Archive for January 2010

Lessons for Insurers (3)

January 31, 2010

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

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)


Bonus Fury

January 29, 2010

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

January 28, 2010

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

January 26, 2010

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)

January 23, 2010

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

January 22, 2010

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

January 21, 2010

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.

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