Archive for November 2009

The Worst Decade

November 30, 2009

Time magazine is calling the 00’s, the Decade From Hell.  At least from an American point of view (admitting that things in China, India or Brazil have been very different in the past 10 years).

Here is a partial list of the problems:

  1. Y2K – one of the highlights actually
  2. 2000 Presidential Election
  3. Tech Bubble bursting
  4. 9/11 WTC
  5. Hurricane Katrina
  6. War in Afghanistan
  7. War in Iraq
  8. Enron & Worldcom & Madoff
  9. 2004 Tsunami
  10. Housing Bubble bursting
  11. Banking Crisis

Time reminds us of Ronald Regan’s famous question “Are you better off than 10 years ago?”

This is also the decade that saw the emergence of Risk Management as a serious discipline.  We should ask ourselves “Was Risk Management a response to these crisis or was it a contributor?”

John Adams calls it the Risk Thermometer effect.  Just like our body seeks to keep the same internal temperature no matter what the temperature outside, our risk thermometer seeks to keep the same level of risk.  That means that when we add risk management for additional safety, we automatically add more risk to bring things back to the same level of risk.

The other claim is that risk management failed.  At the very least, it was heavily over sold.

And finally, there is the argument made by the Senior Supervisors Group that risk management was actually under-bought, that few firms were actually doing risk management in the last decade.

So we have a month left in the decade.  Most were touched by the adverse events of the past decade in some way.  Risk Managers should be able to offer something for the future that is better than the 00’s.

Why were the 00s So Bad?

November 29, 2009

Financial markets in the 00s were dominated by the Individualist point of view described in Cultural Theory.

The Cultural Theory idea of four risk views provides some interesting insights regarding the financial crisis.

In Cultural Theory terms what happened to create the crisis was that Individualists were given control over too much of the world’s resources. Meanwhile, Authoritarians and Egalitarians degree of control over Individualists was almost totally eliminated. (Fatalists usually do not control anything for long.)

Hyman Minsky accurately describes what happens to Individualist systems – they go from investment to speculation to Ponzi to collapse.

When Individualists control fewer resources, take for example the 1987 stock market crash, there was not a major impact outside of the highly Individualist financial markets to hurt the “real” economy. When Individualists control moderate amount of resources, their cycle of financial instability ends in a mild recession. With too much resources in the hands of Individualists, a major financial crisis results.

But why did that happen? Why did Individualists get so much of the resources?

As Minsky observed; “Stability is destabilizing”

Cultural Theory makes two similar observations that help to explain what happened.

1. Each of the four views of risk is correct some of the time. (But not all at the same time – so in any period of time 3 out of 4 are incorrect.)

2. With each passing period during which their world risk view is not validated, some people shift their view to the one that has been validated by events.

Allegiances to these four risk views shift over time.

So favorable financial times led more and more people to shift their view to Individualist. The normal Individualist cycle of investment to speculation to Ponzi to crash happened.

The adverse events of the financial crisis are clearly contrary to the Individualist mean reverting idea of risk and will cause many people to now shift away from an Individualist view of risk.

As long as that trend holds, the Teens decade will end up very different from the 00s.  We must wait to see whether the Authoritarians or the Egalitarians end up dominating the decade.

The political debate in the US is over whether we must return to an almost purely Individualist system or if we can live in an Egalitarian system.

Adaptability is the Key Survival Trait

November 27, 2009

…different and potentially much more difficult issues arise in the identification and measurement of risks where past experience is an uncertain or potentially misleading guide. When risk materialises, it may do so as a risk previously thought to be understood and managed that turns out to be very different indeed, and may do so quickly, well within normal audit cycles. The valuation of an asset or liability in a stressed market environment and the identification of other potential risks that may not previously have been encountered pose major questions for real-time assessment that are unlikely to have been factored into construction of the pre-existing business model.

Excerpt from the Walker Review

To survive such situations, it seems that the ability to quickly assess new situations, especially ones that look like old tried and true but that are seriously more dangerous, and to change what the organization is doing in response to these risks is key.

But to do that, significant amounts of senior resources must be dedicated to determining whether such risks are NOW in the environment each and every day.  The findings of this review must be taken very seriously and the organization must consider the possibility of changing course – not just a minor correction – a major change of business activity.

In addition to the discernment to identify such situations, the organization must cultivate the capacity to make such changes quickly and effectively.

An organization that can do those things have true adaptability and have a much better chance of survival.

However, for a business to be very profitable, it needs to be very focused, very efficient.  Everyone in the organization needs to be pointed in the same direction.  Doubt will undermine.

Within capitalism, the conflict is resolved by allowing individual businesses to maximize profits and relying on an assumption that there will be enough diversity of businesses that enough businesses will have chosen the right business model for the new environment.  Some of the most successful businesses from the old environment will fail to adapt, but some of the laggards will now thrive.

And therefore, the system survives.

But, that is not always so.  In some circumstances, too many firms choose the exact same strategy.  If the environment stays unchanging for too long, individual firms lose any adaptability that they might have had, they all become specialists in that one “most profitable thing”.  A major change in the environment and too many businesses fail too fast.

How does that happen?

Regulators play a large role.  The central bankers work very hard to keep the environment on a steady course, moderating the bumps that encourage diversity.

Prudential and risk management regulation also play a large role, forcing everyone to pay attention to the exact same risks and encouraging similar risk treatments through capital regime incentives.

So for the system to remain healthy, it needs adaptability and adaptability comes from diversity.  And diversity will not exist unless the environment is more variable.  There needs to be diversity in terms of both business strategy and interms of risk management approaches.

So improving the prudential regulation will have the effect of driving everyone to have the same risk management – it will have the perverse effect of diminishing the likelihood of survival of the system.

Register Now for Global ERM Webinar

November 24, 2009

2010 Webinar Now Open for Registrations

Learn how to cut to the core of ERM and identify those elements your strategic plan cannot live without. Gain confidence in your knowledge on ERM by attending this can’t-miss worldwide webcast.

The Casualty Actuarial Society (CAS), The Faculty and Institute of Actuaries (UK), Joint Risk Management Section(JRMS), the Institute of Actuaries of Japan (IAJ), the Institute of Actuaries of Australia(IAAust) and The Society of Actuaries (SOA) present the Global Best Practices in ERM for Insurers and Reinsurers Webcast.

December 1, 2009 Session times vary depending upon location. Speakers from three different regions (Asia Pacific, Europe and North and South America) will provide their own unique perspective on four topics affecting ERM around the world:

Value Creation vs. Systemic Risk Consider some of the concerns around systemic risk and the drivers of value creation that have come under close attention by virtue of their links to systemic risk. The Asia Pacific Region will include a discussion of pension schemes.

Different approaches to ERM and Capital Models Learn how different stakeholders including insurers, banks, regulators and rating agencies are approaching the development of an ERM / ECM framework.

Economic Capital Models Focus on the processes associated with designing, calibrating, validating and the updating of internal models based on bringing new information and intelligence as they arise.

Governance, Strategic Risk and Operational Risk Discuss issues such as ERM governance, tools and techniques to assess strategic and operational risks and their integration into an overall ERM framework.

NEW THIS YEAR! Earn up to 18.0 Continuing Professional Development credits by participating in all four sessions in each region! And with each session presented in at either a basic or advanced level, there is no reason to miss this important global event.

Learn more.

Register today for the Global Best Practices in ERM for Insurers and Reinsurers Webcast.

From Innovation to Exploitation

November 23, 2009

An interesting aspect of the recent financial market chaos is how innovation plays into the facts. While arguably simply bad lending behavior was at the core of the problem, increasingly complex (i.e innovative) financial instruments such as credit default swaps played a key role as well.

By Christopher E. Mandel

What intrigues me is what some view as the cycle of innovation that produces these bad effects.

I recently heard Mark Cuban say: first there’s innovation, then come the imitators then come the idiots. While there are many examples of this cycle of creativity ending in disaster, few to date are of such magnitude as the current credit crisis. Oftentimes it’s not bad behaviors as much as the way in which initial creativity and its success produces laziness.

Today’s good idea is tomorrow’s exploited idea. New products and services often have short lives. In fact most things have their “season” but creative capitalism drives imitation and as more and more imitators pile in for quick profits, it is all destined to be short lived, absent continuous innovation and improvement.

One of the keys to this cycle is the constant drumbeat for better, faster, cheaper and more. Author Richard Swenson in a book titled “Hurtling Toward Oblivion” makes a compelling case for this phenomenon. First his observations: that we are subject to profusion or the phenomenon of always requiring more of everything, forcing progress.

Continued on Risk & Insurance

You may have missed these . . .

November 22, 2009

Riskviews was dormant from April to July 2009 and restarted as a forum for discussions of risk and risk management.  You may have missed some of these posts from shortly after the restart…

Crafting Risk Policy and Processes

From Jawwad Farid

Describes different styles of Risk Policy statements and warns against creating unnecessary bottlenecks with overly restrictive policies.

A Model Defense

From Chris Mandel

Suggests that risk models are just a tool of risk managers and therefore cannot be blamed.

No Thanks, I have enough “New”

Urges thinking of a risk limit for “new” risks.

The Days After – NEVER AGAIN

Tells how firms who have survived a near death experience approach their risk management.

Whose Loss is it?

Asks about who gets what shares of losses from bad loans and suggests that shares havedrifted over time and should be reconsidered.

How about a Risk Diet?

Discusses how an aggregate risk limit is better than silo risk limits.

ERM: Law of Unintended Consequences

From Neil Bodoff

Suggests that accounting changes will have unintended consequences.

Lessons from a Bull Market that Never Happened

Translates lessons learned from the 10 year bull market that was predicted 10 years ago from investors to risk managers.

Choosing the Wrong Part of the Office

From Neil Bodoff

Suggests that by seeking tobe risk managers, actuaries are choosing the wrong part of the office.

Random Numbers

Some comments on how random number generators might be adapted to better reflect the variability of reality.

Twilight Risk Management

November 21, 2009

This is a guest post from Trevor Levine at

With New Moon, the second installment of the Twilight movie saga set to come out this week, I thought I would examine four types of risk treatments from the Edward Cullen point of view. They are ACCEPT, AVOID, TRANSFER and MITIGATE. (Spoiler alert! Stop now if you haven’t read the books and actually care about this stuff.)

In our saga, Edward Cullen is an immortal teenage vampire living in Washington state who falls in love with the mortal, Bella Swan. Edward can hardly stand to be around Bella because her blood smells pretty darn good; he fears he may kill her if he so much as kisses her. Fortunately for Bella, Edward has learned to control his carnal urges and – along with his coven/family of other Cullens – Edward doesn’t eat people any more. Because Bella is so yummy (from a vampire perspective)  she is at risk every time she is near Edward and his “brothers”. The risk is there, but everyone – including Bella has ACCEPTED it.

At the beginning of New Moon, Bella cuts herself and bleeds. One of Edward’s “brothers” who isn’t as good managing his blood thirsty urges, tries attacking Bella. Edward intervenes and saves her, but realizes that the vampire risk to Bella is too great. Although he loves her dearly, he and his family decide it’s best to AVOID the risk of hurting her. Edward would rather live without her than live knowing he had harmed her. They leave Washington.

Well, poor Bella is terribly saddened when her true loves takes off unexpectedly. With lots of free time on her hands she begins to develop a friendship with Jacob Black, a native American teen living on a nearby reservation who also happens to be a shape-shifting werewolf. They build motorcycles and Bella starts to rev Jacob’s engine a bit. Here is an example of risk TRANSFER. The vampire left to protect his love and now she is hanging out with a werewolf who can shape shift at any time and harm those around him.

Later in our saga, Bella begs Edward to turn her into a vampire too so they can live immortally ever after. For our star-crossed lovers, this is the only way to completely MITIGATE the risk of Edward killing Bella.

So there you have it. ACCEPT, AVOID, TRANSFER and MITIGATE, Twilight style.

(And yes, I am already embarrassed that I know this much about the Twilight saga.)

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