Turn VAR Inside Out – To Get 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.
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.
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.
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.
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
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