal services you will be delivering, or what about accountancy or financial services? What other profitable business areas are there that may sit with legal services. Diversification can be both profitable and reduce overdependence on a particular work type or client. Are you thinking about inward investment? What are investors looking for? It is a clearly stated intention that the ABSs will be with us in June 2011. No time to waste.

Competition

With the advent of the ABS, there will be the arrival of new competitors in the legal market. Do not think that this is merely a threat to the small practices. If the area of law is profitable, expect competition. If Tesco can run a bank, what makes you think they will not be able to compete with the work you do? No law firm is immune. With much of the competition coming from the concept that the customer is always right, and protecting the brand is paramount. Some law firms may still be some way off this concept.

Costs

Whatever life will be like once we exit the recession (and that may still be some time on the basis of current evidence), it will certainly not be the same as when the recession started. Clients, both large and small, are unlikely to be prepared to pay fees at the same scale and based on hourly rates. They will want more certainty as to costs. Law firms that provide large scale repeat business to corporate clients are already seeing pressure for more innovative charging methods. If you do not know what slice and price, menu pricing, fixed costs and blended rates are, you need to find out. The days of high hourly rates for most law firms are gone forever.

Regulation

Hunt, Smedley and Clementi have all reviewed regulation of the profession. Differing firms have differing views. What is hoped for is the regulation, while becoming tighter, will become more relevant and effective. Firms who invest a great deal of time and money in ensuring compliance with the ever increasing burden of regulation must not be put at a disadvantage in respect of those firms who do not, and are non-compliant, and pose the greatest risks. This applies not only to law firms currently regulated by the Legal Services Board and the Solicitors Regulation Authority, but new ABS competition as well. The cost of the regulatory burden will increase, as evidenced by the recent eye-watering increases in the practising certificate contribution.

Insurance, the assigned risks pool and the compensation fund

Three areas of hidden potential expense that need to be watched. Professional indemnity insurance has been very cheap for the past several years. In the recent renewal process, a number of firms struggled to obtain affordable terms, or indeed to obtain terms. Most of the larger firms remained immune to this. However, expect future increases as the level of premium income is increased to meet potential liabilities of increased claims generally and lender claims particularly. Compensation fund contributions have increased substantially and will undoubtedly do so again as sufficient reserves to meet liabilities are required a bottomless pit in terms of predictability.

Another bottomless pit is the assigned risk pool (ARP). Currently, in excess of 300 firms in the ARP, exposing qualifying insurers to any unpaid premium, excess and claim payment liability. These costs will be passed on to the remainder of the profession through increased professional indemnity premiums.

So is it all doom and gloom? Not at all. The future will undoubtedly be challenging, but change always provides real opportunity, and it is this opportunity that law firms need to identify, develop and ultimately benefit from. Effective identification and control of risk will be a key part of that process.

John Verry is risk director at TLT LLP. He can be contacted at john.verry@TLTsolicitors.com