Archive for May 2010

Managing Strategic Risks

May 19, 2010

Contributed by Jean-Pierre Berliet

It is not enough for insurance companies to understand and manage the financial risks of their business that can cause insolvency. They need also to manage external “strategic” risks to their business. Strategic risks result from events that can undermine the viability of their business models and strategies or reduce their growth prospects and damage their market value. Strategic risks include changes in competitive dynamics, regulations, taxation, technology and other innovations that disrupt market equilibrium. They also include events and changes in other industries that can impact adversely the going concern viability and financial performance of insurance companies.

Until the present crisis, many insurers did not think much about their dependence on the efficient functioning of credit and other financial markets or the overall safety and soundness of the banking system. Now they do. Although the sub-prime mortgage crisis and resulting credit market meltdown can be viewed simply as market risk events, they should be seen as the combined, unexpected but theoretically predictable result of design weaknesses in institutional and regulatory arrangements and changes in financial technology.

From this vantage point, the near collapse of the financial system resulted from:

  • Pro-cyclical effects of capital regulations under fair value accounting standards,
  • Explosive growth of outstanding derivative contracts, especially credit default swaps
  • The redistribution of housing finance risks (especially sub-prime) across financial institutions on a global basis, facilitated by securitization.

Together, these factors combined to create a time bomb. That it exploded is no market risk event, but rather a failure of risk management.

The explosion could have been anticipated. Had CROs not abdicated their responsibilities to rating agencies and conducted appropriate due diligence, toxic securities would not have found their way to their balance sheets. Similarly, fundamental changes in the characteristics of mortgage products and the creditworthiness of the customer base should have been examined closely. Such examination would have diminished the attractiveness of CDOs as investments, have reduced their spread throughout the financial system and have prevented or reduced the losses of capital that caused confidence to collapse and market liquidity to vanish.

Insurers, however, did not understand that risks to the financial system were elements of their strategic risk. Strategic risk elements embedded in the financial system are difficult to mitigate. They create dependencies among businesses that undermine diversification benefits achieved through underwriting of a multiplicity of risks and exposures. They have a tendency to hit all activities at the same time.

In this area, prudence is the source of wisdom. Companies that have had the discipline not to underwrite exposures that they did not understand, or invest in financial instruments or asset classes that they could not assess to their satisfaction (e.g., tranches of securitization backed by sub-prime mortgages), have withstood the crisis comparatively well. Some of these companies are benefiting from the weakness of their less thoughtful and less disciplined competitors. For example, Warren Buffett’s decision to create a financial guaranty insurer recently and to resume investing in U.S. companies appears perfectly timed to capitalize on opportunities created by the weakness of established competitors and the steep fall in the market value of many companies.

Methodologies for identifying, measuring and managing strategic risks are in their infancy. Since there are no established conceptual frameworks to guide analysis and decision making, building resilient portfolios of insurance businesses and protecting them from strategic risks is a challenge. In their oversight roles, directors and CEOs can help company executives by re-examining the appropriateness of traditions, conventions and modes of thought that influence risk assumption decisions.

They should demand that company management:

  • Conduct periodic defensibility analyses of their companies’ business models and strategy, including consideration of weaknesses in institutional arrangements of the financial system. Such strategy review must also focus on the identification and monitoring of emerging trends with adverse effects on competitive advantage and pricing flexibility (loss of business to competitors, emergence of new risk transfer technologies or product innovations, regulatory developments, etc.) that can reduce company valuations sharply and rapidly.
  • Reassess periodically the company’s strategy for controlling performance volatility and achieving a balance between risk and return through specialization in risk assumption, diversification (e.g., across lines, industries, regions or countries), ceded reinsurance or structural risk sharing and financing vehicles such as captives or side-cars.
  • Assess the possibility for disruption of business plans caused by events that reduce capital availability or flexibility in capital deployment.
  • Develop appropriate responses through adjustment in capabilities, redeployment of capacity across lines of activity, change in limits offered, exclusions, terms and conditions, ancillary services provided, lobbying of lawmakers and regulators and participation in industry associations.
  • Hold executives accountable for discipline in under writing and investment decisions.

Because the insurance industry has been highly regulated, many insurance companies have not developed a deep strategic risk assessment capability. They need one urgently.

©Jean-Pierre Berliet   Berliet Associates, LLC (203) 972-0256

Risk/Reward NOT Linked

May 18, 2010

At least they are not automatically linked.

Here is a description of the “Law of Risk and Reward” from somewhere on the web. . .

The risk versus reward curve is a fundamental principle in business. The simple explanation is that, as risk in a given transaction increases so does the reward.

This is the fallacy that most of us have heard many, many times.  We hear it so often, it actually seems to be true. 

But it definitely is not now, nor was it ever true that increasing risk increases reward.  

Alfred Marshal is the originator of the supply and demand curves that we were all taught in microeconomics. 

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Somehow, as his idea above about “hopes” for gains was repeated over the years, the word “hopes” was left off. 

And in fact, it takes much more than “hopes” to get great gains out of great risks.  In fact, there are two paths to great gains…

  • Great Luck
  • Great Risk Management

The “Law of Risk and Reward” above seems to follow a fairness sort of reasoning.  It would only be fair if increased risk resulted in increased reward.  But the world is not fair. 

It is quite possible to:

  1. Get a large gain after taking a small risk
  2. Get a large loss after taking a small risk
  3. Get a small gain after taking a large risk
  4. Get a small gain after taking a small risk
  5. Get a large gain after taking a large risk
  6. Get a large loss after taking a large risk

There are several reasons for this.  First of all, the size of the risk is always an estimate made in advance with incomplete information.  Clearly the situations like number 2 above are cases where the risk may have been underestimated.  Also, the economists will emphasize that situations like 1 do not usually last for long.  (See the old joke about the economist and the $20 bill.)  A second reason is that the risk management performed by the risk taker can be effective both in terms of risk selection and in terms of loss severity mitigation.  However, the risk management tasks that result in good risk selection and effective loss severity mitigation require skill and execution. 

Risk takers who believe in the “Law of Risk and Reward” will tend to think that the time, effort and expense of doing good risk management is wasted effort since more risk results in more reward by law.

Risk and Strategy

May 17, 2010

Understanding the relationship between RISK and STRATEGY is an extremely important step in incorporating ERM into strategic decision making.

Management and the Board need to decide which of three fundamental relationships that the firm expects to persue over the near term (next several years):

  1. The Firm can GROW the business and the risks taken by the business significantly faster than the growth of capital.
  2. The Firm can MAINTAIN the relationship between the capital of the firm and the risks of the firm at the current level.
  3. The Firm can STRENGTHEN the firm by growing capital faster than the business grows.

If management and the board do not understand these three fundamental choices AND have a clear idea of which choice that the Firm is persuing, it is highly unlikely that conversations about risk and risk management will go anywhere.  In fact, what will happen is that they will spin in whirlpools of changing topics and inconsistencies.

The choice among these three ideas is not permanent.  But it should be a choice that is set down for a multi year period of time.  It should reflect management and the board’s understanding of both the level of resources of the firm as well as the opportuinities in the marketplace.

GROW –  This choice represents the understanding that there are very good opportunities in the marketplace and that the firm has excess capacity to take risks.  That excess capacity might have arisen because of some non-repeatable gains.  The underlying profitability of the business of the firm is not high enough to fund the growth of the firm for some period of time.  The firm either cannot obtain additional outside funding for the growth or else the available funding is too expensive or restrictive.  This strategy cannot be the long term strategy of the firm because the firm will grow ever more risky over time and will eventually experience a loss that will impair the firm.

MAINTAIN – This choice comes from a conclusion that the firm can fund its desired growth level by the profits of the business of the firm.  It might also mean that some of the growth will be funded from outside and that with the funding and the growth and the retained profits, the firm will be able to maintain the level of security that it has had over the recent past.  This strategy is sustainable over a long time period.

STRENGTHEN – This choice is often made after a loss event weakens the firm.  It can be accomplished by increasing profit margins or by limiting growth.  Often, increasing profit margins will limit growth.  This can also be a necessary choice after growth that has far exceeded the level that can be sustained by the earnings of the business.  It can also be a choice that is made during a period when the markets are particularly soft and the choices for profitable growth are poor.  Firms may choose to “keep their powder dry” and to increase their capacity for future growth once market opportunities improve.

The choice among these three strategies is made by every firm, either consciously or unconsciously resulting from their other choices.

A good starting point for bringing Risk into the Strategy discussions is to have a direct discussion of this choice and to find out whether it is possible to get management to clearly understand the choice that is needed at the time for the firm.

Risk Never Sleeps

May 16, 2010

The LORD and Risk Management

May 14, 2010

Great post by Jos Berkemeijer

Check it out.

Managed Risk Taking

May 12, 2010

Is your ALM system a risk management system or is ALM a process at your firm for managed risk taking?

It appears that banks and insurers both use the term ALM to refer to the process that they use with interest rate change risk.  But in general, banks are using ALM as a part of a managed risk taking system, while insurers are most often using ALM as a risk management system.

The difference is in the acceptable targets.  Insurers most often have a target for matching of assets and liabilities to within a 0.50 tolerance in difference in duration for example.  The tolerance is most often justified as a practical consideration, allowing the managers of the ALM system to avoid making too many expensive small moves and to gently steer the portfolio into the matched situation.

Banks will have a much larger mismatch allowance.  A part of the basic business of banks is to borrow funds short term and to lend them long term.  There is a significant duration mismatch embedded into their business model.  The ALM managers are there to make sure that the interest rate risk does not grow beyond those tolerances.  The bank should be setting the limit for mismatch to a level of loss that they can afford.

It is fascinating that for the most part, insurers who are generally buy and hold risk takers are unwilling to take advantage of the generally upward sloping yield curve in anywhere near the level that banks are.  Insurers tend to look at their risks as good risks and bad risks and to avoid any exposure to the bad risks if possible.  Interest rate change risk is seen as a bad risk, probably because (a) there us no underwriting, no selection involved and (b) the risk is totally uncontrollable.

Insurers like risks where they can develop an expertise of underwriting the risk, selecting the better risks over the worse risks.  Interest rate risk, at least within economies has no specific risk component.  If there was underwriting involved, that underwriting would be trying to figure out the forces that drive interest rates up and down.  And that is very difficult to do.

The interest rate change risk is totally uncontrollable because there is no claims management.  There is a major subjective, personal element in the form of the central bankers setting the rates at the short end.  The rates at the long end are driven by both supply and demand as well as by inflation assumptions.  So to get interest rates risht, one would need to read the minds of the central bankers, predict the need for funding and the amount of capital available at various rate levels for various terms as well as the expectations of the market for inflation.  Good luck.

There is another difference between banks and insurers that perhaps explains the difference in strategies.  THe banks are usually able to get their money on a short term basis, paying the low short term interest rates.  Insurers, on the other hand usually get their funds for a longer term.  They may not always need to promise a long term interest rate, but they usually want to keep their customers for the long term, so they want to make plans to pay interest rates at a level consistent with long term.

And if you follow yield curves over time, you will notice that the steepest and most reliable part of the yield curve is at the very short end of the curve.  At the middle of the curve, there is not always an upward slant that is large enough to justify the risk of a significant mismatch, not is it reliable enough to build your business off of it.

So maybe the two segments have it right for their situations.  Banks can have their managed risk taking system while insurers need their risk management system.

Comprehensive Actuarial Risk Evaluation

May 11, 2010

The new CARE report has been posted to the IAA website this week.

It raises a point that must be fairly obvious to everyone that you just cannot manage risks without looking at them from multiple angles.

Or at least it should now be obvious. Here are 8 different angles on risk that are discussed in the report and my quick take on each:

  1. MARKET CONSISTENT VALUE VS. FUNDAMENTAL VALUE   –  Well, maybe the market has it wrong.  Do your own homework in addition to looking at what the market thinks.  If the folks buying exposure to US mortgages had done fundamental evaluation, they might have noticed that there were a significant amount of sub prime mortgages where the Gross mortgage payments were higher than the Gross income of the mortgagee.
  2. ACCOUNTING BASIS VS. ECONOMIC BASIS  –  Some firms did all of their analysis on an economic basis and kept saying that they were fine as their reported financials showed them dying.  They should have known in advance of the risk of accounting that was different from their analysis.
  3. REGULATORY MEASURE OF RISK  –  vs. any of the above.  The same logic applies as with the accounting.  Even if you have done your analysis “right” you need to know how important others, including your regulator will be seeing things.  Better to have a discussion with the regulator long before a problem arises.  You are just not as credible in the middle of what seems to be a crisis to the regulator saying that the regulatory view is off target.
  4. SHORT TERM VS. LONG TERM RISKS  –  While it is really nice that everyone has agreed to focus in on a one year view of risks, for situations that may well extend beyond one year, it can be vitally important to know how the risk might impact the firm over a multi year period.
  5. KNOWN RISK AND EMERGING RISKS  –  the fact that your risk model did not include anything for volcano risk, is no help when the volcano messes up your business plans.
  6. EARNINGS VOLATILITY VS. RUIN  –  Again, an agreement on a 1 in 200 loss focus is convenient, it does not in any way exempt an organization from risks that could have a major impact at some other return period.
  7. VIEWED STAND-ALONE VS. FULL RISK PORTFOLIO  –  Remember, diversification does not reduce absolute risk.
  8. CASH VS. ACCRUAL  –  This is another way of saying to focus on the economic vs the accounting.

Read the report to get the more measured and complete view prepared by the 15 actuaries from US, UK, Australia and China who participated in the working group to prepare the report.

Comprehensive Actuarial Risk Evaluation

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