Archive for the ‘Profits’ category

Hierarchy of Corporate Needs and ERM

October 31, 2010

In psychology 101 class you heard about Maslow’s hierarchy of needs, They are:

  1. Physiological Needs
  2. Safety Needs
  3. Belonging
  4. Eswteem
  5. Self-Actualization

Corporations have needs as well.  The needs of firms is similar to the needs of the people in the firms.

Hierarchy of Corporate Needs

  • Sales

  • Profits

  • Security

  • Growth of Value

The ERM process can help companies to satisfy these needs.  In ways that no other business management process will. This is true for all businesses, but it is particularly true for financial services businesses like insurance and banking where every transaction can have a significant element of risk for the firm.

Sales

  • For a business to exist, it must have something that it can sell to some market.
  • ERM is usually thought of as “the Sales Prevention Department”.  But ERM can be instrumental in planning the sales process.  But let’s come back to that after discussing the other corporate needs.

Profits

  • Once a firm has mastered the ability to produce or otherwise provide something that some market will buy, they need to figure out how to deliver that product or service at a cost lower than the price that the market will pay.  This is a combination of managing costs and convincing the market of the price that the product/service is worth.
  • In businesses like insurance or banking, the fundamental transactions of the business involve risk taking in a way that is different from most other businesses.  Making a profit ultimately means getting the price right for risk and properly managing the risk so that it rarely gets out of hand.
  • That is the prime territory for ERM – evaluating and managing risks.  So to satisfy this second need of corporations, at least for the corporations in the risk business,  ERM is needed.
  • Without ERM, profits are hit or miss for firms in the risk business.

Security

  • Once a business has a product that they can reliably sell to a market and has figured out a way to reliably deliver that product at a profit, then that business has value.  And the third need becomes important; Security.
  • This is the case not just for companies in the risk business,  but for all types of firms.  Once they get used to making money, there is a strong need to keep that happening.
  • But there are many, many things that can go wrong and put an end to that profitable business.  As a general class, we call those things RISKS.
  • So risk management is applied by firms to deal with those things that might go wrong and end the stream of profits – separately, risk by risk as management becomes aware of those risks.
  • Enterprise Risk Management provides a different approach, and one that should appeal to those who are fundamentally interested in the security of the firm.  While risk management seeks to prevent outsized losses from one cause or another, ERM seeks to manage outsized losses from ANY and ALL sources.

Growth of Value

  • Once a business has Sales, Profits and Security the focus shifts.  And it shifts to growing the value of the firm.
  • Some firms focus on growing their value by making more of the sales that they mastered at the outset of their existence.  Others seek to grow value by increasing their efficiency and increasing the profitability of their business.  A few are able to focus on both at the same time.
  • However, the value of the firm, by some reckonings is the present value of future earnings.  Those future earnings can be higher because sales grow or because profits per unit grow.  But that future will be discounted by the market.  Discounted for both risk and for time.
  • Since Risk is a major component to value, growing value means managing risk.  SO we are again back to ERM.  ERM helps management to see the trade-offs, the risk reward trade-offs, that will influence value.

Sales

  • And so, back to sales.  What you find when you look to manage value with ERM is that it helps you to see the value of sales.  And what you see will be that different sales have a different impact on the value of the firm.
  • So ERM can halp to guide the sales planning process, shedding light on which sales to plan to grow the most and which to limit.

So ERM can play a major role in the achievement of all four of the main Corporate Needs.

Around the Corner Risk

August 19, 2010

That is where the risk manager really earns their money.

The risks that are coming straight down the road, well that is important to pay attention to them.  But those are the obvious risks.  I would not pay very much for help in avoiding serious accidents from those risks.

But those round the corner risks, that would be very valuable, to have someone who can help to make sure that those out of sight risks do not ruin things.

However, what any risk manager who has tried to focus attention on the Around the Corner Risks has learned is that attending to such risks is often seen as spoiling the game.

In the Black Swan, Nassim Taleb talks about the degree to which businesses are in effect selling out of the money puts and pocketing the risk premium as if it is pure profits.

And that is often the case.  Risk managers should extend their view to include analysis of the actual source of profits of the various endeavors of their firms.  Any place where the profits are larger than can be explained is a place where the firm might well be getting paid for selling those puts.

The risk manager needs to be able to take that analysis of sources of profits back to top management to have a frank discussion of those unexplained sources of profits.

In most cases, those situations are risks to the firm, either because they represent risk premium for out of the money puts or because they represent temporary inefficiencies.  The risk from the temporary inefficiencies is that if management mistakenly assumes that those inefficiencies are permanent, then the firm may over-invest in that activity.  That over-investment may then eventually lead to the creation of those our of the money puts as a way to sustain profits when the inefficiencies are extinguished by the market.

An example of this situation is the Variable Annuity market in the US.  In the early 1990’s firms were able to achieve good profits from this business largely because there were too few companies in the market.  Every market participant could show good profits and growth in this new market without resorting to price competition.  This situation attracted many additional insurers into the market, flattening the profitability.  The next phase in the market was to offer additional benefits to customers at prices below market cost.  These additional benefits were in the form of out of the money puts – guarantees against adverse experience of the investments underlying the product.  And the risk premium charged for these benefits was often booked as a profit.

One of the reasons for the confusion between risk premium and profit is the way in which we recognize profits on risks where the period of the risk occurrence is much longer than the period for financial reporting.

The analysis of source of profits can be a powerful tool to help risk managers to both see those around the corner risks and to communicate the possible around the corner risks before them become immanent.

Risk Adjusted Performance Measures

June 20, 2010

By Jean-Pierre Berliet

Design weaknesses are an important source of resistance to ERM implementation. Some are subtle and thus often remain unrecognized. Seasoned business executives recognize readily, however, that decision signals from ERM can be misleading in particular situations in which these design weaknesses can have a significant impact. This generates much organizational heat and can create a highly dysfunctional decision environment.

Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM frameworks were shown to produce credible and useful risk adjusted performance measures

Risk adjusted performance measures (RAPM) such as RAROC (Risk Adjusted Return On Capital), first developed in banking institutions, or Risk Adjusted Economic Value Added (RAEVA) have been heralded as significant breakthroughs in performance measurement for insurance companies. They were seen as offering a way for risk bearing enterprises to relate financial performance to capital consumption in relation to risks assumed and thus to value creation.

Many insurance companies have attempted to establish RAROC/RAEVA performance measurement frameworks to assess their economic performance and develop value enhancing business and risk management strategies. A number of leading companies, mostly in Europe where regulators are demanding it, have continued to invest in refining and using these frameworks. Even those that have persevered, however, understand that framework weaknesses create management challenges that cannot be ignored.

Experienced executives recognize that the attribution of capital to business units or lines provides a necessary foundation for aligning the perspectives of policyholders and shareholders.

Many company executives recognize, however, that i) risk adjusted performance measures can be highly sensitive to methodologies that determine the attribution of income and capital and ii) earnings reported for a period do not adequately represent changes in the value of insurance businesses. As a result, these senior executives believe that decision signals provided by risk adjusted performance measures need to be evaluated with great caution, lest they might mislead. Except for Return on Embedded Value measures that are comparatively more challenging to develop and validate than RAROC/RAEVA measures, risk adjusted performance measures are not typically capable of relating financial performance to return on value considerations that are of critical importance to shareholders.

To provide information that is credible and useful to management and shareholders, insurance companies need to establish risk adjusted performance measures based on:

  • A ( paid up or economic) capital attribution method, with explicit allowance for deviations in special situations, that is approved by Directors
  • Period income measures aligned with pricing and expense decisions, with explicit separation of in-force/run-off, renewals, and new business
  • Supplemental statements relating period or projected economic performance/ changes in value to the value of the underlying business.
  • Reconciliation of risk adjusted performance metrics to reported financial results under accounting principles used in their jurisdictions (GAAP, IFRS, etc.)
  • Establishment and maintenance of appropriate controls, formally certified by management, reviewed and approved by the Audit Committee of the Board of Directors.

In many instances, limitations and weaknesses in performance measures create serious differences of view between a company’s central ERM staff and business executives.

Capital attribution

(more…)

The Most Successful Financial System the World has Ever Known

June 2, 2010

Chris Whalen in his June 1 Commentary for RiskCenter reproduces an excerpt from a piece by Peter Wallison.  In that, Peter makes the statement that

“the United States is well on its way to taking down the most innovative and successful financial system the world has ever known.”

And I want to react to the conclusion that he starts with that the financial system is “the most successful”. 

There are two issues that I have with that conclusion. 

  1. The main evidence of success of the financial system is that it has been successful in collecting a major share of the US economy’s profits.  In 1980, the share of the financial sector of total US corporate profits was under 10%.  In the 30 years before that time, the sector had averaged about 12% of profits.  From 1980 to 2006, the financial sector was extremely succesful.  Its share of total US profits grew to over 40%.  A more than four fold leap in share. 
  2. The destruction of value in 2008 in both the financial sector and in the “real economy” was enormous.  In the financial sector, that destruction amounted to over 10 years of profits. 

So first I would question whether the “success” of the financial sector is first of all real?  Shouldn’t we take into account both the losses and the gains when determining success? 

And second, I would question whether even just looking at the “up side” experiences prior to the financial crisis, whether the financial sector success was of any benefit to the economy as a whole, or just to the bankers.  (and many have commented that the bankers did much better than the owners of banks, since the owners had both upside and downside exposures, while the bankers had mostly upside exposures.)

When we decide what sort of regulations that should be applied to the banks, we have concentrated upon the second item above.  The bankers have been concentrating on the first item.  They want to make sure that a system is maintained where their ability to take profits is not constrained by our attempts to limit the possibilities of the second situation reoccurring. 

But I would suggest that in the regulatory discussion, we ought to be thinking about the first situation as well.  Is it possible to run a healthy economy while the bankers are taking over 40% of the profits?  Unless we know the answer to that, we do not know whether we ought to be encouraging the bankers to shoot for 60% of profits or limiting them somehow to under 20% (the pre-1990 maximum level). 

This question is the elephant in the room that is motivating the bankers and that is funding their enormous contributions to politicians.  And the recent Supreme Court decision that allows unlimited political contributions from corporations makes that a much more important question to the politicians than ever before.

The Elephant in the Room

Risk/Reward NOT Linked

May 18, 2010

At least they are not automatically linked.

Here is a description of the “Law of Risk and Reward” from somewhere on the web. . .

The risk versus reward curve is a fundamental principle in business. The simple explanation is that, as risk in a given transaction increases so does the reward.

This is the fallacy that most of us have heard many, many times.  We hear it so often, it actually seems to be true. 

But it definitely is not now, nor was it ever true that increasing risk increases reward.  

Alfred Marshal is the originator of the supply and demand curves that we were all taught in microeconomics. 

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Somehow, as his idea above about “hopes” for gains was repeated over the years, the word “hopes” was left off. 

And in fact, it takes much more than “hopes” to get great gains out of great risks.  In fact, there are two paths to great gains…

  • Great Luck
  • Great Risk Management

The “Law of Risk and Reward” above seems to follow a fairness sort of reasoning.  It would only be fair if increased risk resulted in increased reward.  But the world is not fair. 

It is quite possible to:

  1. Get a large gain after taking a small risk
  2. Get a large loss after taking a small risk
  3. Get a small gain after taking a large risk
  4. Get a small gain after taking a small risk
  5. Get a large gain after taking a large risk
  6. Get a large loss after taking a large risk

There are several reasons for this.  First of all, the size of the risk is always an estimate made in advance with incomplete information.  Clearly the situations like number 2 above are cases where the risk may have been underestimated.  Also, the economists will emphasize that situations like 1 do not usually last for long.  (See the old joke about the economist and the $20 bill.)  A second reason is that the risk management performed by the risk taker can be effective both in terms of risk selection and in terms of loss severity mitigation.  However, the risk management tasks that result in good risk selection and effective loss severity mitigation require skill and execution. 

Risk takers who believe in the “Law of Risk and Reward” will tend to think that the time, effort and expense of doing good risk management is wasted effort since more risk results in more reward by law.

Skating Away on the Thin Ice of the New Day

April 23, 2010

The title of an old Jethro Tull song.  It sounds like the theme song for the economy today!

Now we all know.  The correlations that we used for our risk models were not reliable in the one instance where we really wanted an answer.

In times of stress, correlations go to one.

That is finally, after only four or five examples with the exact same result, become accepted wisdom.

But does that mean that Diversification is dead as a strategy?

I would argue that it certainly puts a hurt to diversification as a strategy for finding risk free returns.  Which is how it was being (mis) used in the Sub Prime markets.

But Diversification should still reign as the king of risk management strategies.  But it needs to be real diversification.  Not tiny diversification that is observable only under a mathematical microscope.  Real Diversification is where risks have completely different drivers.  Not slightly different statistical histories.

So in Uncertain Times, and these days must be labeled Uncertain Times (or the thin ice age), diversification is the best risk management strategy.  Along with its mirror image twin, avoidance of concentrations.

The banks had given up on diversification as a risk strategy.  Instead they believed that they were making risk free returns by taking lots and lots of concentrated risk that they were either fully hedging or moving the risk off their balance sheets very quickly.

Both ideas failed.  Hedging failed when the counter party was Lehman Brothers.  It succeeded when the counter party was any of the other institutions that were bailed out, but there was an extended period of severe uncertainty about that before the bailouts were finally put into place.  Moving the risks off the balance sheet failed in two ways.  First it failed because they were really playing hot potato without admitting it.  When the music stopped, someone was holding the potato.  And some banks were holding many potatoes.  It also failed because some banks had been offloading the risks to hedge funds and other investors who they were lending funds to finance the purchase.  When the CDOs soured, the loans secured by the CDOs were underwated and the CDOs came back onto the bank balance sheets.

The banks that were hurt the least were the banks who were not so very concentrated in just one major risk.

The cost of the simple diversification strategy is that those banks with real diversification showed lower returns during the build up of the bubble.

So that is the risk reward trade off of real diversification – it will often produce lower returns than the mathematical diversification but it will also show lower losses in proportion to total revenue than a strategy that concentrates in the most profitable risk choices according to a model that is tuned to the accounting or performance bonus system.

Diversification is the risk management strategy for the Thin Ice Age.

Lessons for Insurers (1)

January 11, 2010

In late 2009,  the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis.  This report featured nine key Lessons for Insurers.  Riskviews will comment on those lessons individually…

1. The success of ERM hinges on a strong risk management culture which starts at the top of
a company.

This seems like a very simple statement that is made over and over again by most observers.  But why is it important and why is it very often lacking?

First, what does it mean that there is a “strong risk management culture”?

A strong risk management culture is one where risk considerations make a difference when important decisions are made PERIOD

When a firm first adopts a strong risk management culture, managers will find that there will be clearly identifiable decisions that are being made differently than previously.  After some time, it will become more and more difficult for management to notice such distinctions because as risk management becomes more and more embedded, the specific impact of risk considerations will become a natural inseparable part of corporate life.

Next, why is it important for this to come from the top?  Well, we are tying effective risk management culture to actual changes in DECISIONS and the most important decisions are made by top management.  So if risk management culture is not there at the top, then the most important decisions will not change.  If the risk management culture had started to grow in the firm,

when middle managers see that top management does not let risk considerations get in their way, then fewer and fewer decisions will be made with real consideration risk.

Finally, why is this so difficult?  The answer to that is straight forward, though not simple.  The cost of risk management is usually a real and tangible reduction of income.  The benefit of risk management is probabilistic and intangible.  Firms are compared each quarter to their peers.

If peer firms are not doing risk management, then their earnings will appear higher in most periods.

Banks that suffered in the current financial crisis gave up 10 years of earnings!  But the banks that in fact correctly shied away from the risks that led to the worst losses were seen as poor performers in the years leading up to the crisis.

So what will change this?  Only investors will ultimately change this.  Investors who recognize that in many situations, they have been paying un-risk adjusted multiples for earnings that have a large component of risk premiums for low frequency, high severity risks.

They are paying multiples, in many cases where they should be taking discounts!

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)


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