Lessons for Insurers (3)

In late 2008,  the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis.  This report featured nine key Lessons for Insurers.  Riskviews will comment on those lessons individually…

3. The presence of systemic risks means that insurers should pay attention to not only what
is going on inside their “own houses” but also be aware of what is going on in their
“neighbors’ yards.” Regulators should also pay attention to what is happening in other
countries.

Risk management that is inwards directed, referred to above as in “own houses” is not just important because of systemic risk.   At any time, the actions of others in the marketplace could have a massive negative impact on an insurer.  Most parts of the insurance and financial markets are different each year because of changes that are almost always from “outside”.  In insurance markets, there are constant shifts in underwriting standards and pricing strategies of the other firms in the market.  New products and product features change the landscape all of the time.  Risk managers need to stay aware of how those changes impact on the business that gets written by the insurer.  The most important thing to look out for is whether the shifting competition has managed to siphon off the better risks, leaving the insurer with the worse risks.

There are also plenty of times when the rest of the world drags things into the dumps without causing a systemic meltdown.  The term Systemic Risk is highly overused right now.  While the recent Systemic Risk event will be heavily ingrained in the memories of most of us, it is only the second such event in 75 years.   So the risk manager cannot be limiting their concern about the actions of others in the marketplace to events that might become systemic.  For example, the 2000 – 2002 equity bear market was quite difficult to firms that were heavily exposed to equities.  But even three years of losses there did not cause a systemic breakdown.  However, the tech boom that preceded the bust was a clear example of a bubble.

So perhaps, rather than systemic risks, the advice from the report should have read “The presence of bubbles…”  Bubbles are much more common that systemic breakdowns and are definitely worth the time and effort that it takes to avoid them.  Bubbles can be broadly defined to include those points in the underwriting cycle when premiums are far below break-even.

A former boss of mine once said that the problem with the commercial real estate business is that even if you do your homework and pick just the right spot to build a new building, right where there is no competition and strong demand for the type of space you are adding, all it takes is another fool who doesn’t do any homework, but who see the full parking lot outside your building and with that research in hand builds an identical building right down the street.  Overcapacity and you both fail.

That story applies to most things in one way or another in business.  And that is a major source of risk – the fool building an identical building right down the street.

Whenever you find that something that you have been doing successfully becomes highly popular, you need to start making contingency plans and find another niche to exploit.  You will need both.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

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Bonus Fury

is everywhere.  I am not sure that I have heard anyone actually explain what should be done or why they are furious, other than the general idea that there were bail-outs. 

I can think of two reasons to object to the mega bonuses that can be used to help direct future bonuses:

1. There is not any evidence of any claw back being applied in the bonus calculations.  It is likely that a significant number of the folks who have the most culpability for the immense losses of the past are no longer there.  Doing a claw back from folks who were not involved would as is pointed out by the bankers be counter productive.  But they are only partly correct.  While many are gone, some do remain.  In addition, there are many folks remaining at the bank who were indirectly responsible (or should have been indirectly responsible) who are in the executive ranks and on the board as well.  There should be claw backs that apply to everyone who is up the chain of command and in a role with significant corporate wide responsibility.  This would be very productive and would send the signal that executives are responsible.  It would reduce the degree to which executives are willing to look the other way when a strong business unit manager insists on doing something that might not be in the best interests of the firm.  In addition, too little is said of board compensation.  Board members of firms that needed to be bailed out should suffer financial consequences.  Strong consideration should be given to reducing board fees in a manner that is commensurate with what is done to claw back bonuses for executives. 
2. For almost two years now, the Fed has been depressing interest rates to levels that flirt with a zero value.  They do this to help the banks so that the banks will help the economy.  This has created a situation where the banks can operate with a zero cost of good sold.  Any business on the planet could show a profit with zero COGS.  To the extent that banks are taking earnings that result from these low interest rates and turning around and giving the resulting profits to their employees as bonus they are subverting the purpose of the low rates.  This fact has been true for a long time, but the Greenspan Fed that was famous for low interest rates and for ignoring the gross inefficiencies of the approach.   The lower interest rates take money from savers and transfers it to debtors and banks and bankers.  In this case, the interest rates are being kept low both to bolster bank profits as well as to keep money cheap to spur borrowing to encourage spending.  However, credit tightening by the banks has jacked up their effective margins (spread differentials less default losses).  So bank profits are soaring because they are (a) paying a trivial amount for funds and (b) not lending as much of the money to as many businesses and people as they had before.  In addition, in 2008, the banks were able to obtain debt capital at a rate averaging 0.7% with a government guarantee which is expected to rise to 4.7% (per Reuters).  The differential there is purely a gift from the taxpayers, but a gift that was meant to be used to recapitalize the banks to provide funds for loans. And the banks are paying bonuses on these gains, rather than keeping the excess profits to build up balance sheets to be used when they regain the courage to lend.  So this is proving to be a very inefficient way to move the economy.  The flow of funds through the bankers bonuses back into the economy is just too inefficient of a way to stimulate the economy.  Those excess profits that come from both of these interest expense subsidies must be excluded from the bonuses, or else the subsidies must be stopped and the money used in a more efficient manner to stimulate the economy. 

So there are probably several alternatives to make this more efficient and less bothersome.   We just need to figure out exactly what about it that is bothersome and frame it in a way that can direct policy.  Otherwise, we end up with piecemeal solutions aplied in a wack-a-mole approach to problem solving.

The Risk of Market Value

In 1984, Warren Buffet gave a speech about value investing at Columbia University.  Here is a quote from that speech:

“it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem to be able to grasp the concept, simple as it is.” Warren Buffett

Not about risk management but, if you can get your head around Buffett’s comment about upside, there is a logical counterparty about downside.

“Either the idea of buying dollar bills at $2 seems risky to someone immediately or it never will. If the response is, ‘if that is what the market rate is’ then just dig into your pocket and look for some dollars to sell.” Dave Ingram

In the book “The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History”, Greg Zuckerman tells just how difficult it was to be among the few investors who saw that the US mortgage market was overheated – that the market value of the houses and the securities written on the mortgages on those houses were all dollar bills being traded over and over again at $2.

But that was aggressive trading.  The risk management response with that knowledge would been to stay away.  And many, many financial institutions did stay away.  All of the press went to the firms that played that game to their and all of our detriment.

So the Paulson story of good to read because it tells about the other side of some of the trades.  And there always in another side, no matter how poorly the press chooses to cover it.

And the other side of the risk mismanagement by the largest banks and AIG is the risk management of the firms who were not exposed to overpriced mortgage securities.  But it is hard to make a story about the exposures that those firms did not have.

Which is one of the puzzles of risk management.  Sometimes the greatest successes are when nothing happens.

All Things Being Equal

is a phrase that is left out more often than left in when it is actually a key and seldom true assumption behind an argument.

If you are talking about risk and risk models, that phrase should be a red flag.  If the phrase is actually stated, the risk manager should immediately challenge it.  Because when a major risk becomes a loss or threatens to become a loss, very rarely are all things equal.

Most, and possibly all, major loss situations have ripple effects.  These ripple effects may be direct or they may be because they affect people who then in turn take actions that cause other unusual things to happen.

Here is a map of how the World Economic Forum thinks that the major risks of the world are interconnected:

Another example of a problem with the “All things Being Equal” assumption is the discussion of inflation.  Few people remember to say it but when they worry that addional money in the system due to direct Fed actions or Stimulus spending will cause inflation – that would be true – ALL THINGS BEING EQUAL.  But in fact, they are not equal, or even close to equal.

What is different is the amount of money that was in the system prior to the crisis other than the money from the Fed and the Stimulus.  The losses suffered by the banks and the shrinkage of loans and the inability of consumers and businesses to get loans – each of those things REDUCES the amount of money in the economy.  So in no stretch of the imagination are all things equal.

So the old rule about government spending being inflationary is only true ALL THINGS BEING EQUAL.

That does not, however, mean that there is not a difficult task ahead for the Fed to try to discern how fast the total money supply catches up with the economy so that they can reel back the money that they have put in.  But the problem with that idea is that because of the amount of economic activity that has been totally privatized, the Fed does not necessarily have the information to do that directly.

So ALL THINGS BEING EQUAL, they will have to try anyway by looking at the pick up in activity from the parts of the economy that they do have information about.

Meanwhile, folks like the NIF are looking to help to improve the information flow so that proper management of the money supply is possible from direct information.

Lessons for Insurers (2)

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

2. Risk management is most effective at prevention. Failing at prevention results in damage control, which is often expensive and ineffective.

This “lesson” is based upon an old car repair commercial where the mechanic says “You pay me now or pay me later”.

But Loss Prevention is only one of three major goals of risk management.   There is much confusion about the fact that there are really three different things that are all called risk management by different people.

However, many people do not realize that there are really three separate systems involved in those three types of risk management and end up adopting elements of all three systems without necessarily adopting all of any of the three.  That is one of the things that creates much frustration with ERM among general management.

And some ERM systems are not clear themselves about which of the three types of ERM goals that they are trying to accomplish.

Just to be clear, the three goals are:

1. Controlling the Frequency and Severity of Losses
2. Managing the risk reward trade-off on a transactional level
3. Managing the risk reward trade-off on a macro (line of business or subsidiary) level

As you could imagine, completely different people are involved in executing each of the three. And each of these three types of ERM include activities and goals that existed in most firms before the existence of ERM.

Usually, the difference between an ERM approach to these objectives and the pre-ERM approach is two things:

• A commitment to pursuing the goals consistently throughout the entire enterprise
• A common definition of RISK and metrics for measuring RISK applied to all risks

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Inflationary Expectations

Guest Post from Max Rudolph

Financial expectations have a way of holding up mean reverting processes, making them sticky. Inflation expectations are famous for this, with workers anticipating future levels of price increases and demanding higher pay to compensate. When rates stay abnormally high or low for long periods, especially when it is artificially induced, the changes to catch up are especially large and swift. That is the position we are in today. Short term rates are being kept low through Federal Reserve policies. This is the same policy over the past decade that produced several asset class bubbles and increased systemic risk until it nearly took down the financial markets in late 2008. Now a combination of factors are building that will lead to high rates. There are a number of reasons for this, some new and some old.

Building Pressures

Many of the unfunded accruals have been documented elsewhere, but it recently became obvious to me that there are now so many that our path is predestined. It’s not obvious how to avoid these issues through an investment strategy today, but a stress scenario that considers long-term Treasury rates of 10% or higher should be included in any strategic planning exercise. Here are some reasons why.

• Federal deficit – you can’t print this many dollars without increasing inflationary pressure

• Trade deficit – we need dollars to buy oil and other imported goods. We don’t export a comparable amount, so the dollar’s inevitable trend is down. This is inflationary.

• Unfunded mandates

o Social Security (annuity benefits) has a trust fund backed by promises of future taxpayers to pay retirees but little more than that.

o Social Security (health benefits) has little in the trust fund today. It will get much, much, worse over the next 30 years.

• Willingness to bail out anyone and everyone – it is hard to argue that everyone who received federal bailouts so far were systemic risks by providing these funds, implied promises were made that others would be helped too. This incents more risk in the system. Besides the union vote it is hard to argue that GM is now a systemic risk, yet lots of my money is being passed through to them and others who lacked understanding of risks and lived by the lobbyist. An academic should do a correlation study between lobbying expenses and bailout money. I think we would find that the first department to go after a bailout should be lobbying to push out the private sector by buying troubled assets. More market feedback is needed.

• Giveaways have no plan to slow down – several stimulus plan programs continue to push out the private sector by buying troubled assets. More market feedback is needed.

• Waiting in the wings – others are waiting to be bailed out, including states, municipalities and municipal insurers.

It occurs to me that a politician’s legacy can change long after he/she is out of office. I wonder if Franklin Roosevelt, champion of the retirement safety net, has yet to meet his fate. If the United States government is bankrupted at some point due to generous benefits to seniors and federal deficits under a Keynesian mantle, it will put a new perspective to his ideas.

Waiting in the wings – others are waiting to be bailed out, including states,

Warning: The information provided in this post is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Good luck!

Crisis Pre-Nuptial

What is the reaction of your firm going to be in the event of a large loss or other crisis? 

If you are responsible for risk management, it is very much in your interest to enter into a Crisis Pre-Nuptial. 

The Crisis Pre-Nuptial has two important components. 

1. A protocol for management actions in the event of the crisis.  There is likely a need for there to be a number of these protocols.   These protocols can be extremely valuable, their value will most likely far exceed the entire cost of a risk management function.  Their value comes because they eliminate two major problems that firms face in the event of a crisis or large loss.  First is the deer in the headlights problem – the delay when no one is sure what to do and who is to do it.  That delay can mean that corrective actions are much less effective or much more expensive or both.  Second is the opposite, that too many people take actions, but that the actions are conflicting.  This again increasses costs and decreases effectiveness.  Just as with severe medical emergencies, prompt corrective actions are almost always more likely to have the most favorable results. 
2. Setting up an expectation that the crises and losses either are or are not an expected part of the risks that the firm is taking.  If the firm is taking high risks, but does not expect to ever experience losses, then there is a major disconnect between the two.  Just as a marital pre-nuptial agreement is a conscious acknowledgement that marriages sometimes end in divorce, a Crisis Pre-Nuptial is an acknowledgement that normal business activity sometimes involves losses and crises. 

Risk managers who have a Crisis Pre-Nuptial in place might, just might, have a better chance to survive with their job in tact after a crisis or large loss. 

And if someday, investors and/or boards come to the realization that firms that plan for rainy days are, in the long run, going to be more valuable, the information that is in the Crisis pre-nuptial could be very important information for them.

Why the valuation of RMBS holdings needed changing

Post from Michael A Cohen, Principal – Cohen Strategic Consulting

Last November’s decision by the National Association of Insurance Commissioners (NAIC) to appoint PIMCO Advisory to assess the holdings of non-agency residential mortgage-backed securities (RMBS) signaled a marked change in attitude towards the major ratings agencies. This move by the NAIC — the regulatory body for the insurance industry in the US, comprising the insurance commissioners of the 50 states – was aimed at determining the appropriate amount of risk-adjusted capital to be held by US insurers (more than 1,600 companies in both the life and property/casualty segments) for RMBS on their balance sheets.

Why did the NAIC act?

A number of problems had arisen from the way RMBS held by insurers had historically been rated by some rating agencies which are “nationally recognized statistical rating organizations” (NRSROs), though it is important to note that not all rating agencies which are NRSROs had engaged in this particular rating activity.

RMBS had been assigned (much) higher ratings than they seem to have deserved at the time, albeit with the benefit of hindsight. The higher ratings also led to lower capital charges for entities holding these securitizations (insurers, in this example) in determining the risk-adjusted capital they needed to hold for regulatory standards.

Consequently, these insurance organizations were ultimately viewed to be undercapitalized for their collective investment risks. These higher ratings also led to lower prices for the securitizations, which meant that the purchasers were ultimately getting much lower risk-adjusted returns than had been envisaged (and in many cases losses) for their purchases.

The analysis that was performed by the NRSROs has been strenuously called into question by many industry observers during the financial crisis of the past two years, for two primary reasons:

• The level of analytical due diligence was weak and the default statistics used to evaluate these securities did not reflect the actual level of stress in the marketplace; as a consequence ratings were issued at higher levels than the underlying analytics in part to placate the purchasers of the ratings, and a number of industry insiders observed that this was done.
• Once the RMBS marketplace came under extreme stress, the rating agencies subsequently determined that the risk charges for these securities would increase several fold, materially increasing the amount of risk-adjusted capital needed to be held by insurers with RMBS, and ultimately jeopardizing the companies’ financial strength ratings themselves.

Flaws in rating RMBS

Rating agencies have historically been paid for their rating services by those entities to which they assign ratings (that reflect claims paying, debt paying, principal paying, etc. abilities). Industry observers have long viewed this relationship as a potential conflict of interest, but, because insurers and buyers had not been materially harmed by this process until recently, the industry practice of rating agencies assigning ratings to companies who were paying them for the service was not strenuously challenged.

Further, since the rating agencies can increase their profit margins by increasing their overall rating fees while maintaining their expenses in the course of performing rating analysis, it follows that there is an incentive to increase the volume of ratings issued by the staff, which implies less time being spent on a particular analysis. Again, until recently, the rated entities and the purchasers of rated securities and insurance policies did not feel sufficiently harmed to challenge the process.

Basis Risk

In the simplest terms, basis risk is the difference between the hedge you bought and the risk that you own.  Especially the difference that is most noticeable when you had expected to be needing the hedge.

But that is not the topic here.  There is another Basis Risk.  That is the risk that you are using the wrong basis to judge your gains and losses.  This risk is particularly prevalent right after a bubble pops.  Everyone is comparing their wealth to what they thought that they had at the height of the bubble.

Here are two stories that show the problem with that:

1. Think about a situation where someone made an error in preparing your brokerage statement.  That IBM stock you have was worth $100,000.  The mistake was that an extra zero slipped in somehow.  The position was recorded as $1,000,000.  Add that in to your net worth and most of us would have an exaggerated feeling of wealth.  Think of how destructive to your long term happiness it would be if you really came to believe that you had that extra $900,000?  Two ways that could be destructive.  First of all, you could start spending other funds as if you had all that excess value.  Second of all, once you were informed of the error, you could then undertake more aggressive investments to try to make up the difference.  The only way to be safe from that destruction is if you never believe the erroneous basis for the IBM stock.
2. Possibly more realistic, think of someone in a casino.  During their day there they bet on some game or other continuously.  At one point in the visit, they are up by $100,000.  When they leave, they are actually down by $1000 compared to the amount they walked in the door with.  Should they tell people you lost $1000 or $101,000?

In both cases, it sounds silly to even think for long about the larger numbers as your “basis”.  But that seems to pervade the financial press.  Unfortunately, with regard to home values, many folks were persuaded to believe the erroneous valuation at the peak of the market and to borrow based upon that value.

So, now you know what is meant by this type of “Basis Risk”.  Unfortunately, it is potentially much larger than the first type of basis risk.  Behavioral Finance abounds with examples of how the wealth effect can distort the actions of people.  Possibly, the reason that the person in the casino walked out with a $1000 loss is realted to the sorts of destructive decisions that are made when wealth is suddenly increased.  Therefore, it is much more important to protect against this larger basis risk.

To protect against this type of risk requires a particularly strong ability to stick to your own “disciplined realism” valuation of your positions.  Plus an ability to limit your own valuation to include only reasonable appreciation.  Mark to mark is the opposite of the disciplined realism, at least when it comes to upside MTM.  For downside movements in value, it is best to make sure that your disciplined realism is at least as pessimistic as the market. 

This is a very different approach than what has been favored by the accounting profession and adoppted by most financial firms.  But they have found themselves in the position of the second story above.  They feel that they have made gigantic profits based upon the degree to which their bets are up in the middle of the session.  They have not left the casino yet, however.

And that is the last place where disciplined realism needs to be applied.  Most of us have been schooled to believe that “realized gains” are REAL and therefore can of course be recognized.  But think of that second story about the casino.  If you are taking those gains and putting them right back on the table, then you really do not “have” them in any REAL sense.  Firms need to adopt disciplined realism by recognizing that a series of similar positions are in reality not at all different from a single position held for a long time.  The gains should not be recognized until the size of the position is significantly reduced.

Moral Hazard

Kevin Dowd has written a fine article titled “Moral Hazard and the Financial Crisis” for the Cato Journal.  Some of his very well articulated points include:

• Moral Hazard comes from the ability for individuals to benefit from gains without having an equal share in losses.  (I would add that that has almost nothing to do with government bailouts.  It exists fully in the compensation of most executives of most firms in most economies. )
• Bad risk model (Gaussian).  That ignore abnormal market conditions. 
• Ignoring the fact that others in the market all have the same risk management strategy and that that strategy does not work for the entire market at once. 
• Mark to Model where model is extremely sensitive to assumptions. 
• Using models that were not designed for that purpose. 
• Assumption of continuously liquid markets. 
• Risk management system too rigid, resulting in easy gaming by traders. 
• “the more sophisticated the [risk management] system, the more unreliable it might be.”
• Senior management was out of control.  (and all CEOs are paid as if they were above average!)
• Fundamental flaw in Limited Liability system.  No one has incentive to put a stop to this.  Moral Hazard is baked into the system.

Unfortunately, there are two flaws that I see in his paper. 

First, he misses the elephant in the room.  The actual exposure of the financial system to mortage loan losses in the end was over 400% of the amount of mortgages.  So without the multiplication of risk that happened under the guise of risk spreading had not happened, the global financial crisis would have simply been a large loss for the banking sector and other investors.  However, with the secret amplification of risk that happened with the CDO/CDS over the counter trades, the mortgage crisis became a depression sized loss, exceeding the capital of many large banks. 

So putting all of the transactions out in the open may have gone a long way towards allowing the someone to react intelligently to the situation.  Figuring out a way to limit the amount of the synthetic securities would probably be a good idea as well.  Moral Hazard is a term from insurance that is important to this situation.  Insurable interest in one as well. 

The second flaw of the paper is the standard Cato line that regulation should be eliminated.  In this case, it is totally outrageous to suggest that the market would have applied any discipline.  The market created the situation, operating largely outside of regulations. 

So while I liked most of the movie, I hated the ending. 

We really do need a Systemic Risk Regulator.  And somehow, we need to create a system so that 50 years from now when that person is sitting on a 50 year track record of no market meltdowns, they will still have enough credibility to act against the mega bubble of those days.

Best Risk Management Quotes

The Risk Management Quotes page of Riskviews has consistently been the most popular part of the site.  Since its inception, the page has received almost 2300 hits, more than twice the next most popular part of the site.

The quotes are sometimes actually about risk management, but more often they are statements or questions that risk managers should keep in mind.

They have been gathered from a wide range of sources, and most of the authors of the quotes were not talking about risk management, at least they were not intending to talk about risk management.

The list of quotes has recently hit its 100th posting (with something more than 100 quotes, since a number of the posts have multiple quotes.)  So on that auspicous occasion, here are my favotites:

1. Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.  Douglas Adams
2. “when the map and the territory don’t agree, always believe the territory” Gause and Weinberg – describing Swedish Army Training
3. When you find yourself in a hole, stop digging.-Will Rogers
4. “The major difference between a thing that might go wrong and a thing that cannot possibly go wrong is that when a thing that cannot possibly go wrong goes wrong it usually turns out to be impossible to get at or repair” Douglas Adams
5. “A foreign policy aimed at the achievement of total security is the one thing I can think of that is entirely capable of bringing this country to a point where it will have no security at all.”– George F. Kennan, (1954)
6. “THERE ARE IDIOTS. Look around.” Larry Summers
7. the only virtue of being an aging risk manager is that you have a large collection of your own mistakes that you know not to repeat  Donald Van Deventer
8. Philip K. Dick “Reality is that which, when you stop believing in it, doesn’t go away.”
9. Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.  Albert Einstein
10. “Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”  Sherlock Holmes (A. Conan Doyle)
11. The fact that people are full of greed, fear, or folly is predictable. The sequence is not predictable. Warren Buffett
12. “A good rule of thumb is to assume that “everything matters.” Richard Thaler
13. “The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.”  Avinash Persaud
14. There are more things in heaven and earth, Horatio,
    Than are dreamt of in your philosophy.
    W Shakespeare Hamlet, scene v
15. When Models turn on, Brains turn off  Til Schuermann

You might have other favorites.  Please let us know about them.

Lessons for Insurers (1)

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

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

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

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

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

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

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

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

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

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

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

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

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

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

A Bird in the Hand

is Worth Two in the Bush. 

is an old maxim for risk adjusting asset valuation.  It suggests a 50% discount for recording unrealized values.  Notice that is not a discount for recognizing unrealized GAINS, it is a discount on VALUE. 

You have to wonder whether that 50% discount is because there is only a 50% chance that you will catch a bird in the bush or if it reflects a higher chance of actually catching the bird, plus some risk premium because there is some chance that you will catch none.  Is catching none your risk tolerance, or can you go several days without bird for supper, so you have a risk tolerance of zero birds for two or even three days? 

How do you provide for that worst case?  Do you hold a bird in reserve?  Or half a bird?  How do you keep the reserve bird?  Do you have to feed it or refrigerate it? 

Older versions of the saying show a much higher discount.  Two versions from the 1400’s suggest a 90% discount for birds that are on the fly or in the wood.  Were the risk tolerances much lower then or methods of catching birds much less developed?  We may never know. 

But times change and discounts change.  Following the pattern of diminishing discounts, the current standard is that one bird in the hand is worth one bird in the bush according to current accounting standards.  

That is called mark to market accounting.  Older acounting standards might have applied 100% discounts to unrealized GAINS.  But the current wisdom is to not discount anything ever.  So holding cash is exactly the same as holding paper that does not even promice to be worth any cash if at some time in the recent past, someone thought that paper had a particular value. 

With a 50% discount on unrealized VALUES, there was little chance of ever having to do a write-off.  Usually recoveries even in dire situations exceed 50%.  With no discount, there is a very high chance of a write-off because the assets are booked at a value that is the most that one might expect to recover. 

Clever people have figured ways to go even further.  For assets where there are no easy market prices, they get to count future birds that they haven’t even seen yet. 

That is one reason why banks are fighting so hard to keep derivatives off of exchanges, so that they can keep those future birds on their books and do not have to suffer the discounts that an exchange would impose.

Risky Blogs

Some good blogs on risk and risk management:

De-Risk Blog

Recent post “Extreme Risk Management – Mountaineers and Project Management”

Risk Czar Blog

Recent post “The Risk Management of Everything”

Thomas M. Bragg on Business Risk Management

Recent post “The 5 Coulds Technique”

Clear Risk Blog

Recent Post “Examining Strategic Risk – ‘Strategic’ Risk or ‘Strategic Risk’ Management?”

Riskovation

Recent Post “Top Ten Risk Management Lessons and Trends from 2009“

New Decade Resolutions

Here are New Decade Resolutions for firms to adopt who are looking to be prepared for another decade

1. Attention to risk management by top management and the board.  The past decade has been just one continuous lesson that losses can happen from any direction. This is about the survival of the firm.  Survival must not be delegated to a middle manager.  It must be a key concern for the CEO and board.
2. Action oriented approach to risk.  Risk reports are made to point out where and what actions are needed.  Management expects to and does act upon the information from the risk reports.
3. Learning from own losses and from the losses of others.  After a loss, the firm should learn not just what went wrong that resulted in the loss, but how they can learn from their experience to improve their responses to future situations both similar and dissimilar.  Two different areas of a firm shouldn’t have to separately experience a problem to learn the same lesson. Competitor losses should present the exact same opportunity to improve rather than a feeling of smug superiority.
   
4. Forwardlooking risk assessment. Painstaking calibration of risk models to past experience is only valuable for firms that own time machines.  Risk assessment needs to be calibrated to the future. 
   
5. Skeptical of common knowledge. The future will NOT be a repeat of the past.  Any risk assessment that is properly calibrated to the future is only one one of many possible results.  Look back on the past decade’s experience and remember how many times risk models needed to be recalibrated.  That recalibration experience should form the basis for healthy skepticism of any and all future risk assessments.

6. Drivers of risks will be highlighted and monitored.  Key risk indicators is not just an idea for Operational risks that are difficult to measure directly.  Key risk indicators should be identified and monitored for all important risks.  Key risk indicators need to include leading and lagging indicators as well as indicators from information that is internal to the firm as well as external. 
   
7. Adaptable. Both risk measurement and risk management will not be designed after the famously fixed Ligne Maginot that spectacularly failed the French in 1940.  The ability needs to be developed and maintained to change focus of risk assessment and to change risk treatment methods on short notice without major cost or disruption. 
   
8. Scope will be clear for risk management.  I have personally favored a split between risk of failure of the firm strategy and risk of losses within the form strategy, with only the later within the scope of risk management.  That means that anything that is potentially loss making except failure of sales would be in the scope of risk management. 
   
9. Focus on  the largest exposures.  All of the details of execution of risk treatment will come to naught if the firm is too concentrated in any risk that starts making losses at a rate higher than expected.  That means that the largest exposures need to be examined and re-examined with a “no complacency” attitude.  There should never be a large exposure that is too safe to need attention.   Big transactions will also get the same kind of focus on risk.