Archive for December 2009

Top 10 Posts of 2009

December 31, 2009

ERM only has value to those who know that the future is uncertain 174

Author: Riskviews

Commentary on Timeline of the Global Financial Crisis 165

Author: Riskviews

Elevator Speech – Actuaries & ERM 126

Author: Compilation

Enterprise Risk Management for Smaller Insurers 92

Author: Max Rudolph

The Interest Rate Spike of the Early 1980’s 86

Author: Mike Cohen

Black Swan Free World (5) 78

Author: Riskviews

Project Risk Management 67

Author: Johann Meeke

The Future of Risk Management – Conference 66

Author: Riskviews

Bad Label leads to Bad Thinking 63

Author: Riskviews

Good data, Models, Instincts and statistics 51

Author: Jawwad Farid

Avatar – The Five Rationalities

December 27, 2009

The characters of the new James Cameron movie AVATAR demonstrate the five risk rationalities of Cultural Theory.

Jake Sully is the Fatalist.  He takes over for his brother with no training and no idea of what might happen next.  Fatalists believe that the future is unpredictable.  So in the mind of a Fatalist, this day is no different from any other.  They never believe that they know what is coming next.  Jake also has some Individualist characteristics with his No Fear ethos.  The Individualists believe that everything will work out – so No Fear is an extreme form of their rationality.  Jake Scully evidences a change of rationality over the course of the movie.  The threats to the Na’vi and the Great Tree cause him to shift to the Egalitarian point of view of the Na’vi.

The Na’vi are pure Egalitarians.  Egalitarians believe that the world is in a delicate balance and that resources are finite.  Pure Egalitarian societies would not grow or change very much over time.  They would enforce a very strong degree of uniformity of belief, which the Na’vi evidence with their very intense initiation ceremony.

Parker Selfridge represents the Individualists.  Individualists believe that raw materials are infinite, because new science will always develop ways to exploit the raw materials that are available.  Individualists believe that the best ideas and people will prevail.  Might makes right is a very Individualist point of view.  Parker believes that because the Humans have superior force, then they have a right to the unobtainium by any means.  Individualists believe that risky situations will all work out because the universe will always revert back to the situation where Individualists were in total control.

Colonel Miles Quaritch and the military forces represent the Authoritarian rationality, but not well.  A true Authoritarian would believe that there was a limit to what could be accomplished – a view that the world has boundries within which one must operate to be safe.  Quaritch changes into a more Individualist point of view over the course of the movie.  Instead of trying to learn and work within the boundaries of the world he finds himself in, he works to change those boundaries to ones that he prefers, which is a more Individualist point of view.

Dr. Grace Augustine represents the Hermit, seeking to understand the world, but not necessarily to change it.  She sometimes acts more as the Authoritarian expert, trying to define and set down the boundaries within which it is safe for humans to operate and sometimes more like an Individualist when she tries to change the world theough her schools.  But you sense that the schools were more of a stalling action to allow more time for study.

Important note:  Individualists and Authoritarians are not always villains.  Individualists do not all believe that might makes right.  They do believe that individual achievement and individual rewards should go hand in hand.   Individualists are largely responsible for “progress”.  So if you like your electric light better than a candle, thank an Individualist.

Authoritarians do not all run armies.  They are usually the key people in any hierarchical system.  They are the backbone of governments and the legal profession.  Authoritarians are responsible for the idea of the rule of law.  So if you like to walk down the street in safety thank the Authoritarians.

Fatalists are not all action heroes either.  Most drug addicts and alcoholics are Fatalists.  Fatalists buy most of the lottery tickets.  Generally Fatalists do not control much of the world.  Fatalists are the perennial outsiders.  They also make up many of the ranks of the very talented computer specialists – the prototypical computer nerd is a Fatalist all the way.  Hackers are Fatalists.

Pure Egalitarians groups tend not to last for very long among humans.  Some have fantasied that Native Americans were like the Na’vi – in a stable long term relationship with nature.  Others have suggested that  there was constant war among the different groups that kept them from having the luxury of peace to develop more advance technology.  Most attempts at Egalitarian groups fail due to the tendency of Egalitarians to believe strongly in purity of common motivation and thought.  Egalitarian groups would totally lack adaptability.

Hermits are the scientists and monks who study the world, trying to understand it but not to have any influence over it.  They generally only leave their world when they take on another rationality and decide to try to act on their knowledge.

More on Cultural Theory of Risk

Risk Management in 2009 – Reflections

December 26, 2009

Perhaps we will look back at 2009 and recall that it is the turning point year for Risk Management.  The year that boards ans management and regulators all at once embraced ERM and really took it to heart.  The year that many, many firms appointed their first ever Chief Risk Officer.  They year when they finally committed the resources to build the risk capital model of the entire firm.

On the other hand, it might be recalled as the false spring of ERM before its eventual relegation to the scrapyard of those incessant series of new business management fads like Management by Objective, Managerial Grid, TQM, Process Re-engineering and Six Sigma.

The Financial Crisis was in part due to risk management.  Put a helmet on a kid on a bicycle and they go faster down that hill.  And if the kid really doesn’t believe in helmets and they fail to buckle to chin strap and the helmet blows off in the wind, so much the better.  The wind in the hair feels exhilarating.

The true test of whether the top management is ready to actually DO risk management is whether they are expecting to have to vhange some of their decisions based upon what their risk assessment process tells them.

The dashboard metaphor is really a good way of thinking about risk management.  A reasonable person driving a car will look at their dashboard periodically to check on their speed and on the amount of gas that they have in the car.  That information will occasionally cause them to do something different than what they might have otherwise done.

Regulatory concentration on Risk Management is. on the whole, likely to be bad for firms.  While most banks were doing enough risk management to satisfy regulators, that risk management was not relevant to stopping or even slowing down the financial crisis.

Firms will tend to load up on risks that are not featured by their risk assessment system.  A regulatory driven risk management system tends to be fixed, while a real risk management system needs to be nimble.

Compliance based risk management makes as much sense for firms as driving at the speed limit regardless of the weather, road conditions or the conditions of the car’s breaks and steering.

Many have urged that risk management is as much about opportunities as it is about losses.  However, that is then usually followed by focusing on the opportunities and downplaying the importance of loss controlling.

Preventing a dollar of loss is just as valuable to the firm as adding a dollar of revenue.  A risk management loss controlling system provides management with a methodology to make that loss prevention a reliable and repeatable event.  Excess revenue has much more value if it is reliable and repeatable.  Loss control that is reliable and repeatable can have the same value.

Getting the price right for risks is key.  I like to think of the right price as having three components.  Expected losses.  Risk Margin.  Margin for expenses and profits.  The first thing that you have to decide about participating in a market for a particular type of risk is whether the market in sane.  That means that the market is realistically including some positive margin for expenses and profits above a realistic value for the expected losses and risk margin.

Most aspects of the home real estate and mortgage markets were not sane in 2006 and 2007.  Various insurance markets go through periods of low sanity as well.

Risk management needs to be sure to have the tools to identify the insane markets and the access to tell the story to the real decision makers.

Finally, individual risks or trades need to be assessed and priced properly.  That means that the insurance premium needs to provide a positive margin for expenses and profits above the realistic provision for expected losses and a reasonable margin for risk.

There were two big hits to insurers in 2009.  One was the continuing problems to AIG from its financial products unit.  The main lesson from their troubles ought to be TANSTAAFL.  There ain’t no such thing as a free lunch.  Selling far out of the money puts and recording the entire premium as a profit is a business model that will ALWAYS end up in disaster.

The other hit was to the variable annuity writers.  In their case, they were guilty of only pretending to do risk management.  Their risk limits were strange historical artifacts that had very little to do with the actual risk exposures of the firm.  The typical risk limits for a VA writer were very low risk retained from equities if the potential loss was due to an embedded guarantee and no limit whatsoever for equity risk that resulted in drops in basic M&E revenue.  A typical VA hedging program was like a homeowner who insured every item of his possessions from fire risk, but who failed to insure the house!

So insurers should end the year of 2009 thinking about whether they have either of those two problems lurking somewhere in their book of business.

Are there any “far out of the money” risks where no one is appropriately aware of the large loss potential ?

Are there parts of the business where risk limits are based on tradition rather than on risk?

Have a Happy New Year!

Enduring Fundamentals in a ‘Relocated World’ (Recovering From This Dislocation)

December 22, 2009

From Mike Cohen

“Where do we go from here, and what have we learned to help us arrive there safely and prosperously?” What risk management lessons have been learned?

Dislocations have occurred many times in history, and have occurred in many societal areas, changing many aspects of life profoundly:

– Economy: Agrarian, manufacturing, technology, service

– Military history: Strategies/tactics, weaponry

– Social/family mores: Many, many variations with intensely personal and emotional elements

– Political systems: Capitalism vs. socialism, big vs. small government, government leadership vs. self-determination

Dislocations will, without question, continue to occur in the future, and just as surely manifest themselves in unpredictable ways. Survivors, and ideally ‘thrivers’, will understand when dislocations occur and make the changes necessary to operate well in their new environments.

There are a number of business and societal behaviors that have been culpable in contributing to the interim demise of our socio-economic system:

– Greed

– Poor analysis

– Nonchalance

They are not effective, and have eerie parallels to the seven deadly sins.

While many aspects of our personal and business lives have changed, certain themes remain the same. Righting the ship will be driven by adherence to a number of fundamentals that have driven our success over history and will drive our success in the future.

1) Responsibility and trust: Our actions … what we say and what we do … are our legacy. Do we stand behind them in terms of honesty and wisdom?

Kahlil Gibran, in his epic work ‘The Prophet’, said that “You are the bows from which your children as living arrows are sent forth.” Quite so, but we need to make sure our aim is straight and sure. Our children are our most sacred trust, the most important manifestations of our legacy. Our actions are right along side in terms of importance.

2) Be ‘students’ of what we do:

– What is the purpose of our actions? What are we trying to accomplish?

– Are people or institutions going to be hurt by what we are doing?

– What risks are we taking?

– Functions of all kinds … how do they need to be performed?

3) How do our products work? What needs and wants do they satisfy? In life insurance, for example, those needs and wants to be satisfied are:

– Protection

– Asset accumulation

– Transactions

– Advice:

* Our financial world has never been more complicated and uncertain, and customers (both individuals and corporations) have never had a greater need for guidance

* ‘Caveat emptor’ (let the buyer beware) – Is this too difficult a burden for the consumer of the 21st century?

4) What do corporations need to do to succeed?

– Satisfy their customers’ needs and wants, more effectively and efficiently than their competitors can

– Manage the profit characteristics, for themselves and their customers, well

– Understand the risks in their enterprise, and ensure that they don’t interfere with the interests of their stakeholders

– Operate with integrity and transparency

We have recovered from dislocations in the past; we’re here, aren’t we? Understanding change, that it will always be occurring and how changes have manifested themselves, is critical to our evolution. Not recovery, but evolution. If we forget history, then we are doomed to repeat it. The same is true for understanding history, although the understanding of history is affected by the authors who report it. “How was your vacation?” “I don’t know. I have to wait to see the pictures”

We will solve the major issues confronting our financial system, but we will in all likelihood come out the other end in a very different place.

You may not be able to Grow out if it

December 21, 2009

Growth does not always mean excessive risk, but excessive risk is almost always associated with high growth.

Growth has a way of masking problems.  Things are changing and it is often very difficult to understand whether the changes are just a lag in reporting the good things that come from healthy growth or if they are leading indicators of major problems.

The firm needs to grow risk management analysis and attention along with highest growth activities.  That needs to be demanded from the top.  No middle or even high level risk officer will ever have the authority to slow down the part of the company that is growing the best.  Firms need to have CEO commitment to extra risk analysis of the fastest growing business.

The firm needs to establish its operational capacity for handling growth.  The most common reaction to unexpected growth is to delay hiring additional staff (along with delaying adding additional risk staff as mentioned above).  After more delay and more growth, the business might seem much more profitable than expected.  Some of that excess profitability is coming from the understaffing.  Some of the profitability might be coming from mistakes in recordkeeping due to the understaffing.  A sudden delayed effort to fix the under staffing will most often hurt more than it helps in the short run.

And what is most likely to be shortchanged in an understaffed growing situation  Why it is quality control and recordkeeping.  So if there is a growing problem it is very hard to notice it.

So what to do?

Every great mistake has a halfway

moment, a split second when it can be

recalled and perhaps remedied.

Pearl Buck

Part of the process of planning for each new thing that might grow, if it is as successful as is hoped, needs to be to determine where that halfway moment might be.

Risk Intelligence

December 20, 2009

Nick sent out a link to a test that you can take that measures Risk Intelligence

http://www.projectionpoint.com/

Try it…  I believe that it does give some insight to a different aspect of intelligence that is needed for good risk management.

I would not say that it suggests anything new.  In fact, it seems to link Risk Intelligence back to the ancient inscription at the Oracle of Delphi,

KNOW THYSELF

To be able to understand RISK, that is a good first step, to be able to distinguish between things that you know and things that you do not know are true. I would suggest that is pretty basic for success in any endeavor, including risk management.

However, I would suggest a slightly different standard as the most important kind of intelligence needed for risk management. That would be the ability to

Distinguish between Future Events that are Certainties and Future Events that are Uncertain.

Distinguish between RISK and UNCERTAINTY in a Knightian sense for the Uncertain events.

Remember after the fact that at some past time, when a decision had to be made, the future events that we now all know to be certain because they have happened, were uncertain.

But those conditions seem like boundary conditions – there is no Risk Intelligence if those conditions are not met.

Real Risk Intelligence would then be the ability to make reliable estimates of the likelihood of Uncertain Events.

Real Risk Intelligence would need to be scored as the Projection Point test is scored, that is against a scale that incorporates the idea that answers are not right or wrong, but that acknowledges that probabilistic answers should be scored on a curve (actually they use a diagonal) that reflects the likelihood as well as the outcome.

I would suggest that taking the Projection Point Risk Intelligence Test is worth the 10 minutes that it takes.  But it is the beginning rather than the end of investigation into the idea of Risk Intelligence.

Does Bloomberg Understand Anything about Risk Management?

December 18, 2009

On December 18, Bloomberg posted a story about losses on interest rate swaps at Harvard.   The story says that in 2004, Harvard entered into long term swaps to lock in future rates for planned borrowing.  That seems like ok risk management.  But as it happened, interests did not rise, they fell.  So the hedge was not needed.  They type of hedging strategy that they chose had no initial cost.  The cost of risk management was incurred only if the hedged event did not happen.   If interest rated did risk, then the swaps would have resulted in a gain so that Harvard’s costs were limited to a predetermined amount.  If Interest rates fell, then Harvard would pay on the swaps, but save on the interest costs, bring the sum of interest paid on their borrowing and the swap payments to a fixed predetermined total in all cases.

However, Bloomberg chooses to say is this way:

Harvard was betting in 2004 that interest rates would rise by the time it needed to borrow.

The bulk of the story is about how Harvard lost their “bet” and how much money that they lost because they lost the “bet” when interest rates fell, and Harvard had to postpone their planned borrowing.

No wonder it is difficult for firms to disclose any information about actual risk management actions and plans.  If a reasonable, but not perfect risk management action is seen as a “bet”, rather than a move to stablize interest costs.

Every risk management action will have a cost.  Harvard’s real bad move, similar to the one by Soc Gen in January 2008, the choice to lock in losses, and at the worst time.  Interest rates cannot go below zero, so there is absolutely no reason to get out of those swaps, unless their cashflow was so, so poor that they had no way to pay the monthly interrest swap amount (even though they somehow had the cash to settle all of the swaps, presumably paying the present value of the long term swap amounts as viewed at a time ov very low interest rates).

Their other bad move was to fail to hedge the possibility that they would not even do the project and therefore not need the hedge.  To identify how to hedge that situation, they would have had to do some scenario testing of scenarios of extreme losses in their endownment that would have resulted in the situation that they now find themselves.  That analysis should have resulted in some far out of the money hedges on the investments in Harvard’s portfolio.  And the fact that much of their portfolio may be unhedegable should have been a warning about the wisdom of making forward committments like the swaps that presume that the endownment will not tank.

Seeing how wrongheaded the coverage of the transactions was, Harvard probably felt that they had long term reputational risk from paying the monthly payments.

Alternately, if as the article says, the swap markets are so much more liquid at periods for up to 3 years, they why didn’t they enter into trades to reverse the first 3 years of the payments?

No matter what the market says right this minute, I find it hard to believe that interest rates for Harvard will never again reach 4.72% that the swaps were locking in as the rate.

But that is not the point.  The point is that Bloomberg reports Risk Management as a “bet” implying that lack of risk management is not a “bet”.

But, how many companies are implicitly taking a “bet” that the future will never get worse than the present by not hedging anything?

Why is that NEVER a story?


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