Regime Change

If something happens more or less the same way for any extended period of time, the normal reaction of humans is consider that phenomena as constant and to largely filter it out.  We do not then even try to capture new information about changes to that phenomena because our senses tell us that that input is “pure noise” with no signal.  Hence the famous story about boiling frogs.  Which may or may not be actually true about frogs, but it definitely reveals something about the way that humans take in information about the world.

But things can and do actually change.  Even things that are more or less the same for a very long time.

In the book, “This Time It’s Different”, the authors state that

“The median inflation rates before World War I were well below those of the more recent period: 0.5% per annum for 1500 – 1799 and 0.71% for 1800 – 1913, in contrast with 5% for 1914 – 2006.”

Imagine that.  Inflation averaged below 0.75% for about 300 years.  Since there is no history of extended periods of negative inflation, to get an average that low, there must be a very low standard deviation as well.  Inflation at a level of 3 or 4% is probably a one in a million situation.  Or so intelligent financial analysts before WWI must have thought that they could make plans without any concern for inflation.

But in the years following WWI, governments found a new way to default on their debts, especially their internal debts.  Reinhart and Rogoff point out that almost all of the discussion by economists regarding sovereign default is about external debt.  But they show that internal debt is very important to the situations of sovereign defaults.  Countries with high levels of internal debt and low external debt will usually not default, but countries with high levels of both internal and external debt will often default.

So as we contemplate the future of the aging western economies, we need to be careful that we do not exclude the regime changes that could occur.  And which regime changes that we should be concerned about becomes clearer when we look at all of the entitlements to retirees as debt (is there any effective difference between debt and these obligations?).  When we do that we see that there are quite a few western nations with very, very large internal debt.  And many of those countries have indexed much of that debt, taking the inflation option off of the table.

Reinhart and Rogoff also point out the sovereign default is usually not about ability to pay, it is about willingness to make the sacrifices that repayment of debt would entail.

So Risk Managers need to think about possible drastic regime changes, in addition to the seemingly highly unlikely scenario that the future will be more or less like the past.

Advertisement

A Friedman Model

Friedman freed the economists with his argument that economic theories did not need to be tied to realistic assumptions:

a theory cannot be tested by comparing its “assumptions” directly with “reality.” Indeed, there is no meaningful way in which this can be done. Complete “realism” is clearly unattainable, and the question whether a theory is realistic “enough” can be settled only by seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories. Yet the belief that a theory can be tested by the realism of its assumptions independently of the accuracy of its predictions is widespread and the source of much of the perennial criticism of economic theory as unrealistic. Such criticism is largely irrelevant, and, in consequence, most attempts to reform economic theory that it has stimulated have been unsuccessful.

Milton Friedman, 1953, Some Implications for Economic Issues

Maybe Friedman fully understood the implications of what he suggested.  But it seems likely that many of the folks who used this argument to justify their models and theories definitely took them to extremes.

You see, the issue relates to the question of how you test that the theory predictions are realistic.  Because it is quite easy to imagine that a theory could make good predictions during a period of time when the missing or unrealistic assumptions are not important because they are constant or are overwhelmed by the importance of other factors.

The alternate idea that a model has both realistic inputs and outputs is more encouraging.  The realistic inputs will be a more stringent test of the model’s ability to make predictions that take into account the lumpiness of reality.  A model with unrealistic assumptions or inputs does not give that.

Friedman argued that since it was impossible for a theory (or model) to be totally realistic, that realism could not be a criteria for accepting a theory.

That is certainly an argument that cannot be logically refuted.

But he fails to mention an important consideration.  All theories and models need to be re-validated.  His criteria of “seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories” can be true for some period of time and then not true under different conditions.

So users of theories and models MUST be constantly vigilant.

And they should be aware that since their test of model validity is purely empirical, that as things change that are not included in the partial reality of the theory or model, that the model or theory may no longer be valid.

So a Friedman Model is one that lacks some fundamental realism in its inputs but gives answers that give “good enough” predictions.  Users of Friedman models should beware.

Responsibility for Risk Management

Who should have responsibility for risk management?

Is it the CRO? Is it the Business Unit Heads? Is it everyone? or is it the CEO (As Buffet suggests)?

My answer to those questions is YES. Definitely.

You see, there is plenty of risk to go around.

The CEO should be responsible for the Firm Killing Risks. He/She should be the sole person who is able to commit the firm to an action that creates or adds to a firm killing risk position. He/She should have control systems in place so that they know that no one else is taking and Firm Killing Risks. He/She should be in a constant dialog with the board about these risks and the necessity for the risks as well as the plans for managing those sorts of risks.

At the other end of the spectrum, there are the Bad Day Risks. Everyone should be responsible for their share of the Bad Day Risks.

And somewhere in the middle are the risks that the CRO and Business Unit Heads should be managing. Those might be the Bad Quarter Risks or the Bad Year Risks.

As the good book says, “To each according to his ability”. That is how Risk Management responsibility should be distributed.

Ponzi and Rolling Stone Risk Management

Managers of some firms just know that they do not need that risk management stuff.

They can tell because they have positive cash flow.

A firm with positive cannot possibly go out of business.  They know that.

Many young firms that are growing quickly utilize this sort of thinking to put off any development of risk management.  Because they just know that risk management would create real risk.  Risk management could put a stop to the positive cash flow.

Early in its history, insurance carriers thought that this positive risk management idea was just great.  It was so easy to keep the cashflow positive for an insurer.  Steady growth helped.  And the natural process of collecting premiums now and paying out claims later helped even more.

But then some spoilsport came along and ruined things and discovered the idea of reserves.

So the game had to shift to positive net income risk management.  As long as your net income was positive, there was no problem.  That sort of risk management created tensions between the positive net income folks and the actuary setting the reserves.  But many firms found a way around that and could set lower reserves and keep up the Ponzi Risk Management for a few more periods.

But periods of slower growth, due to economic slow downs or other issues were especially troublesome for the Ponzi Risk Management firms.  Or like its namesake, the real Ponzi scheme, Ponzi Risk Management runs into trouble as soon as the flow of new customers slows for any reason.

A variation on Ponzi RIsk Management is the Rolling Stone Risk Management.  Under Rolling Stone Risk Management, the firm keeps acquiring new smaller firms.  The chaos that exists through the transition is good to hide the waning growth and fundamental unprofitability of the Rolling Stone company.  If they can keep rolling, they gather no Loss.

But Rolling Stone risk management requires larger and larger acquisitions to be big enough to hid all of the prior sins because the backlog of problems keeps getting larger and larger.  And the compulsion to acquire means that the Rolling Stone company pays more and more for the acquisitions because those purchases are really a life and death matter for them.  They desperately need more Good Will to amortize.

But to be slightly clearer, Ponzi Risk Management is not real risk management.

The difference between Ponzi Risk Management and real Risk Management is that real Risk Management provides protection to firms that are growing and to firms that are not growing.  Real risk management means that the risk manager has taken into account the risks of the firm in both a going concern basis to help to maximize value of the firm as well as the potential risks of a stoppage of growth.  Real risk management means that the firm has made provision, not just for the profitability of most parts of the business on a stand alone, more or less static basis, they have also made sufficient provision for the risks of that business both in terms of margin to compensate the firm for the risks and to provide a cushion against the fluctuations of profitability and even the extreme loss potential of that business.

Risk Attitudes and the New ERM Program

There are four different Risk Attitudes that are found among business managers:

Conservators who are concerned that the environment is extremely risky and they must be very careful.

Maximizers who believe that the environment is fairly benign and that they need to take risk to be rewarded.

Managers who believe that the environment is risky but can be managed with the help of experts.

Pragmatists who do not know whether things are risky or not because they do not believe that anyone can know the future.

Now you are tasked with creating a new ERM program for your firm and how can you use knowledge of these Risk Attitudes to help you?

The first thing to do is to recognize which of those four attitudes predominates in the decision-making of your firm.

This question is a little tricky, because that is not the same thing as the Risk Attitude of the head of the firm in all cases.  Good leaders may choose a path for their firm that is based upon the capacities and circumstances of the firm, even if they might prefer a different strategy if they were blessed with unlimited resources and no constraints.

But in the end, you can look at the decisions of the firm over a period of time and discern which Risk Attitude is driving firm decisions and orient the new ERM program to the predominant Risk Attitude.

If the predominant risk attitude is Conservator, then the first place to take your ERM program is to worst case losses.  The risk management system can be based upon a series of stress tests, where the stresses are worst cases.  The exposure to these worst cases can be added up and reported regularly.  A limit system can be established based upon these worst case exposures to make sure that the exposure does not accidentally get any higher.  Hedging and reinsurance programs should be considered to reduce the extent of these losses. Risk management decisions will always be made with loss potential in mind.

If the predominant risk attitude is Maximizer, then the risk management system should be focused on sales.  The risk reports will be risk weighted sales reports.  In addition, they should clearly show the amount of profit margin in the sales so that the risk weighted sales can easily be compared to the profit margin.  Maximizers will want to make sure that the company is getting paid for the risk that it takes.  Note that there are two kinds of Maximizers.  Those who believe that you can lose a dollar per thousand and make it up on volume and those who believe that a sale without a profit is not a sale.  Stay away from the first type.  A company run by them will not last long. Risk management decisions will always be made with revenue in mind.

If the predominant risk attitude is Manager, then the risk management system will sooner or later be based upon an Economic Capital Model.  As the model is built, you can start to build the systems and reports that will work off of the model for capital budgeting, product pricing, risk reward monitoring and risk adjusted incentive compensation.  The Managers will very much want to form a risk tolerance for the firm and to base the risk limits off of the tolerance and to create a process for monitoring those limits.  Risk adjusted return is the banner for Managers.

If the predominant risk attitude is Pragmatist, then the risk management system will need to focus first on the spread of risk.  Reports will show the degree to which the firm holds very different risks.  Otherwise, risk reports will need to be flexible.  The Pragmatists will be irregularly be changing their minds about what they think might be most important to pay attention to about risk.  And whatever is the important topic of the moment, the risk reports need to be there to probe very deeply into that topic.  Pragmatists will want a deep dive on the hot risk topic of the day and will have a very hands on approach to decision making about that issue.

Sounds confusing.  But get it wrong and you will find that the key decision makers will quickly lose interest.  Imagine putting the information desired by the Conservators in front of a Maximizer.  Or putting the details desired by a Pragmatist in front of a Manager who wants things summarized into neat packets of information.  Get it wrong and you are done for.

Mitigating Crises

ERM Central to Restoring Capital Adequacy

By Jean-Pierre Berliet

It is easy to blame CROs (Chief Risk Officers) and ERM (Enterprise Risk Management) for the impact of the crisis on companies, but such blame is often unfair and disingenuous. In few companies did CROs have the power to prevent the execution of strategies that, although fraught with risk, were pursued to deliver on investor profit expectations and management incentive targets.

The primary objective of crisis mitigation must be to realign risk exposures with risk bearing capital and to improve capital adequacy.  Realigning exposures with capital (and implied “risk capacity”) enhances insurance strength ratings and the confidence of investors and customers. Without such confidence, a company’s business and franchise would erode rapidly.

In response to the present crisis, many companies improved capital adequacy by (a) cutting expenses, (b) decreasing dividend payments, (c) discontinuing share repurchase programs, and (d) selling assets and non-strategic operating subsidiaries, all to preserve or increase capital. There are few buyers during a crisis, however, and so divestitures and asset sales are at lower prices than in normal times (e.g. sale of HSB Group by AIG) and are therefore very expensive sources of capital.

Realignment strategies also involve retrenchment from businesses with substandard returns on capital. Typical outcomes are: (a) sales of blocks of business and renewal rights, (b) cessation of certain coverage types, (c) sales of entire subsidiaries, (d) changes in underwriting limits, terms, and exclusions, (e) reinsurance strategies, etc. ERM risk analysis models provide a basis for assessing the relationship between capital needs and value contributions of various businesses. Without that assessment, it is hard to align risk exposures with available capital.

Estimates of capital requirements based on risk measures over a one-year horizon (typical of solvency regulations) are not credible during a crisis because they assume that fresh “recovery” capital can be raised. Rating agencies, regulators, and investors, however, know that many solvent companies cannot raise fresh capital during a crisis. Capital is only adequate if it can sustain the company’s operations on a “going concern” basis in the absence of access to recovery capital, but with credit for capital generated internally.

Companies need robust insights from ERM to assess their capital needs (on or off balance sheet, including contingent capital) and to develop effective mitigation strategies. Their ERM must:

• Measure capital consumption by activity and risk type
• Identify the relative value creation of individual businesses, with appropriate recognition for differences in risk
• Demonstrate the impact and future value creation of alternative retrenchment strategies

Through such ERM informed views of capital utilization, capital adequacy, and value creation, insurance companies can chart effective strategies to restore their capital adequacy and mitigate the impact of crises.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

Enterprise Risk Management Through the Business Cycle

A PRMIA Webinar Presented by David Ingram and Alice Underwood of Willis Re

August 10, 2010

11:00 am – 12:00 pm US Eastern Time

ERM was not a focus at the top of the business cycle, when record profits were being recorded. Many CROs now report that they gave clear warnings of impending problems — which were completely ignored! Now everyone talks as if ERM is very important and will be forever after.

Over the past several years some firms went through the motions of creating an ERM function to appease regulators. Others had a much more conservative risk culture and avoided both the profits and the madness of the boom. At some firms, “doubling down” after a loss was the preferred risk strategy; a great trader — a hero — was someone who had the fortitude to keep doubling down until the trade made a profit. A few firms were doing full-fledged ERM with intensive modeling, and yet were surprised when they confronted circumstances their models characterized as 1 in 10,000 year losses.

This presentation will suggest a new/old theory that explains all of those stories with ideas borrowed from Cultural Anthropology – The Theory of Plural Rationalities. This approach helps to explain firms’ risk strategies during different phases of the business cycle and perhaps indicates some drivers of the cycle itself. Finally, using these ideas, we will suggest a new approach to ERM through the business cycle that some ERM purists may hate, but the pragmatists in the audience might just love.

---

FEE: $25 –  Special Rate for CAS members (Casualty and Actuarial Society)

REGISTRATION: To register online, click on Register Online in the left-hand margin of this page. To be invoiced, Download Enrollment Form, and e-mail completed form to jill.fisher@prmia.org or contact Jill Fisher by phone at +1-612-216-5497.

About one week prior to the webinar, you will be sent information on how to access the webinar.

The Presenters

ABOUT THE WEBINAR

The webinar will conclude after 60 to 75 minutes.  The length of the webinar will  depend upon the number of discussion questions submitted by attendees during the webinar.

All attendees are muted and can submit questions to the presenter by typing them into the webinar software question pane.  You can access the webinar audio via your computer speakers or by toll-based telephone.

Unable to attend the live webinar? Register for the live webinar and the recording link and presentation will automatically be sent to you soon after the conclusion of the live webinar.

RECORDING: The webinar series will be recorded and available for review to all participants within one hour of each session. You will need Windows Media Player 9 or higher to view the presentation. If you are unable to attend the Live Webinar, you may register to receive the webinar recording only. The recording of this webinar will not be available until after the start of the live webinar. Contact Jill Fisher at training@prmia.org for more information on recordings.

This Webinar is a part of the Plural Rationalities and ERM project.

Diversification as ERM

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Diversification.

The fourth type of ERM program focuses on Diversification.

Modern practitioners may not agree that a program of Diversification IS in any sense a risk management program.  But in fact it has been one of the most successful risk management programs.

Think about it.  Dollar Cost Averaging is fundamentally a Diversification based risk management program.  The practitioner is admitting that at any point in time, they do not know which risk is better or worse than another.  So they rebalance to eliminate the concentration that has crept into their portfolio.

A diversification risk strategy would also mean taking very different risks.  Firms that focus on a true Diversification strategy will be regularly moving into entirely new businesses.  They are not seeking the mathematical diversification of the Managers with their Risk Steering that tries to take advantage of similar risks that are not totally correlated.  Firms that follow the Diversification strategy want risks that are totally unrelated.  Soap and machine parts.  Their business choices may seem totally insane to the tidy Managers.

Diversification can be shown to provide two benefits for the firm that practices it.  First, they will seek to avoid having too much at risk in any one situation or company.  So avoiding concentration is their prime directive.  Second, there is an upside benefit as well.  Since they are involved in many different markets, they feel that they are likely to be in at least one and possibly two hot products or markets at any one time.  Unsuccessful practitioners of this strategy will find that they have found a way to buy into different risks that are all duds at the same time.

The practitioners of this strategy will also tend to adopt the same sort of approach to the day to day work of their risk management program.  That would be the “high attention, low delegation” approach.  The conglomerates that operate in this manner will have frequent meetings between the managers and the people at the top of the conglomerate, possibly even with the top person.  Warren Buffett (Berkshire Hathaway) and Jack Welsh (GE) are two examples of this high touch style as is Hank Greenberg (AIG).

Seems pretty simple.  Mix it up and pay attention.

A few firms have managed to combine the high tech economic capital modeling approach with a Diversification ERM system.  In those firms, they have strict concentration limits requiring that at most a small percentage of their economic capital ever be from any one risk.  One such firm will never take on any large amount of any one risk unless they are able to grow all of their other risks.

This post is a part of the Plural Rationalities and ERM project.

Crippling Epistemology

Google the term crippled epistemology and you get lots of articles and blog posts about extremists and fanatics and also some blog posts BY the extremists and fanatics.

Crippled epistemology means that someone cannot see the truth.

Daniel Patrick  Moynahan is reported as saying “Everyone is entitled to his own opinion, but not his own facts.”

But there are just too many facts.  Any one person cannot attend to ALL of the facts.  They must filter the facts, choose the facts that are more important.  We all filter the facts that we pay attention to.

But sometimes, those filters become too strong.  Things went along in a certain pattern for a length of time, so we filtered out of our consideration many of those things that either failed to evidence any variability or that had totally predictable variability.

Those filters take on the aspect of a crippling epistemology.  Our approach to knowledge keeps us from understanding what is actually happening.

Sounds pretty esoteric.  But in fact it is one of the most important issues in risk management.

We need to have systems that work on a real time basis to provide the information that drives our risk decisions.  But we must be careful that that expensive and impressive risk information system does not actually obscure the information that we really need.

For the investors in sub prime mortgages prior to 2007, they had developed an epistemology, an approach to their knowledge of the markets.  Ultimately that epistemology crippled them, because it did not allow them to see the real underlying weakness to that market.

So a very important step to be performed periodically for risk managers is an Epistemology Review.  Making sure that the risk systems actually are capturing the needed information about the risks of the firm.

Financial Reform & Risk Management – Financial Services Oversight Council

According to an AP summary of the negotiated consolidated Financial Reform act of 2010, there are 9 major provisions.  These posts will feature commentary on the Risk Management implications of each.

1. OVERSIGHT A 10-member Financial Services Oversight Council made up of the treasury secretary, Federal Reserve chairman, a presidential appointee with insurance expertise, heads of regulatory agencies and a new consumer protection bureau would monitor financial markets and watch for threats.

Does that make you feel safe?  An Oversight Council?  Not me.

Each of the 10 members will be busy protecting their turf.  Any action or proposed action that will damage “their” part of the financial services business more than the rest of the sector will be fought tooth and nail.

Or else, the group will be out to prove that they are really watching.  They will protect us from 10 of the next two financial crises.

More protection might seem like a good idea right now, but no one has any idea how disruptive it will be to the economy to have an committee of 10 fighting to be the one who drives the car of the economy.

And in addition, to date there has been no indication that any of these folks will protect us from the NEXT crisis.  Instead they will be watching out for a repeat of the last crisis.

The next crisis will come from whatever part of the world economy that they are not paying attention to.  Almost by definition.

So my advice is to watch out for yourself.  Do not rely on these folks.  Do your own homework.  Mind your own risks.

How to do that?  Start HERE.

Death by Solvency

Another great post by  Maggid.

It seems that Solvency II is perfectly designed to reproduce the conditions that led US banks to believe that they were impervious to risks.  They and the regulators believed that they knew what they were doing with regard to Risks and Risk Management.

In 2004, the US Federal Reserve allowed investment banks to cut their capital levels by 2/3, tripling their potential leverage!  Not to worry, they knew how to manage risk.

European insurers are all being told that they need to have economic capital models to manage risks.  A few firms have had these models for more than five years now.  Those models tell us that those firms can reduce their capital by a third or more.

But everyone leaves out of their thinking two important things that will always happen.

The first is called the Peltzman effect by economists.  John Adams calls it the Risk Thermostat effect.  In both cases, it means that when people feel risk decreasing due to safety measures, they often respond by increasing the riskiness of their behaviors.  So the success of Solvency II will make some firms feel safer and some of them will take additional risks because of that.

The second effect is what I call the Law of Risk and Light.  That says that you will accumulate risks wherever you are not looking out for them.  So anywhere that there is a flaw in the Economic Capital model, the activity that accentuates that flaw will look like the best, most desirable business to be in.

But read Maggid’s post.  He provides some actual analysis to support his argument.

Risk Steering as ERM

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Risk Steering.

If you ask most actuaries who are involved in ERM, they would tell you that Risk Steering IS Enterprise Risk Management.

Standard & Poor’s calls this Strategic Risk Management:

SRM is the Standard & Poor’s term for the part of ERM that focuses on both the risks and returns of the entire firm. Although other aspects of ERM mainly focus on limiting downside, SRM is the process that will produce the upside, which is where the real value added of ERM lies. The insurer who is practicing SRM will use their risk insights and take a portfolio management approach to strategic decision making based on analysis that applies the same measure for each of their risks and merges that with their chosen measure of income or value. The insurer will look at the possible combinations of risks that it can take and the earnings that it can achieve from the different combinations of risks taken, reinsured, offset, and retained. They will undertake to optimize their risk-reward result from a very quantitative approach.

For life insurers, that will mean making strategic trade-offs between products with credit, interest rate, equity and insurance risks based on a long-term view of risk-adjusted returns of their products, choosing which to write, how much to retain and which to offset. They will set limits that will form the boundaries for their day-to-day decision-making. These limits will allow them to adjust the exact amount of these risks based on short-term fluctuations in the insurance and financial markets.

For non-life insurers, SRM involves making strategic trade-offs between insurance, credit (on reinsurance ceded) and all aspects of investment risk based on a long-term view of risk-adjusted return for all of their choices. Non-life SRM practitioners recognize the significance of investment risk to their total risk profile, the degree or lack of correlation between investment and insurance risks, and the fact that they have choices between using their capacity to increase insurance retention or to take investment risks.

Risk Steering is very similar to Risk Trading, but at the Total Firm level.  At that macro level, management will leverage the risk and reward information that comes from the ERM systems to optimize the risk reward mix of the entire portfolio of insurance and investment risks that they hold.  Proposals to grow or shrink parts of the business and choices to offset or transfer different major portions of the total risk positions can be viewed in terms of risk adjusted return.   This can be done as part of a capital budgeting / strategic resource allocation exercize and can be incorporated into regular decision making.  Some firms bring this approach into consideration only for major ad hoc decisions on acquisitions or divestitures and some use it all of the time.

There are several common activities that may support the macro level risk exploitation:

1. Economic Capital. Realistic risk capital for the actual risks of the company is calculated for all risks and adjustments are made for the imperfect correlation of the risks. Identification of the highest concentration of risk as well as the risks with lower correlation to those higher concentration risks is the risk information that can be exploited.  Insurers will find that they have a competitive advantage in adding risks to those areas with lower correlation to their largest risks.  Insurers should be careful to charge something above their “average” risk margin for risks that are highly correlated to their largest risks.  In fact, at the macro level as with the micro level, much of the exploitation results from moving away from averages to specific values for sub classes.
2. Capital Budgeting. The capital needed to fulfill proposed business plans is projected based on the economic capital associated with the plans. Acceptance of strategic plans includes consideration of these capital needs and the returns associated with the capital that will be used. Risk exploitation as described above is one of the ways to optimize the use of capital over the planning period.
3. Risk Adjusted Performance Measurement (RAPM). Financial results of business plans are measured on a risk-adjusted basis. This includes recognition of the economic capital that is necessary to support each business as well as the risk premiums and loss reserves for multi-period risks such as credit losses or casualty coverages.
4. Risk Adjusted Compensation.  An incentive system that is tied to the risk exploitation principles is usually needed to focus attention away from other non-risk adjusted performance targets such as sales or profits.  In some cases, the strategic choice with the best risk adjusted value might have lower expected profits with lower volatility.  That will be opposed strongly by managers with purely profit related incentives.  Those with purely sales based incentives might find that it is much easier to sell the products with the worst risk adjusted returns.  A risk adjusted compensation situation creates the incentives to sell the products with the best risk adjusted returns.

A fully operational risk steering program will position a firm in a broad sense similarly to an auto insurance provider with respect to competitors.  There, the history of the business for the past 10 years has been an arms race to create finer and finer pricing/underwriting classes.  As an example, think of the underwriting/pricing class of drivers with brown eyes.  In a commodity situation where everyone uses brown eyes to define the same pricing/underwriting class, the claims cost will be seen by all to be the same at $200.  However, if the Izquierdo Insurance Company notices that the claims costs for left-handed, brown-eyed drivers are 25% lower than for left handed drivers, and then they can divide the pricing/underwriting into two groups.   They can charge a lower rate for that class and a higher rate for the right handed drivers.  Their competitors will generally lose all of their left handed customers to Izquierdo, and keep the right handed customers.  Izquierdo will had a group of insureds with adequate rates, while their competitors might end up with inadequate rates because they expected some of the left-handed people in their group and got few.  Their average claims costs go up and their rates may be inadequate.  So Izquierdo has exploited their knowledge of risk to bifurcate the class, get good business and put their competitors in a tough spot.

Risk Steering can be seen as a process for finding and choosing the businesses with the better risk adjusted returns to emphasize in firm strategic plans.  Their competitors will find that their path of least resistance will be the businesses with lower returns or higher risks.

JP Morgan in the current environment is showing the extreme advantage of macro risk exploitation.  In the subprime driven severe market situation, JP Morgan has experienced lower losses than other institutions and in fact has emerged so strong on a relative basis that they have been able to purchase several other major financial institutions when their value was severely distressed.  And by the way, JP Morgan was the firm that first popularized VaR in the early 1990’s, leading the way to the development of modern ERM.  However, very few banks have taken this approach.  Most banks have chosen to keep their risk information and risk management local within their risk silos.

This is very much an emerging field for non-financial firms and may prove to be of lower value to them because of the very real possibility that risk and capital is not the almost sole constraint on their operations that it is within financial firms as discussed above.

This post is a part of the Plural Rationalities and ERM project.

REDUCING MORAL HAZARD

By Jean-Pierre Berliet

The MBO (Management By Objectives) process translates business objectives into performance targets and drives incentive compensation awards. Certain weaknesses of MBO processes make companies more vulnerable to crises. .

The MBO process is central to crisis prevention.  Weaknesses in the MBO process of an insurance company must be corrected to ensure that management action do not unwittingly exacerbate risk and magnify the impact of crises.

Senior management often takes pride in its tough and disciplined approach to managing performance. This involves setting stretch objectives, rewarding managers who deliver, and punishing those who fall short. It is argued that a “greed and fear” approach is necessary to motivate managers and align their interests with those of shareholders. It is not widely recognized, however, that this approach can increase moral hazard and induce managers to make decisions that reduce the resilience of their company to crises.

In such performance management cultures, managers are incented to exceed management expectations by using all means available.  This may include:

• Reducing or postponing spending on product or service quality, product leadership, process productivity, or customer service responsiveness
• Under-pricing risks to increase business volume and earnings
• Taking on higher investment risks to increase current investment yields
• Under investing in market growth, thereby increasing short-term earnings but losing market share.

Actions like these can enhance short-term earnings, but they can also undermine a company’s competitive capabilities and value creation potential. This, in turn, can reduce the company’s ability to raise capital and thus its resilience. The introduction of risk adjusted performance metrics into a company’s control framework can help reduce the incidence of actions taken inappropriately to “game” the incentive compensation system. However, it is hard to detect moral hazard because the effects of actions taken can remain latent for years to come.

Moral hazard of this type tends to affect decisions where senior management focuses on reported financial results rather than on underlying operating success factors. Excessive, and sometimes exclusive, emphasis on financial results gives operating managers overly broad discretion to “make the numbers”. In many instances (e.g. AIG, Bear Stearns, Citigroup, Lehman Brothers) such an approach to oversight invited moral hazard with serious consequences. When combined with financial leverage and risk leverage, decisions tainted by moral hazard can result in enormous shareholder losses.

Insurance companies need to revamp their MBO frameworks to reduce the risk of moral hazard.  They need to establish corporate cultures in which discussions about objectives, strategies, and results, while never informed by perfect knowledge and foresight, are guided by “high road” values of trust and loyalty. Revamped MBO frameworks should explicitly include consideration of risk insights produced by ERM and verification of the alignment of actions taken with approved plans and strategies.

To accomplish such a transformation of their cultures, insurers may need to link their ERM and MBO processes through the implementation of:

• Risk-adjusted financial performance metrics
• Risk-adjusted performance benchmarks, related to expectations of capital market investors
• Incentive compensation awards linked to long-term measures of business value, including indicators of operational performance, and current profits.

Since no company operates with perfect foresight, Boards of Directors need to grant adequate discretion and flexibility to senior management for performance management.  Adjusting objectives and targets can be of critical importance when business conditions change unexpectedly. In an uncertain world, rigid enforcement reinforces greed and fear elements of corporate cultures, undermines trust, breeds cynicism and “gaming the system”, and increases moral hazard by inducing behavior that can, in time, fatally weaken an insurance company.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

It’s Usually the Second Truck

In many cases, companies survive the first bout of adversity.

It is the second bout that kills.

And more often than not, we are totally unprepared for that second hit.

Totally unprepared because of how we misunderstand statistics.

First of all, we believe that large loss events are unlikely and two large loss events are extremely unlikely.  So we decide not to prepare for the extremely unlikely event that we get hit by two large losses at the same time.  And in this case, “at the same time” may mean in subsequent years.  Some who look at correlation, only use an arbitrary calendar year split out of experience data.  So that they would consider losses in the third and fourth quarter to be happening at the same time but fourth quarter and first quarter of the next year would be considered different periods and therefore might show low correlations!

Second, we fail to deal with our reduced capacity immediately after a major loss event.  We still think of our capacity as it was before the first hit.  A part of our risk management plans for a major loss event should have been to immediately initiate a process to rationalize our risk exposures with our newly reduced capacity.  This may in part be due to the third issue.

Third, we misunderstand that the fact of the first event does not reduce the likelihood of the other risk events.  Those joint probabilities that made the dual event, no longer apply.  In fact, with the reduced capacity, the type of even that would incapacitate the firm has suddenly become much more likely.

Most companies that experience one large loss event do not experience a second shortly thereafter, but many companies that fail do.

So if your interest is to reduce the likelihood of failure, you should consider the two loss event situation as a scenario that you prepare for.

But those preparations will present a troubling alternative.  If, after the first major loss event, the actions needed include a sharp reduction in retained risk position, that will severely reduce the likelihood of growing back capacity.

Management is faced with a dilemma – that is two choices, neither of which are desirable.   But as with most issues in risk management, better to face those issues in advance and to make a reasoned plan, rather than looking away and hoping for the best.

But on further reflection, this issue can be seen to be one of over concentration in a single risk.  Some firms have reacted to this whole idea by setting their risk tolerance such that any one loss event will be limited to their excess capital.  Their primary strategy for this type of concentration risk is in effect a diversification strategy.

Murphy was a Risk Manager!

Perhaps you have heard the saying…

If anything can go wrong, it will.

Widely known as Murphy’s Law.  Well, you may not know it but Murphy was actually a risk manager.

The originator of Murphy’s Law was an engineer named Captain Ed Murphy.  He was responsible for safety testing for the Air Force and later for several private engineering firms.

He was a reliability engineer.  And in his mind, the statement that became known as Murphy’s Law was just his way of describing how you had to think to design stress tests.

He had just experienced the failure of a device that he had designed because of incorrect wiring.  At the time, he may have blamed the problem on the people who installed his device, but later, he came to realize that he should have anticipated the possibility of confusion over which lead to connect to what and made provision for the wiring error in his design.

His original design required that the installer would have perfect knowledge of his intentions with the design.  Instead he should have assumed that the installer would have been completely ignorant of what was in his head.

Does that sound like a word of caution for the designers of risk models?

Will future operators of your risk model need to fully understand what you had intended?  Or do you anticipate that they will doubtless not.

I had that experience.  Fifteen years after I had completed a risk model for a company and in the process taken some shortcuts that made perfect sense to me, I was told that the firm was still using my model, but they suddenly noticed that it was giving very troubling signals, signals that turned out to be almost completely incorrect.

Those shortcuts had moved further and further away from the truth.  I had some realization that the model needed regular recalibration, but I had failed to make that completely clear to the people who inherited the model from me and they certainly had not thought it important to pass along my verbal instructions to the people who inherited it from them.

So remember Murphy’s Law and this little story about how Murphy came to originally say what became known as his law.  It could happen to you.

RECOVERING FROM CRISIS

By Jean-Pierre Berliet

The VBM process helps companies compare the value contribution of alternative strategies and select a course that would increase company value,

Weaknesses in its VBM process can prevent an insurance company from restoring its risk capacity through earnings retention or the raising of additional capital. Such weaknesses thereby limit its ability to resume growing and recover from a crisis

Access to capital is a critical strategic advantage during a financial crisis.

Companies with a strong reputation for value creation can raise new “recovery” capital without excessive shareholder dilution (e.g. Goldman Sachs). Others find it more difficult, or impossible, to access the public market. This makes them vulnerable to inroads by competitors or unsolicited tender offers. The primary purpose of VBM frameworks and processes is to ensure that companies consistently meet investor value creation expectations and survive crises.

VBM frameworks help managers compare alternatives, so that they can direct capital towards uses that would support the achievement of a sustainable competitive advantage, and also create value. This is challenging in the insurance industry because competitors can duplicate innovations in product features, service delivery, or operational effectiveness in relatively short times and can redirect capital at the stroke of a pen. Such competitive dynamics call for companies to compete by developing organizational capabilities that (a) are tougher to duplicate by competitors and (b) provide a pricing or cost advantage based on service quality, underwriting insights, investment performance, and risk and capital management

Because risk drives capital utilization in insurance businesses, the integration of ERM and VBM frameworks is required in order to develop strategies and plans that meet value expectations. Integration rests on (a) superior insights into risk exposures and capital consumption and (b) consistent risk metrics at the level of granularity needed to achieve a loss ratio advantage (possibly on the same level of granularity as loss ratios are calculated). In practice, these insights and metrics lead to decisions to reject businesses and strategies that will not create value. They provide a foundation for:

• Measuring capital utilization by line, by market, and in aggregate
• Driving a superior, more disciplined underwriting process
• Optimizing product features
• Maintaining pricing discipline through the underwriting cycle
• Pricing options and guarantees embedded in products fairly
• Controlling risk accumulation, by client and distribution channel
• Managing the composition of the book of business
• Driving marketing and distribution activities
• Optimizing risk and capital management strategies

Achieving superior shareholder returns is critical for a company to earn investor trust and maintain access to affordable capital. Having access to capital during a financial crisis may well be the ultimate indicator of success for a company’s VBM framework.

Anecdotal evidence suggests that insurance companies that consistently trade at significant premiums over book value have such insights about risk and maintain a highly disciplined approach to writing business.

The present crisis has increased the cost of capital dramatically, but not equally for all insurers. Capital remains most affordable to those with a strong record of value creation and adequate capital as a result of good risk management. Conversely, it has become prohibitive for those with a lesser record of value creation and who lost credibility as stewards of shareholders’ interests. The latter are at risk of forced mergers or liquidation, which may be punishment for not integrating ERM and VBM processes more effectively.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

Risk Managers MUST be Humble

Once you think of it, it seems obvious.  Risk Managers need humility.

If you are dealing with any killer physical risk, there are two types of people who work close to that risk, the humble and the dead.

Being humble means that you never lose sight of the fact that RISK may at any time rise up in some new and unforeseen way and kill you or your firm.

Risk managers should read the ancient Greek story of Icarus.

Risk managers without humility will suffer the same fate.

Humility means remembering that you must do every step in the risk management process, every time.  The World Cup goalkeeper Robert Green who lets an easy shot bounce off of his hands and into the goal has presumed that they do not need to consciously attend to the mundane task of catching the ball.  They can let their reflexes do that and their mind can move on to the task of finding the perfect place to put the ball next.

But they have forgotten their primary loss prevention task and are focusing on their secondary offense advancement task.

The risk managers with humility will be ever watchful.  They will be looking for the next big unexpected risk.  They will not be out there saying how well that they are managing the risks, they will be more concerned about the risks that they are unprepared for.

Risk managers who are able to say that they have done all that can be done, who have taken all reasonable precautions, who can help their firm to find the exact right level and mix of risks to optimize the risk reward of the firm are at serious risk of having the wax holding their feathers melt away and of falling to earth.

Firms Can Treat Systemic Risk Same as Emerging

As one looks back at the recent history of the financial crisis, it can now be clearly seen that a large number of financial firms and a few regulators did identify the looming problems and took reasonable steps to avoid excessive losses. Almost all of the attention has been on the firms and regulators who missed the crisis until it was much too late.

Now, everyone is talking about how to avoid the next crisis and the focus seems to be on the regulators and the largest firms – in short, those who got it wrong just a few years ago.

“The unknown losses can potentially bring the system to a halt at a much lower amount of loss than known losses.”

But we should also be focusing on what everyone else could be doing to prevent their firms from experiencing excessive losses in future crises.

Planning to have no future crises is not a realistic way to proceed [see my earlier article: IERM, Risk governance, 16 September 2009, “Understanding the four seasons of risk management“). The broad idea of Basel II and Solvency II is sound. Firms would be forced to identify their risk exposures and compare that to their capacity to bear risk. That information would be available to five groups under the three pillars: management, boards, regulators, investors and counterparties. It is assumed that one or more of the five groups would notice upticks in risk and prevent the firms from taking on more risk than their capacity to bear that risk.

There have been many problems with the execution of those principles and Solvency II is just starting the discussion of exactly what information will be made available for investors and counterparties. But the broad idea of disclosure to all those groups is sound. The disclosure of potential systemic risks is absolutely necessary for firms to use as a basis for developing their own programmes for avoiding excessive losses in these situations.

Systemic risks

The way that the term “systemic risk” is used and misused, it seems clear that most people understand that systemic risk was a problem that led to the crisis, but beyond that there is little consensus, other than a conviction that we want much less of that in the future. The IMF provides a definition:

“the risk of disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.”

Had the quote ended after 10 words, that would have been sufficient.

For the system to be disrupted, two things need to be true:

1. there needs to be an exposure that everyone believes or suspects will turn into a loss of an amount that exceeds the capacity to bear losses of a large number of participants in the system and
2. there needs to be either a high degree of interdependency in the system or else widespread exposure to the loss-making large exposure. The system may seize up because the losses are known and the institutions are known to be insolvent or more commonly, because the losses are unknown.

For the rest of this discussion go to InsuranceERM.com

Risk Trading as ERM

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Risk Trading.

Modern ERM can be traced to the trading businesses of banks. Hard lessons from uncontrolled risk trading led to the development of processes and standards for controlling the traded risks. A major element in these systems is the function of valuing, or in other words, pricing of risks. For this discussion, all activities that include the deliberate acquisition of risks for the purpose of making a profit by management of a pool of risks to be risk trading. With that definition, insurance and reinsurance companies can be seen to be pure risk trading firms. Actuaries are at the heart of this activity as major players in the pricing and valuation of insurance risks. With this method of organizing risk management activities, it is clear that most actuarial activity is and has always been risk management. In fact, as is usually boasted, the actuarial profession probably has over 100 years more experience in risk management than any other field of risk management.

Risk assessment for pricing purposes involves the assessment of expected losses as well as the range of potential losses. The pricing process uses this information as well as the risk preference function of the risk trader to form a target price for a risk. This target price is compared to the market price. The risk trader will make decisions to buy or sell a risk depending on the relationship between the target price and the market price.

Some risk trading is not based on risk assessment but only on analysis of the market prices. This type of trading is only viable if there is a liquid market (or as some call it a “Greater Fool”).

In Insurance, risk pricing is most often not quite so tightly tied to market pricing because there are not usually not deep and liquid markets for insurance risks.  Instead, insurers tend to evaluate the expected claims to be paid plus expenses and then look at the risk margin that they would like to get for accepting the risk over and above those expected costs.  Evaluating and managing these risk margins has been the main concern of for the risk management of many insurers.

ERM changes risk pricing by introducing a consistent view of valuing risk margins across all risks. For actuaries and insurance products this has taken the form of economic capital and cost of capital pricing. Risk assessments are done that provide consistent information for all risks. Most commonly, the risk margins are then assessed relative to standard deviation of losses or in relation to extreme event losses stated in terms of Value at Risk or Expected Shortfall.

This post is a part of the Plural Rationalities and ERM project.