Archive for July 2010

Regime Change

July 30, 2010

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.

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A Friedman Model

July 29, 2010

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

July 28, 2010

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

July 26, 2010

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

July 25, 2010

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

July 21, 2010

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

July 20, 2010

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.


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