Archive for May 2010

Aligning Interests

May 30, 2010

By Jean-Pierre Berliet

Companies that withstood the crisis and are now poised for continuing success have been disciplined about aligning interests of shareholders and managers

Separation of ownership and control creates conflicts of interests between managers and owners. To mitigate this situation, companies expend much effort to develop and implement incentive compensation systems that align the interests of managers and shareholders. The present crisis demonstrates clearly, however, that such arrangements are imperfect: large incentive payments were made to many people in companies that have performed poorly or even failed. There has been a public outcry.

But there is nothing really new in misalignments of incentives, or weaknesses in incentive designs that produce harmful results: they exist in every company to some degree. In a typical situation, managers are concerned about minimizing financial and career consequences of not achieving their objectives. If the situation requires it, managers will exploit every opportunity to change their operating plans to achieve their targets. They will seek and capitalize on opportunities to convert unreported intangible assets, such as market share, product or service quality, product leadership, plant productivity or customer service responsiveness into current profits by postponing and reducing related expenses. Financial results will look good, and they will be praised for accomplishing their objectives. Actions that they took, however, accelerated uncertain future income to the present period while undermining the company’s competitive capabilities and reducing the sustainability of its performance. This is dangerous. Mitigating this form of moral hazard is difficult because its effects are not readily apparent.

In insurance companies (and banks), business managers have even greater opportunities to “game” incentive plans:  they can increase reported business volume and profit in the current period by slightly under-pricing or increasing risks assumed.  This approach to “making the numbers” is particularly tempting in lines of coverage in which losses can take many years to emerge and develop; it is also particularly dangerous because losses from mispriced policies, especially in lines with high severity/low frequency loss experience can be devastating.  Similarly, investment officers can invest in assets that offer higher yields to increase portfolio performance, while involving risks that can result in significant capital losses later.

Based on these observations, Directors and CEOs of insurance companies need to work with management to:

  • Link incentive compensation payments to the ultimate outcome of business written rather than to current profits (especially when fair value accounting standards cause immediate recognition of profits on contracts).
  • Establish and empower an internal control and audit function to verify that managers’ actions are aligned with business strategies and plans.
  • Verify the integrity of underwriting and investment decisions, in relation to explicitly approved guidelines and processes.

The present crisis has demonstrated how unbundling of risk assumption businesses can increase moral hazard by redistributing risks, gains and potential losses across originators, arrangers of securitization transactions and investors/risk bearers.

Reconstruction of incentive programs and establishment of appropriate oversight and enforcement mechanisms are needed to reduce moral hazard and restore confidence in the financial system, including insurance companies.

©Jean-Pierre Berliet   Berliet Associates, LLC  (203) 972-0256 jpberliet@att.net

Stress to Failure

May 28, 2010

It is clear and obvious that BP and the US government regulators were not at all prepared for failure of a deep water oil rig in the Gulf.

What would have helped them is a procedure that I have heard Dave Sandberg describe many times that is used at his employer, Allianz.

Stress to Failure.

  1. Whenever something new is proposed, they require that a demonstration is prepared that shows the type of stress that will cause complete failure. That test provides them with several pieces of very valuable information: It helps to put a boundry around the situations under which it will NOT fail. This is the green (and yellow) zone for the new project. They can then evaluate the expected return and volatility of return in those scenarios.
  2. It allows an estimate of the likelihood of success vs. failure of the project.  This can be seen by looking at the type of situation that causes failure and the likelihood of that situation.  However, caution should be applied to not put too much weight on this likelihood estimate if the failure type of even has never before happened.  Human nature may well be biased towards underestimating adversity. 
  3. It allows for planning for the failure event.  This is where the BP folks and Transocean as well as the Minerals Management Service failed.  They clearly had no plan for the failure event.  It sounds like they were able to convince themselves that any failure event was so remote in likelihood that there was no need to plan for one. 
  4. Understanding the true weaknesses of the system.  If you do not know how to break it, then perhaps you do not understand the system. 

This is an idea our of engineering and probably we could learn much by studying how they have used the idea.

Window Dressing

May 26, 2010

The Wall Street Journal reported today that banks are again very actively doing significant amounts of end out the quarter clean-up that is otherwise known as “window dressing“.

This is a practice that works well, allowing banks to hold capital (figured on their quarter end balance sheets) that is much lower than the risk levels that they are using to create their profits.  This makes them look safer to investors in addition to boosting their ROE.

And while it probably is within the rules of Basel II, it violates the underlying idea behind Pillar 1 and Pillar 3.

The idea behind Pillar 1 is that the banks should hold capital for their risks.  This window dressing practice clearly illustrates one of the major logical flaws in the application of Pillar 1.

To understand the flaw, you need to think for a minute about what the capital is for.  It is not actually for the risks that the bank held during the quarter, nor is it mostly for the risks that happen to be on the balance sheet as of the end of the quarter.  It is primarily to protect the bank in the event of losses form the risks that the banks will be exposed to during the next quarter.  The beginning of quarter balance sheet is being used as a proxy for the risks over the coming quarter.

For a firm that has a highly disciplined risk management process, it would actually make more sense for the firm to hold capital for the RISK LIMITS that it has extended for the coming quarter.  That would be a firm where you could rely upon them to keep their risks within their risk limits for the most part. This makes more sense than holding capital for some arbitrary point in time.  The window dressing proves that point better than any possible theoretical argument.  Besides being the wrong idea, it is subject to easy manipulation.

For firms that are not disciplined in keeping their risks within their risk limits, something higher than the level of capital on their risk limits would be the logical level.  For these firms it would make sense to keep track of the degree to which they exceed their limits (at maximum) and charge them for capital at a level above that.  Say for example 200%.  So if a firm exceeds its risk limits by 10% at maximum in a quarter, their capital for the next quarter would be 120% of the capital needed to support their risk limits for the following quarter.

This check on risk discipline would have several benefits.  It moves the easy possibility of manipulation away from the capital level.  The “legal” window dressing would have to be replaced by fraudulent manipulation of risk reports to fix the capital level.  In addition, disclosure of the degree to which a bank exceeds its risk limit could be disclosed under Pillar 3 and then investors and counterpraties could give their reaction to a bank that cannot control its risks exposures.

In addition, this same logic could be applied to insurers under Solvency II.  There is no reason why insurance regulators need to follow the flawed logic of the banking regulators.

Addendum:  Above I say that the window dressing works well.  That is only partly true.  Sometimes, it does not work at all.  And banks can become stuck with risks and losses from those risks that are far larger than what they had been disclosing.  That happens when markets freeze up.

You see, if many banks are doing the same sorts of window dressing, they all run the risk that there will be too many sellers and not enough buyers for those couple of days at the end of the quarter.  Or maybe just for that one night.  And the freeze is likeliest when the losses are about tho strike.

So in reality, window dressing is not a good plan if you believe that things can ever go poorly.

Lessons for Insurers (6)

May 25, 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…

6. Insurers must pay special attention to high growth/profit areas in their companies, as these are often the areas from which the greatest risks emanate.

All high growth areas are not risk problems, but almost all risk problems come from areas of high growth.

And high growth areas present several special problems for effective risk management.

  1. High growth in the financial services field usually results when a firm has a new product or service or territory.  There is almost always a deficit of experience and data about the riskiness of the new area.  Uncertainty rules.
  2. In new high growth areas, pricing can be far off the mark at the outset.  If the initial experience is benign, then the level of pricing can become firmly set in the minds of the distributors, the market and the management.  When adverse experience starts to undermine the pricing, it may be initially dismissed as an anomaly, a temporary loss.  It may be very difficult to determine the real situation.
  3. If risk resources were included in the plan for the high growth activity, they were probably not increased when the growth started to exceed expectations.  As growth occurs, the risk resources are most often held at the level called for in the initial plan.  Any additional resources that are applied to the growing area are needed to support the higher level of activity.  Often this is simply a natural caution about increasing expenses in what may well be a temporary situation.  This caution is often justified as growth ebbs.  But in the situations where growth does not wane, a major mismatch between risk resources and business activity develops.
  4. There is usually a political problem within the firm.  The management of the highest growth area are most likely the current corporate heroes.  It is very highly unlikely that the CRO will have as much clout within the organization as the heroes.  The only solution to this issue is support from the CEO for the importance of risk.
  5. Risk efforts need to be seen not as “business prevention” but as a partner with the business in getting it right.  This is difficult to accomplish unless risk is involved from the outset.  If the business gets going and growing with procedures that are questionable from a risk perspective, then it is quite possible that changing those procedures might well hurt the growth of the area.  Risk needs to be involved form the outset so that appropriate procedures and execution of those procedures does not become a growth issue later on.

This is the most difficult and important area for the risk management of the firm.  The business needs to be able to take chances in new areas where good growth is possible.  The Risk function needs to be able to help these new activities to have the chance to succeed.

At the same time, the organization needs to be protected from the sort of corner cutting that leads to growth through drastically under-priced risks.

It is a delicate balancing act that requires a high degree of political skill as well as good business judgment about when to dig in the heels and when to let go.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Holding Sufficient Capital

May 23, 2010

From Jean-Pierre Berliet

The companies that withstood the crisis and are now poised for continuing success have been disciplined about holding sufficient capital. However, the issue of how much capital an insurance company should hold beyond requirements set by regulators or rating agencies is contentious.

Many insurance executives hold the view that a company with a reputation for using capital productively on behalf of shareholders would be able to raise additional capital rapidly and efficiently, as needed to execute its business strategy. According to this view, a company would be able to hold just as much “solvency” capital as it needs to protect itself over a one year horizon from risks associated with the run off of in-force policies plus one year of new business. In this framework, the capital need is calculated to enable a company to pay off all its liabilities, at a specified confidence level, at the end of the one year period of stress, under the assumption that assets and liabilities are sold into the market at then prevailing “good prices”. If more capital were needed than is held, the company would raise it in the capital market.

Executives with a “going concern” perspective do not agree. They observe first that solvency capital requirements increase with the length of the planning horizon. Then, they correctly point out that, during a crisis, prices at which assets and liabilities can be sold will not be “good times” prices upon which the “solvency” approach is predicated. Asset prices are likely to be lower, perhaps substantially, while liability prices will be higher. As a result, they believe that the “solvency” approach, such as the Solvency II framework adopted by European regulators, understates both the need for and the cost of capital. In addition, these executives remember that, during crises, capital can become too onerous or unavailable in the capital market. They conclude that, under a going concern assumption, a company should hold more capital, as an insurance policy against many risks to its survival that are ignored under a solvency framework.

The recent meltdown of debt markets made it impossible for many banks and insurance companies to shore up their capital positions. It prompted federal authorities to rescue AIG, Fannie Mae and Freddie Mac. The “going concern” view appears to have been vindicated.

Directors and CEOs have a fiduciary obligation to ensure that their companies hold an amount of capital that is appropriate in relation to risks assumed and to their business plan. Determining just how much capital to hold, however, is fraught with difficulties because changes in capital held have complex impacts about which reasonable people can disagree. For example, increasing capital reduces solvency concerns and the strength of a company’s ratings while also reducing financial leverage and the rate of return on capital that is being earned; and conversely.

Since Directors and CEOs have an obligation to act prudently, they need to review the process and analyses used to make capital strategy decisions, including:

  • Economic capital projections, in relation to risks assumed under a going concern assumption, with consideration of strategic risks and potential systemic shocks, to ensure company survival through a collapse of financial markets during which capital cannot be raised or becomes exceedingly onerous
  • Management of relationships with leading investors and financial analysts
  • Development of reinsurance capacity, as a source of “off balance sheet” capital
  • Management of relationships with leading rating agencies and regulators
  • Development of “contingent” capital capacity.

The integration of risk, capital and business strategy is very important to success. Directors and CEOs cannot let actuaries and finance professionals dictate how this is to happen, because they and the risk models they use have been shown to have important blind spots. In their deliberations, Directors and CEOs need to remember that models cannot reflect credibly the impact of strategic risks. Models are bound to “miss the point” because they cannot reflect surprises that occur outside the boundaries of the closed business systems to which they apply.

©Jean-Pierre Berliet   Berliet Associates, LLC (203) 972-0256  jpberliet@att.net

What’s the Truth?

May 21, 2010

There has always been an issue with TRUTH with regard to risk.  At least there is when dealing with SOME PEOPLE. 

The risk analyst prepares a report about a proposal that shows the new proposal in a bad light.  The business person who is the champion of the proposal questions the TRUTH of the matter.  An unprepared analyst can easily get picked apart by this sort of attack.  If it becomes a true showdown between the business person and the analyst, in many companies, the business person can find a way to shed enough doubt on the TRUTH of the situation to win the day. 

The preparation needed by the analyst is to understand that there is more than one TRUTH to the matter of risk.  I can think of at least four points of view.  In addition, there are many, many different angles and approaches to evaluating risk.  And since risk analysis is about the future, there is no ONE TRUTH.  The preparation needed is to understand ALL of the points of view as well many of the different angles and approaches to analysis of risk. 

The four points of view are:

  1. Mean Reversion – things will have their ups and downs but those will cancel out and this will be very profitable. 
  2. History Repeats – we can understand risk just fine by looking at the past. 
  3. Impending Disaster – anything you can imagine, I can imagine something worse.
  4. Unpredictable – we can’t know the future so why bother trying. 

Each point of view will have totally different beliefs about the TRUTH of a risk evaluation.  You will not win an argument with someone who has one belief by marshalling facts and analysis from one of the other beliefs.  And most confusing of all, each of these beliefs is actually the TRUTH at some point in time. 

For periods of time, the world does act in a mean reverting manner.  When it does, make sure that you are buying on the dips. 

Other times, things do bounce along within a range of ups and downs that are consistent with some part of the historical record.  Careful risk taking is in order then. 

And as we saw in the fall of 2008 in the financial markets there are times when every day you wake up and wish you had sold out of your risk positions yesterday. 

But right now, things are pretty unpredictable with major ups and downs coming with very little notice.  Volatility is again far above historical ranges.  Best to keep your exposures small and spread out. 

So understand that with regard to RISK, TRUTH is not quite so easy to pin down. 

A Risk Management Classic

May 20, 2010

I had occasion recently to search the Basel website to try to document the history of their involvement in risk management. 

The oldest document that is still available there that has the term Risk Management in its title is July 1994, Risk Management Guidelines for Derivatives.  That matches up with my impression that modern risk management can be traced back to the efforts of banks and banking supervisors to contain the risks associated with derivatives trading that had lead to several blow-ups in the early 1990’s. 

But the first real classic is the next oldest document on the Basel website,  Principles for the management of interest rate risk, from September 1997.  That document clearly lays out the structure and process for a full scale risk management system.  If you take that link, it will tell that the 1997 document has been superceded.  But if you look at the 2004 update and the 1997 original, you will see that they have added lots of details and lost most of the clarity to the original.  So if you want trees, take the 2004 version, if you want forest, like me, you would prefer the original 1997 version. 

What I particularly liked about the original is that it really wasn’t about interest rate risk at all.  It really captured the essence of risk management and applied that essence to interest rate risk.  Therefore, I believe that the document can easily be used as a guide to building a risk management system for any risk. 

The document is built around 1o Principles:

The role of the board and senior management

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should approve strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks. The board of directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk.
 Principle 2: Senior management must ensure that the structure of the bank’s business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk.
Principle 3: Banks should clearly define the individuals and/or committees responsible for managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the risk management process to avoid potential conflicts of interest. Banks should have risk measurement, monitoring and control functions with clearly defined duties that are sufficiently independent from position-taking functions of the bank and which report risk exposures directly to senior management and the board of directors. Larger or more complex banks should have a designated independent unit responsible for the design and administration of the bank’s interest rate risk measurement, monitoring and control functions.

Policies and procedures

Principle 4: It is essential that banks’ interest rate risk policies and procedures be clearly defined and consistent with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible obstacles to cash movements among affiliates.
 Principle 5: It is important that banks identify the risks inherent in new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the board or its appropriate delegated committee.

Measurement and monitoring system

 
Principle 6: It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management.
 Principle 7: Banks must establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies.
Principle 8: Banks should measure their vulnerability to loss under stressful market conditions – including the breakdown of key assumptions – and consider those results when establishing and reviewing their policies and limits for interest rate risk.
Principle 9: Banks must have adequate information systems for measuring, monitoring, controlling and reporting interest rate exposures. Reports must be provided on a timely basis to the bank’s board of directors, senior management and, where appropriate, individual business line managers. 

Internal controls

Principle 10: Banks must have an adequate system of internal controls over their interest rate risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or  enhancements to internal controls are made. The results of such reviews should be available to the relevant supervisory authorities. 

 



 
  

 

I would generalize these with very simple editing.  Here is Generalized Principle 1:

Principle 1: In order to carry out its responsibilities, the board of directors in a firm should approve strategies and policies with respect to  risk management and ensure that senior management takes the steps necessary to monitor and control these risks. The board of directors should be informed regularly of the  risk exposure of the firm in order to assess the monitoring and controlling of such risk.

This was done by simply deleting 2 instances of the words “interest rate” and exchanging the word “firm” for the word “bank”. 

This mindless editing can be done to almost every one of the 10 principles and the result is not just usable, but is a very clear and basic guideline for any risk management program. 

That is what makes this a classic.


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