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 riskczar.com

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.)

Reflexivity of Risk

November 19, 2009

George Soros says that financial markets are reflexive.  He means that the participants in the system influence the system. Market prices reflect not just fundamentals, but investors expectations.

The same thing is true of risk systems.  This can be illustrated by a point that is frequently made by John Adams.  Seat belts are widely thought to be good safety devices.  However, Adams points out that aggregate statistics of traffic fatalities do not indicate any improvement whatsoever in safety.  He suggests that because of the real added safety from the seat belts, people drive more recklessly, counteracting the added safety with added risky behavior.

That is one of the problems that firms who adopted and were very strong believers in their sophisticated ERM systems.  Some of those firms used their ERM systems to enable them to take more and more risk.  In effect, they were using the ERM system to tell them where the edge of the cliff was and they then proceeded to drive along the extreme edge at a very fast speed.

What they did not realize was that the cliff was undercut in some places – it was not such a steady place to put all of your weight.

Stated more directly, the risk system caused a feeling of safety that encouraged more risk taking.

What was lost was the understanding of uncertainty.  Those firms were perfectly safe from risks that had happened before and perhaps from risks that were anticipated by the markets.  The highly sophisticated systems were pretty accurate at measuring those risks.  However, they were totally unprepared for the risks that were new.  Mark Twain once said that history does not repeat itself, but it rhymes.  Risk is the same only worse.

Non-Linearities and Capacity

November 18, 2009

I bought my current house 11 years ago.  The area where it is located was then in the middle of a long drought.  There was never any rain during the summer.  Spring rains were slight and winter snow in the mountains that fed the local rivers was well below normal for a number of years in a row.  The newspapers started to print stories about the levels of the reservoirs – showing that the water was slightly lower at the end of each succeeding summer.  One year they even outlawed watering the lawns and everyone’s grass turned brown.

Then, for no reason that was ever explained, the drought ended.  Rainy days in the spring became common and one week it rained for six days straight.

Every system has a capacity.  When the capacity of a system is exceeded, there will be a breakdown of the system of some type.  The breakdown will be a non-linearity of performance of the system.

For example, the ground around my house has a capacity for absorbing and running off water.  When it rained for six days straight,  that capacity was exceeded, some of the water showed up in my basement.   The first time that happened, I was shocked and surprised.  I had lived in the house for 5 years and there had never been a hint of water in the basement. I cleaned up the effects of the water and promptly forgot about it. I put it down to a 1 in 100 year rainstorm.  In other parts of town, streets had been flooded.  It really was an unusual situation.

When it happened again the very next spring, this time after just 3 days of very, very heavy rain.  The flooding in the local area was extreme.  People were driven from their homes and they turned the high school gymnasium into a shelter for a week or two.

It appeared that we all had to recalibrate our models of rainfall possibilities.  We had to realize that the system we had for dealing with rainfall was being exceeded regularly and that these wetter springs were going to continue to exceed the system.  During the years of drought, we had built more and more in low lying areas and in ways that we might not have understood at the time, we altered to overall capacity of the system by paving over ground that would have absorbed the water.

For me, I added a drainage system to my basement.  The following spring, I went into my basement during the heaviest rains and listened to the pump taking the water away.

I had increased the capacity of that system.  Hopefully the capacity is now higher than the amount of rain that we will experience in the next 20 years while I live here.

Financial firms have capacities.  Management generally tries to make sure that the capacity of the firm to absorb losses is not exceeded by losses during their tenure.  But just like I underestimated the amount of rain that might fall in my home town, it seems to be common that managers underestimate the severity of the losses that they might experience.

Writers of liability insurance in the US underestimated the degree to which the courts would assign blame for use of a substance that was thought to be largely benign at one time that turned out to be highly dangerous.

In other cases, though it was the system capacity that was misunderstood.  Investors miss-estimated the capacity of internet firms to productively absorb new cash from the investors.  Just a few years earlier, the capacity of Asian economies to absorb investors cash was over-estimated as well.

Understanding the capacity of large sectors or entire financial systems to absorb additional money and put it to work productively is particularly difficult.  There are no rules of thumb to tell what the capacity of a system is in the first place.  Then to make it even more difficult, the addition of cash to a system changes the capacity.

Think of it this way, there is a neighborhood in a city where there are very few stores.  Given the income and spending of the people living there, an urban planner estimates that there is capacity for 20 stores in that area.  So with encouragement of the city government and private investors, a 20 store shopping center is built in an underused property in that neighborhood.  What happens next is that those 20 stores employ 150 people and for most of those people, the new job is a substantial increase in income.  In addition, everyone in the neighborhood is saving money by not having to travel to do all of their shopping.  Some just save money and all save time.  A few use that extra time to work longer hours, increasing their income.  A new survey by the urban planner a year after the stores open shows that the capacity for stores in the neighborhood is now 22.  However, entrepreneurs see the success of the 20 stores and they convert other properties into 10 more stores.  The capacity temporarily grows to 25, but eventually, half of the now 30 stores in the neighborhood go out of business.

This sort of simple micro economic story is told every year in university classes.

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It clearly applies to macroeconomics as well – to large systems as well as small.  Another word for these situations where system capacity is exceeded is systemic risk.  The term is misleading.  Systemic risk is not a particular type of risk, like market or credit risk.  Systemic risk is the risk that the system will become overloaded and start to behave in severely non-linear manner.  One severe non-linear behavior is shutting down.  That is what the interbank lending did in 2008.

In 2008, many knew that the capacity of the banking system had been exceeded.  They knew that because they knew that their own bank’s capacity had been exceeded.  And they knew that the other banks had been involved in the same sort of business as them.  There is a name for the risks that hit everyone who is in a market – systematic risks.  Systemic risks are usually Systematic risks that grow so large that they exceed the capacity of the system.  The third broad category of risk, specific risks, are not an issue, unless a firm with a large amount of specific risk that exceeds their capacity is “too big to fail”.  Then suddenly specific risk can become systemic risk.

So everyone just watched when the sub prime systematic risk became a systemic risk to the banking sector.  And watch the specific risk to AIG lead to the largest single firm bailout in history.

Many have proposed the establishment of a systemic risk regulator.  What that person would be in charge of doing would be to identify growing systematic risks that could become large enough to become systemic problems.  THen they are responsible to taking or urging actions that are intended to diffuse the systematic risk before it becomes a systemic risk.

A good risk manager has a systemic risk job as well.  THe good risk manager needs to pay attention to the exact same things – to watch out for systematic risks that are growing to a level that might overwhelm the capacity of the system.  The risk manager’s responsibility is then to urge their firm to withdraw from holding any of the systematic risk.   Stories tell us that happened at JP Morgan and at Goldman.  Other stories tell us that didn’t happen at Bear or Lehman.

So the moral of this is that you need to watch not just your own capacity but everyone else’s capacity as well if you do not want stories told about you.

Black Swan Free World (10)

November 17, 2009

This is the final post in a 10 part series.

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Of the ten suggestions, this one has the most value by far.  Unfortunately, this one may be the suggestion that has the least chance of being taken up.  No one is talking about any part of this.  We seem to be moving to try to set the world back into the place that is was, or very close to it.

We should be asking “What should be the place of banking in our economy?”  This is not a question of allowing the free market to choose.  The free market has nothing to do with this.  The role of the banking sector is entirely determined by the government.  The banking sector had grown to eat up a huge percentage of all of the profits of the entire economy.  Does that make any sense to anyone?  Banking can be a symbiont with the economy or it can be a parasite or it can be a cancer.  Before the crisis, banking had definitely moved beyond the level of parasite to becoming a harmful cancer.  Too much of all of the profits of all of business activity in the entire economy were being diverted to the banks and with the pay structure of the banks, into the pockets of a very small number of bankers.  Did that make any sense whatsoever?  Is there any way that anyone can show that situation makes for a healthy economy?  The bubbles that happened twice could be seen as the way that bankers justified their huge take from the economy.  If values were growing rapidly, no one seemed to mind that bankers took so much out of the deals.

Finance Share of GDP PhilipponSource:Evolution of the US Financial Sector Thomas Philippon

However, if the economy and the values of businesses and assets in the economy grow at only a sane pace, and bankers try to go back to the level of take from the economy that they have grown accustomed to, then the amount of total profits left for the rest of the economy are bound to be negative.  So unless we re-think things and figure out how to muzzle the banks, then we are headed for more bubbles that will justify their stratospheric incomes.

The financial sector, once it exceeds a certain share of the economy, should be viewed as a tax on the economy.  Many protest the taxes that the government imposes because the money is not well spent.  Well, the money from this tax goes to personal expenditures of the bankers themselves.  There is not even any pretense that this tax will be spent for the common good.

One question that really needs to be answered is how much of this financial “innovation” that is touted as the result is really beneficial to the economy and how much of it is just unnecessary complexity that hides that take of the bankers and hedge funds.  The excuse that is always given is that all of this financial innovation helps to provide lubrication for businesses.  But that is more like an excuse than a reason.  Mostly the financial innovation has fueled bubbles.  It has led to the excessive leverage that feeds into one sided deals for hedge fund managers.

More often than not, financial innovation has helped to fuel the extreme fixation on short term gains in the economy.  Financial innovation has featured hollowing out companies to maximize short term values.  Quite often the companies “helped” by this process turn into worthless shells somewhere along the process.  This destroys that productive capacity of the economy to allow for the extraction of the maximum amount of short term profits.

Financial innovation helps to turn corporate assets into profits and to take those profits out of the firm through leverage.

So Taleb’s suggestion that we think through Capitalism 2.0 is a good and timely one.  But we need to start asking the right questions to figure out what Capitalism 2.0 will be.

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Many Deadly Sins of Risk Management

November 16, 2009

Compiled by Anton Kobelev at www.inarm.org

Communication Breakdown

  • CEO thinks that risk management is the CRO’s job;
  • Not listening to your CRO – having him too low down the management chain;
  • Hiring a CEO who “doesn’t want to hear bad news”;
  • Not linking the Board tolerance for risk to the risk management practices of the company;
  • Having the CRO report to the CFO instead of to the CEO or Board, i.e., not having a system of checks and balances in place regarding risk practices;
  • The board not leading the risk management charge;
  • Not communicating the risk management goals;
  • Not driving the risk management culture down to the lower levels of the organization;

Ignorance is not Bliss

  • Not doing your own risk evaluations;
  • Not expecting the unexpected;
  • Overreacting to risks that turn out to be harmless;
  • Don’t shun the risk you understand, only to jump into a risk you don’t understand;
  • Failure to pay attention to actual risk exposure in the context of risk appetite;
  • Using outsider view of how much capital the firm should hold uncritically;

Cocksureness

  • Believing your risk model;
  • The opinion held by the majority is not always the right one;
  • There can be several logical, but contradictive explanations for one sequence of events, and logical doesn’t mean true;
  • We do not have perfect information about the future, or even the past and present;
  • Don’t use old normal assumptions to model in the new normal;
  • Arrogance of quantifying the unquantifiable;
  • Not believing your risk model –  waiting until you have enough evidence to prove the risk is real;

Not Seeing the Big Picture

  • Making major changes without heavy involvement of Risk Management;
  • Conflict of interest: not separating risk taking and risk management;
  • Disconnection of strategy and risk management: Allocating capital blindly without understanding the risk-adjusted value creation;
  • One of the biggest mistakes has to be thinking that you can understand the risks of an enterprise just by looking at the components of risk and “adding them up” – the complex interactions between factors are what lead to real enterprise risk;
  • Looking at risk using one single measure;
  • Measuring and reporting risks is the same as managing risks;
  • Risk can always be measured;

Fixation on Structure

  • Thinking that ERM is about meetings and org charts and capital models and reports;
  • Think and don’t check boxes;
  • Forgetting that we are here to protect the organization against risks;
  • Don’t let an ERM process become a tick-box exercise;
  • Not taking a whole company view of risk management;

Nearsightedness

  • Failing to seize historic opportunities for reform, post crisis;
  • Failure to optimize the corporate risk-return profile by turning risk into opportunity where appropriate;
  • Don’t be a stop sign.  Understand the risks AND REWARDS of a proposal before venturing an opinion;
  • Talking about ERM but never executing on anything;
  • Waiting until ratings agencies or regulatory requirements demand better ERM practices before doing anything;
  • There is no obstacle so difficult that, with sufficient thought, cannot be turned into an opportunity;
  • No opportunity so assured that, with insufficient thought, cannot be turned into a disaster;
  • Do not confuse trauma with learning;
  • Using a consistent discipline to search for opportunities where you are paid to accept risk in the context of the entire entity will move you toward an optimized position. Just as important is using that discipline to avoid “opportunities” where this is not the case.
    • undertake positive NPV projects
    • risk comes along with these projects and should be priced in the NPV equation
    • the price of risk is the lesser of the external cost of disposal (e.g., hedging) or the cost of retention “in the context of the entire entity”;
    • also hidden in these words is the need to look at the marginal impact on the entity of accepting the risk. Am I better off after this decision than I was before? A silo NPV may not give the same answer for all firms/individuals;
  • What is important is the optimization journey, understanding it as a goal we will never achieve;

More Skin in the Game

  • Misalign the incentives;
  • Most people will act based on their financial incentives, and that certainly happened (and continues to happen) over the past couple of years. Perhaps we could include one saying that no one is peer reviewing financial incentives to make sure they don’t increase risk elsewhere in the system;
  • Not tying risk management practices to compensation;
  • Not aligning risk management goals with compensation;

Most Popular on Riskviews

November 15, 2009

Most Visited on Riskviews:

Since August 2009 when the blog was restarted as a forum for ERM discussions.

Risk Management Quotes 668 visits

A haphazard collection of over 100 quotes from people who might be either famous or knowledgeable or both.  This page drew about 150 hits per month even when there was zero new activity on Riskviews for 3 months.

Risk Management Failures 230 visits

Names of over 75 firms around the world that have encoundered serious financial difficulties that may or may not have been related to poor risk management.

ERM only has value to those who know that the future is uncertain 149 visits

There is a massive difference in the value of risk management when you look forward from when you look backwards.

Chief Risk Officers in the News 149 visits

Another haphazard collection of items from the news.  Mostly collected from a Google News alert for the phrase “Chief Risk Officer”.

Enterprise Risk Management for Smaller Iinsurers 83 visits

Much of what is written and discussed about risk management focuses on the needs and efforts of the largest firms.  This post tells how ERM is different for a smaller firm.

Bad Label leads to Bad Thinking 63 visits

For years, risk managers have been telling people that they are transferring risks.

Introduction to ERM 111 visits

Materials prepared for a week long seminar for TASK (The Actuarial Society of Kenya).   Also includes slides from a 1/2 day workshop for Kenyan Bank and Insurance CEOs.

Project Risk Management 62 visits

Discussion of how risk management ideas can help to get projects to run on time and within budget.

Black Swan Free World (5) 61 visits

Part of a series of ten reflections on comments by Nassim Taleb on how to create a Black Swan Free World.  This particular discussion is about complexity and simplicity.

The Interest Rate Spike of the Early 1980’s 58 visits

Discussion  of how the unprecedented levels of interest rates affected the US life insurance industry 30 years ago.

The Future of Risk Management – Conference at NYU November 2009

November 14, 2009

Some good and not so good parts to this conference.  Hosted by Courant Institute of Mathematical Sciences, it was surprisingly non-quant.  In fact several of the speakers, obviously with no idea of what the other speakers were doing said that they were going to give some relief from the quant stuff.

Sad to say, the only suggestion that anyone had to do anything “different” was to do more stress testing.  Not exactly, or even slightly, a new idea.  So if this is the future of risk management, no one should expect any significant future contributions from the field.

There was much good discussion, but almost all of it was about the past of risk management, primarily the very recent past.

Here are some comments from the presenters:

  • Banks need regulator to require Stress tests so that they will be taken seriously.
  • Most banks did stress tests that were far from extreme risk scenarios, extreme risk scenarios would not have been given any credibility by bank management.
  • VAR calculations for illiquid securities are meaningless
  • Very large positions can be illiquid because of their size, even though the underlying security is traded in a liquid market.
  • Counterparty risk should be stress tested
  • Securities that are too illiquid to be exchange traded should have higher capital charges
  • Internal risk disclosure by traders should be a key to bonus treatment.  Losses that were disclosed and that are within tolerances should be treated one way and losses from risks that were not disclosed and/or that fall outside of tolerances should be treated much more harshly for bonus calculation purposes.
  • Banks did not accurately respond to the Spring 2009 stress tests
  • Banks did not accurately self assess their own risk management practices for the SSG report.  Usually gave themselves full credit for things that they had just started or were doing in a formalistic, non-committed manner.
  • Most banks are unable or unwilling to state a risk appetite and ADHERE to it.
  • Not all risks taken are disclosed to boards.
  • For the most part, losses of banks were < Economic Capital
  • Banks made no plans for what they would do to recapitalize after a large loss.  Assumed that fresh capital would be readily available if they thought of it at all.  Did not consider that in an extreme situation that results in the losses of magnitude similar to Economic Capital, that capital might not be available at all.
  • Prior to Basel reliance on VAR for capital requirements, banks had a multitude of methods and often used more than one to assess risks.  With the advent of Basel specifications of methodology, most banks stopped doing anything other than the required calculation.
  • Stress tests were usually at 1 or at most 2 standard deviation scenarios.
  • Risk appetites need to be adjusted as markets change and need to reflect the input of various stakeholders.
  • Risk management is seen as not needed in good times and gets some of the first budget cuts in tough times.
  • After doing Stress tests need to establish a matrix of actions that are things that will be DONE if this stress happens, things to sell, changes in capital, changes in business activities, etc.
  • Market consists of three types of risk takers, Innovators, Me Too Followers and Risk Avoiders.  Innovators find good businesses through real trial and error and make good gains from new businesses, Me Too follow innovators, getting less of gains because of slower, gradual adoption of innovations, and risk avoiders are usually into these businesses too late.  All experience losses eventually.  Innovators losses are a small fraction of gains, Me Too losses are a sizable fraction and Risk Avoiders often lose money.  Innovators have all left the banks.  Banks are just the Me Too and Avoiders.
  • T-Shirt – In my models, the markets work
  • Most of the reform suggestions will have the effect of eliminating alternatives, concentrating risk and risk oversight.  Would be much safer to diversify and allow multiple options.  Two exchanges are better than one, getting rid of all the largest banks will lead to lack of diversity of size.
  • Problem with compensation is that (a) pays for trades that have not closed as if they had closed and (b) pay for luck without adjustment for possibility of failure (risk).
  • Counter-cyclical capital rules will mean that banks will have much more capital going into the next crisis, so will be able to afford to lose much more.  Why is that good?
  • Systemic risk is when market reaches equilibrium at below full production capacity.  (Isn’t that a Depression – Funny how the words change)
  • Need to pay attention to who has cash when the crisis happens.  They are the potential white knights.
  • Correlations are caused by cross holdings of market participants – Hunts held cattle and silver in 1908’s causing correlations in those otherwise unrelated markets.  Such correlations are totally unpredictable in advance.
  • National Institute of Financa proposal for a new body to capture and analyze ALL financial market data to identify interconnectedness and future systemic risks.
  • If there is better information about systemic risk, then firms will manage their own systemic risk (Wanna Bet?)
  • Proposal to tax firms based on their contribution to gross systemic risk.
  • Stress testing should focus on changes to correlations
  • Treatment of the GSE Preferred stock holders was the actual start of the panic.  Leahman a week later was actually the second shoe to drop.
  • Banks need to include variability of Vol in their VAR models.  Models that allowed Vol to vary were faster to pick up on problems of the financial markets.  (So the stampede starts a few weeks earlier.)
  • Models turn on, Brains turn off.

Turn VAR Inside Out – To Get S

November 13, 2009

S

Survival.  That is what you really want to know.  When the Board meeting ends, the last thing that they should hear is management assuring them that the company will be in business still when the next meeting is due to be held.

S

But it really is not in terms of bankruptcy, or even regulatory take-over.  If your firm is in the assurance business, then the company does not necessarily need to go that far.  There is usually a point, that might be pretty far remote from bankruptcy, where the firm loses confidence of the market and is no longer able to do business.  And good managers know exactly where that point lies.  

S

So S is the likelihood of avoiding that point of no return.  It is a percentage.  Some might cry that no one will understand a percentage.  That they need dollars to understand.  But VAR includes a percentage as well.  Just because no one says the percentage, that does not mean it is there.  It actually means that no one is even bothering to try to help people to understand what VAR is.  The VAR nuber is really one part of a three part sentence:

The 99% VAR over one-year is $67.8 M.  By itself, VAR does not tell you whether the firm has trouble.  If the VAR doubles from one period to the next, is the firm in trouble?  The answer to that cannot be determined without further information.

S

Survival is the probability that, given the real risks of the firm and the real capital of the firm, the firm will sustain a loss large enough to put an end to their business model.  If your S is 80%, then there is about  50% chance that your firm will not survive three years! But if your S is 95%, then there is a 50-50 chance that your firm will last at least 13 years.  This arithmetic is why a firm, like an insurer, that makes long term promises, need to have a very high S.  An S of 95% does not really seem high enough.

S

Survival is something that can be calculated with the existing VAR model.  Instead of focusing on a arbitrary probability, the calculation instead focuses on the loss that management feels is enough to put them out of business.  S can be recalculated after a proposed share buy back or payment of dividends.  S responds to management actions and assists management decisions.

If your board asks how much risk you are taking, try telling them the firm has a 98.5% Survival probability.  That might actually make more sense to them than saying that the firm might lose as much as $523 M at a 99% confidence interval over one year.

So turn your VAR inside out – to get S 

2040 – America Becomes the Land of the Very Poor Old Baby Boomers

November 12, 2009

By 2040, the oldest of the infamous Baby Boom generation will turn 95.  The youngest, born almost 20 years later will be 75.  Unless there is a drastic change in course for the way that we generally prepare for retirement living, amost all of the Baby Boomers who survive until then, and many of us will, will be living entirely off of Social Security.

For more than half of the retirees, that will mean a big drop in the standard of living that we have grown accustomed to.  Five factors will feed into that trend:

  • Unless there is a sub prime like boom in lending, the part of Baby Boomers standard of living that is supported by debt, will lose that support.  Lenders are quite likely to develop a lack of ability to understand that people with low fixed income and declining assets are not good credit risks, but I would not plan the future of the generation on that presumption.
  • Real estate will NOT be the unbeatable asset that is has been most of the lives of the Baby Boomers.  There will just not be enough demand from the smaller generations coming after the Baby Boomers to keep real estate appreciation at levels comparable to inflation.
  • Inflation will be higher into the future.  That is because there are two ways that future generations can afford to pay off the promises that have been made to Baby Boomers for retirement:  Inflation and a Miracle.  With inflation, wages can grow enough to fund the retirement and medical benefits if there are small differences in the ways that the inflation impacts on Social Security and Medical expenses and how inflation impacts wages and taxes.  The Clinton administration started this trend by changing the definition of inflation, lowering it by 1%.   Future changes will be needed to allow for balance without large tax increases.  Medical costs inflation must be controlled to something lower than wage inflation, or health care will simply bankrupt the economy.
  • It is well known that Baby Boomers are not saving enough for retirement.  And the Boomers who started late were all putting much of their savings into stocks to roll the dice to hope that they picked up 30% per year returns to make up for 30 years of zero savings.
  • Very few Boomers will have a significant part of their retirement income in lifetime guaranteed annuities.  The most common approach to dealing with longevity risk is for retirees to plan to spend their retirement income over their life expectancy.  That thinking is the same as planning to run across the street knowing that you have a 50% chance of being struck by a car.  Half of all people live beyond the life expectancy.  Life expectancy is another one of those very bad terms that totally misleads people, in this case will help for them to plan for a very poor old age.

This could be thought of as a Black Swan scenario, except that it is highly likely.  It is probably much too late for anything different to happen.  There are just not enough future working years for the Boomers to make a major change in their own future and there is doubtless little will for the rest of the world to sacrifice to focus yet one more period in history on our generation.

But this scenario needs to be seriously understood by both the individuals who will be a part of this and by the firms who are in the businesses that will be most impacted.

Are We “Due” for an Interest Rate Risk Episode?

November 11, 2009

In the last ten years, we have had major problems from Credit, Natural Catastrophes and Equities all at least twice.  Looking around at the risk exposures of insurers, it seems that we are due for a fall on Interest Rate Risk.

And things are very well positioned to make that a big time problem.  Interest rates have been generally very low for much of the past decade (in fact, most observers think that low interest rates have caused many of the other problems – perhaps not the nat cats).  This has challenged the minimum guaranteed rates of many insurance contracts.

Interest rate risk management has focused primarily around lobbying regulators to allow lower minimum guarantees.  Active ALM is practiced by many insurers, but by no means all.

Rates cannot get much lower.  The full impact of the historically low current risk free rates (are we still really using that term – can anyone really say that anything is risk free any longer?) has been shielded form some insurers by the historically high credit spreads.  As the economy recovers and credit spreads contract, the rates could go slightly lower for corporate credit.

But keeping rates from exploding as the economy comes back to health will be very difficult.  The sky high unemployment makes it difficult to predict that the monetary authorities will act to avoid overheating and the sharp rise of interest rates.

Calibration of ALM systems will be challenged if there is an interest rate spike.  Many Economic Capital models are calibrated to show a 2% rise in interest rates as a 1/200 event.  It seems highly likely that rates could rise 2% or 3% or 4% or more.  How well prepared will those firms be who have been doing diciplined ALM with a model that tops out at a 2% rise?  Or will the ALM actuaries be the next ones talking of a 25 standard deviation event?

Is there any way that we can justify calling the next interest rate spike a Black Swan?

Monty Python on governance, risk, and compliance

November 10, 2009

Guest Post from Riskczar

I read too much about what GRC needs or what ERM needs but far too often suggestions read like my favourite Monty Python skit (a lot of easier said than done steps):

Alan Well, last week we showed you how to become a gynecologist. And this week on ‘How to do it’ we’re going to show you how to play the flute …but first, here’s Jackie to tell you all how to rid the world of all known diseases.
Jackie Hello, Alan.
Alan Hello, Jackie.
Jackie Well, first of all become a doctor and discover a marvellous cure for something, and then, when the medical profession really starts to take notice of you, you can jolly well tell them what to do and make sure they get everything right so there’ll never be any diseases ever again.
Alan Thanks, Jackie. Great idea. How to play the flute. (picking up a flute) Well here we are. You blow there and you move your fingers up and down here.

So when I read very articulate comments like these from the blog Corporate Integrity, it makes me think of how you play the flute:

Risk management does not happen in a vacuum … The board and management have to clearly define and communicate the culture of risk taking, acceptance, tolerance, and appetite. … Once a proper culture of risk management is defined – including risk tolerance, and appetite – this gets established and communicated through policies and procedures.

… organizations need to establish an enterprise committee to initiate a collaboration on defining, communicating, and managing a culture of risk in their environment. The goal is to define and communicate a culture of risk, establish it in policy and procedures, and monitor adherence to staying within boundaries of risk tolerance and appetite.

Again, easier said than done. I am not criticizing this approach, I actually agree 100% with what he writes, it’s just very difficult to execute.

Telling someone how to play the flute is not the same as teaching him or her how to play the flute, which take a lot of time, patience and practice. And telling business leaders or organizations what boards and committees need to do is not the same a getting buy in, getting them to do it and being successful at it.

MARTA – Risk Management… beyond mitigation

November 9, 2009

Submitted by Antony Marcano

From his Blog Testingreflections.com

In a previous rant about the misuse of the term mitigate in the context of risk management I listed the following strategies (I call them MARTA) for managing a given risk:

  • Mitigate – Reduce the severity of its impact
  • Avoid – Don’t do the thing that makes the risk possible
  • Reduce – Make the risk less likely to happen
  • Transfer – Move the impact of the problem to another party (e.g. insure such as paid insurance or outsource with penalties for failure)
  • Accept – Do nothing or set aside budget to cope with the impact

I recently found myself having to explain this and used the analogy of crossing a busy road with fast-moving cars. What’s the risk? Well, you might get hit by a car.

This will probably be more useful if you take a moment to think of a busy road with fast moving traffic that you know of and then use each of the above strategies to identify different ways of managing the risk. What factors would be significant in deciding on which strategy (or combination of strategies) was the way to go?

Ok, now that you’ve had a chance to think about it, here is what I came up with:

  • Mitigate – Walk down the street until I can find a section of the road where there is a 20mph speed restriction. (This is mitigation because I’m not necessarily making it any less likely that I’m hit, but if I am hit the ‘impact’ is reduced – i.e. I’ll probably live – albeit with injury).
  • Avoid – I could simply not cross the street, by deciding that whatever is on the other side simply isn’t that important or I could use an underground subway (which of course has other risks associated with it depending on the area you’re in).
  • Reduce – Find a stretch of road where there are fewer cars – reducing the probability of being hit by a car.
  • Transfer – Get someone else to cross the street, maybe someone more skilled at crossing the road than me.
  • Accept – Now, if it was a busy street, I wouldn’t ‘accept’ the risk. But, if the road allowed for lots of visibility and there were very few cars and there were speed bumps slowing the traffic down to 10mph then I might just accept the risk.

The person I explained this to found this to be a useful exercise in understanding my views on risk management – beyond mitigation. Hope you find this way of explaining it useful too.

» Antony Marcano’s blog

Black Swan Free World (9)

November 7, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

The treatment of retirement in many countries has been drastically marred by a fundamental lack of understanding of risk and of risk pooling.  Taleb’s suggestion here seems drastically radical, especially here in the US where we came very close just a few years ago to shifting all retirement programs over to market based.

Whether or not you believe in the “socialization” of social security, no one seems to be thinking of the risk management aspect of retirement.  One of the fundamental concepts of risk management is to take specific risk and to use diversification to minimize the relative impact of any specific adverse event.  What the planned market based alternatives to Social Security did was to maximize two specific risks.  Those are the risk of the level of the market at point of retirement and the risk of outliving the funds.  An individual can avoid one of the two, but never both as savings plans are currently run.

This would have been one more step in the direction away from any recognition that there is any risk whatsoever in the idea of providing pensions.  In 1974, the US Congress, in effect, drove the insurance industry out of the business of providing guarantees of pensions in any form.  They did that by telling businesses that they were fully funded if they put up an amount that was sufficient to pre-fund their promices and made sure that the amount was determined without any risk margin whatsoever.  You see, when insurers were in the business of guaranteeing pension benefits, they included a risk margin.  So if you compare an actuarial projection of costs WITHOUT a risk margin to an actuarial projection of costs WITH a risk margin, the projection WITHOUT a risk margin will always seem more economical.

So looking at an individual retirement savings plan without regard to risk is just one more step in this same wrong direction.

So I believe that Taleb has a point, but I would not agree that it is necessarily the best solution to remove the retirement issue entirely from the markets.  That is because I firmly believe that with the entirely unrealistic way that government approaches financial issues that extend into the far future (meaning after lunch), some relationship to the market provides discipline and transparency around the adequacy of the funding.

I would suggest two simple adjustments to the normal features of the personal retirement savings programs.  These can be additional options that are required for all qualified retirement vehicles (US term for plans that meet regulatory standards – there must be similar terms for any other countries where there are personal retirement accounts), or they can be required for all plans – if you are the type that prefers making people do things for their own good.  For investing, the single date dependency of the current system can be repaired with a fund that bases its earnings on an average of 5 prior years and that can only be cashed out over 5 years.

For the longevity risk, my suggestion is to offer an annuity payout option that can be purchased piecemeal at any time prior to retirement.  This option should appear very competitive to younger workers since their cost for an annuity unit deferred until their retirement will appear very inexpensive.  The annuity option can be provided through purchasing additional units of Social Security benefits or through private insurers.  Since the lack of income for elderly people in the countries like the US where lack of lifetime annuity ownership by retired individuals (like the US) will become an extremely serious issue within 20 years when most of the baby boomers who had retirement savings will have spent that savings long before half of us expire, some amount of annuity purchase should be required.  I would favor the gradual elimination of tax advantage to any funds withdrawn as a lump sum or as any form that has no lifetime guarantee.

In the end, to do this right with individual accounts may just be too much trouble for all.  Perhaps what would be better would be to require all employers to provide defined benefit plans and to fund them with risk adjusted premiums.  Now that would make sense.

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

VAR is not a Good Risk Measure

November 6, 2009

Value at Risk (VAR) has taken alot of heat lately and deservedly so.

VAR, as banks are required to calculate it, relies solely on recent past data for calibration.  The use of “recent” data means that following any period of low losses, the VAR measure will show low risk.  That is just not the case.  It fails to recognize the longer term volatility that might exist.  In other words if there are problems that have a periodicity longer than the usual one year time frame of VAR, then VAR will ignore them most of the time and over emphasize them some of the time. Like the stopped clock that is right twice a day, except that VAR might never be right.

Risk models can be calibrated to history, long term or short term, or to future expectations, either long term or short term or they can be calibrated to assumptions consistent with market prices, either spot or over some period of time.  Of those six choices, VAR is calibrated from one of the less useful possible choices.

What VAR does is to answer the question of what would the 1/100 loss have been had I held the current risk positions over the past year.  The advantage of the definition chosen is that you can be sure of consistency.  However, that is only a consistently useful result if you always believe that the world will remain exactly as risky as it was in the past year.

If you believe in equilibrium, then of course the next year will be very similar to the last.  So risk management is a very small task relating to keeping things in line with past variability.  However, the world and the markets do not evidence a fundamental belief in equilibrium.  Some years are riskier than others.

So VAR is not a Good Risk Measure if it is taken alone.  If used with other more forward looking risk measures, it can be a part of a suite of information tat can lead to good risk management.

On the other hand, if you divorce the idea of VAR from the actual implementation of VAR in the banks, then you can conclude that Var is not a Bad Risk Measure.

How to Fail

November 5, 2009

Reasons Civilizations Fail

from Jared Diamond
Author of “Guns, Germs & Steel”
1. Failure to anticipate a problem before it arrives
2. Failure to see a problem once it arrives
3. Failure to even try to solve a problem once they have perceived it
4. Failure to solve a problem that they are trying to solve.
http://www.edge.org/3rd_culture/diamond03/diamond_index.html

Diamond presents a simple taxonomy of failure.  Much of what risk management attempts to do is to prevent failures.

So a risk manager can use this list as a control list for risk management practices.

Failure to anticipate a problem before it arrives – this appplies to both emerging risks as well as identified risks. Anticipating a problem means more than just fretting about it; it means preparing for it as well.

Failure to see a problem once it arrives. Knowing of a risk, but not knowing when that risk becomes risky is almost as bad as not knowing about the risk at all.  The risk manager needs to assist the business manager in identifying when risk is risky.  In addition, there needs to be a process for identifying emerging risks, especially those that are just about emerged. 

Failure to even try to solve a problem once they have perceived it As Diamond points in his books, sometimes people fail to act because they know that the first action would be to stop or reduce something that is really important to them.  This part of the risk management role falls on the CEO.  The CEO needs to be able to take the reins out of the hand of the frozen manager.  And if it is the CEO that is frozen, then the board needs to act.

Failure to solve a problem that they are trying to solve. In the risk management context, this occurs when the standard rules and tools just do not work.  The risk manager needs to reframe the problem along with a scramble for alternate tools while throwing out the rules.

Diversification Causes Correlations

November 3, 2009

The Bond insurers diversified out of their niche of municpal bonds into real estate backed securities and suddenly these two markets that previously seemed to have low correlation were highly correlated as the sub prime crisis brought down the Bond Insurers and their problems rippled into the Muni market.

(I say seemed uncorrelated, but of course they are highly dependent since a high fraction of municipal incomes comes from taxes relating to real estate values.  That is a major problem with the statistical idea of correlation – statistical approaches must never be used uncritically.)

But the point of the first paragraph above is that interdependencies do not have to come from the fundamentals of two markets – that is to come from common drivers of risk.  Interdependencies especially of market prices can and often do come from common ownership of securities from different markets.  The practice of holding risks from seemingly unrelated risks or markets is generally thought to create better risk adjusted results because of diversification.

But the perverse truth is that like many things in real economics (not book economics) the more people use this rule, the less likely it is that it will work.

There are several reasons for this:

  • When a particularly large organization diversifies, their positions in every market will be large.  For anyone to get the most benefit from diversification, they need to have positions in each diversifying risk that are similar in size.  Since even the largest firms had to have started somewhere, they will have a primary business that is very large and so will seek to take very large positions in the diversifying markets to get that diversifying benefit.  So there ends up being some very significant specific risk of a sudden change in correlation if that large firm runs into trouble.  These events only ever happen once to a firm so there is never, ever any historical correlations to be found.  But if you want to avoid this diversification pitfall, it pays to pay attention to where the largest firms operate and be cautious in assuming diversification benefits where THEY are the correlating factor.
  • When large numbers of firms use the same correlation factors (think Solvency II), then they will tend to all try to get into the same diversifying lines of business where they can get the best diversification benefits.  This results in both the specific risk factor mentioned above and to a pricing pressure on those markets.  Those risks with “good” diversification will tend to price down to their marginal cost, which will be net of the diversification benefit.  The customers will end up getting the advantage of diversification.
  • Diversification is commonly believed to eliminate risk.  THis is decidedly NOT TRUE.  No risk is destroyed via diversification.  All of the losses that were going to happen do happen, unaffected by diversification.  What diversification hopes to accomplish is to make this losses relatively less important and more affordable because some risk taking activity is likely to be showing gains while others is showing losses.  So people who thought that because they were diversified, that they had less risk, were willing to go out and take more risk.  This effect causes more of the stampede for the exits behaviors when times get tough and the losses that were NOT destroyed by diversification occur.
  • The theory of a free lunch with diversification encourages firms who are inexperienced with managing a risk to take on that risk because their diversification analysis says that it is “free”.  These firms will often help to drive down prices for everyon, sometimes to the point that they do not make money from their “diversification play” even in good years.  Guess what?  All that fancy correlation math does not work as advertised if the expected earnings from a “diversifying risk” is negative.  These is no diversification from a losing operation because it has no gains to offset the losses of other risks.

Capabilities

November 2, 2009

Your firm’s Risk Profile is a function of two things, the Opportunities for risk taking and your capabilities.  Using your capabilities, you will choose from your opportunities for risk to get your gross risk exposures. Then your capabilities will again take over and treat your risks to bring them to the net risks.

So your capabilities make two contributions to risk management.

A firm with strong capabilities will find the best opportunities from the choices that the firm has based upon its access to sourcing risks.  Those opportunities will have the most favorable risk reward potential.

Then the strong capabilities will seek to trim the risk through risk treatment, giving up as little return as possible while offsetting or otherwise reducing returns as much as possible.

A firm that wants to increase its capabilities has three choices:  Acquiring, Partnering or Training.

Risk capabilities can be Acquired in bulk by acquiring a firm with good capabilities, or by hiring one risk professional at a time.  With Partnering, the firm gets help from the partner who could be a consulting firm or an intermediary.  By using Training to acquire capabilities, the firm seeks to add capabilities to existing staff.

Each possibility has different short and long term costs and each has different levels of dependability and time to start up.


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