Post Pandemic Period

10 August 2010 – the WHO declares that the Swine Flu Pandemic has ended.

Or rather they say that we have entered the Post Pandemic Period.

The H1N1 Pandemic is an example of what happens when you do a good job of risk management.  Because of the preparations that were made to develop and distribute vaccines as well as other measures to reduce possible transmission of the virus, and to the fact that the virus did not mutate in a way to become either lethal or resistant to the vaccine, the impact of the Pandemic was not severe.

This is what should happen with good risk management of an emerging risk like that.  Many companies created and/or tested their emergency plans and are now much better prepared for the next emergency.  The plans to prevent systemic failure did go into effect and they worked.

But one of the reactions to effective risk management is disbelief that there ever was a threat.

So it goes.  Do not be discouraged.  Keep up the good fight.

The firms that are run by the skeptics who refuse to take heed of such warnings will at some point get what they haven’t prepared for.

Meanwhile, we now get to learn what Post Pandemic Period means.

Forget you ever read this

I just read a great post that may be a key to understanding both the course of the economy and the public sentiment about government policies.

Queasing over Quantitative Easing, Part III

David Merkel suggests that people are unhappy with the unfairness of government policies.

I would go even further.  People have overwhelmingly come to the conclusion that they need to reduce their own debt.  Many, many people are enduring what they think of as hardship (by ceasing to spend money that they do not have) to bring down their personal debt level.  At the same time, they see the government adding to the public debt.  People are not stupid.  They think of the government debt as THEIR debt.  So they are economizing for naught if for every dollar of debt that they reduce, the government adds a dollar of debt.

Perhaps some day someone will discover a Pelzman effect like mechanism at work with regard to debt.  During the credit bubble that led up to the financial crisis, people where almost totally insensitive to the level of debt.  But now there is a high degree of sensitivity.  So if people feel that there is a right level of debt, then they will take actions to get to that level.  If the government works against that effort, then they will adjust their personal targets so that the aggregate of personal and public debt comes into line with their perceived optimal level of debt.  This may not be because they set a specific target, but because the rising level of public debt makes people uncomfortable and they express that discomfort in the way of looking for more security and less debt.

So maybe the extreme cutting of government spending that is happening in the UK is what is actually needed.  Because the government actions do not exist in some “all things being equal” economics textbook argument.  Government policy and the economy exist in and among the people of the world.

It is widely known that household consumption is a large fraction and major driver of the GDP in the US.  So if we want the GDP to grow, we need to do the things that will get households spending again.  Not in an all things being equal world, but in the real world with real people.

An interesting wrinkle to this is that the Keynesian ideas of using government spending to get out of the Great Depression did not work until the spending for WWII came along and the war spending did the trick.  Some economists have suggested that showed that a larger amount of government spending was needed than was tried prior to WWII.  But the ideas above – that the government spending will not be effective if the people want to save may have kept the earlier spending from working.  The spending for WWII may have worked though BECAUSE people thought of that spending as having its own merits.  WWII spending was necessary.

So perhaps government spending cannot go against the grain of public sentiment to overcome the Paradox of Thrift, unless the public believes that the spending is necessary.

And now to finally link this discussion to risk and risk management…

Perhaps Greenspan is right when he says that he did not know how to pop a bubble.  Maybe that is because he did not believe that he could have changed public opinion about the value of an asset class.  He could take actions that might temporarily hurt the value of an asset class, but it was quite possible that the public attitude would swing right back and keep inflating the bubble in spite of the actions of the Fed.

The same thing certainly has been true within firms.  When the risk manager finds him/her self at odds with the prevailing idea in a firm about a risk, he/she is more likely to lose their job than to change the prevailing opinion.

So in all three cases, in the general economy in severe recession, in an asset bubble and in a company overconfident about a particular risk. the only actions that can be effective will be actions that are not obviously going against the grain.  The actions will need to be designed so that they appear to go with the popular sentiment even when they are really intended to change the fundamentals with regard to that sentiment.

So, I now realize that I need to keep this secret.  So please forget you ever read this.

On The Top of My List

I finished a two hour presentation on how to get started with ERM and was asked what were my top 3 things to keep in mind and top 3 things to avoid.

Here’s what I wish I had said:

Top three hings to keep in mind when starting an ERM Program:

1. ERM must have a clear objective to be successful.  That objective should reflect both the view of management and the board about the amount of risk in the current environment as well as the direction that the company is headed in terms of the future target of risk as compared to capacity.  And finally, the objective for ERM must be compatible with the other objectives of the firm.  It must be reasonably possible to accomplish both the ERM objective and the growth and profit objectives of the firm at the same time.
2. ERM must have someone who is committed to accomplishing the objective of ERM for the firm.  That person also must have the authority within the firm to resolve most conflicts between the ERM development process and the other objectives of the firm. And they must have access to the CEO to be able to resolve any conflicts that they do not have the authority to resolve personally.
3. Exactly what you do first is much less important than the fact that you start doing something to develop an ERM program.   Doing something that involves actually managing risk and reporting the activity is a better choice than a long term developmental project.  It is not optimal for the firm to commit to ERM, to identify resources for that process and then to have those people and ERM disappear from  sight for a year or more to develop the ERM system.  Much better to start giving everyone in management of the firm some ideas of what ERM looks and feels like.  Recognize that one product that you are building is confidence in ERM.

Things to Avoid:

1. Valuing ERM retrospectively taking into account only experienced gains and losses.  (see ERM Value)  A good ERM program changes the likelihood of losses, but in any short period of time actual losses are a matter of chance.  On the other hand, if your ERM programs works to a limit for losses from an individual transaction, then it IS a failure if the firm has losses above that amount for individual transactions.
2. Starting out on ERM development with the idea that ERM is only correct if it validates existing company decisions.  New risk evaluation systems will almost always find one or more major decisions that expose the company to too much risk in some way. At least they will if the evaluation system is Comprehensive.
3. Letting ERM routines substitute for critical judgment.  Some of the economic carnage of the Global Financial Crisis was perpetuated by firms where their actions were supported by risk management systems that told them that everything was ok.  But Risk managers need to be humble.

But in fact, I did get some of these out. So next time, I will be prepared.

Changing Risk Tolerance

One of the reasons that many firms have not yet set a risk tolerance seems to be that management is afraid that the Risk Tolerance will then take over the company and they will no longer be able to make major decisions because of the risk tolerance.

I imagine the picture of a large sumo wrestler with the name “risk tolerance” sitting in the  corner of the executive conference room.  It would be really smart to avoid making risk tolerance unhappy.

But that is not really the case.  Risk Tolerance is not going to sit on you if you make the wrong decision.  Risk Tolerance is not going to actively insist that you make a decision that you know is wrong.

Risk Tolerance is more like the little brother that tags along behind you.  You know that if you do anything little brother will tell Mom.

Risk Tolerance is a commitment to acting as your own little brother.  Telling on yourself if you take on risk that goes beyond a certain pre-agreed upon point.

Then it is up to you to convince the higher authority that your risk taking was appropriate for whatever reason that you have.

In addition, Risk Tolerance should not be carved in stone.  Risk Tolerance should be written on the white board in Erasable marker.  You should not expect to clean that board every week.  But the option will always be there to walk up to the board and wipe it clean.

That does not mean that every time that it is inconvenient that the Risk Tolerance should be changed.  But it does mean that as the world changes, you should be sure that you Risk Tolerance still means what you intended it to mean when it was set.

Otherwise, you are in danger of having it turn into a Sumo Wrestler in the corner.

Around the Corner Risk

That is where the risk manager really earns their money.

The risks that are coming straight down the road, well that is important to pay attention to them.  But those are the obvious risks.  I would not pay very much for help in avoiding serious accidents from those risks.

But those round the corner risks, that would be very valuable, to have someone who can help to make sure that those out of sight risks do not ruin things.

However, what any risk manager who has tried to focus attention on the Around the Corner Risks has learned is that attending to such risks is often seen as spoiling the game.

In the Black Swan, Nassim Taleb talks about the degree to which businesses are in effect selling out of the money puts and pocketing the risk premium as if it is pure profits.

And that is often the case.  Risk managers should extend their view to include analysis of the actual source of profits of the various endeavors of their firms.  Any place where the profits are larger than can be explained is a place where the firm might well be getting paid for selling those puts.

The risk manager needs to be able to take that analysis of sources of profits back to top management to have a frank discussion of those unexplained sources of profits.

In most cases, those situations are risks to the firm, either because they represent risk premium for out of the money puts or because they represent temporary inefficiencies.  The risk from the temporary inefficiencies is that if management mistakenly assumes that those inefficiencies are permanent, then the firm may over-invest in that activity.  That over-investment may then eventually lead to the creation of those our of the money puts as a way to sustain profits when the inefficiencies are extinguished by the market.

An example of this situation is the Variable Annuity market in the US.  In the early 1990’s firms were able to achieve good profits from this business largely because there were too few companies in the market.  Every market participant could show good profits and growth in this new market without resorting to price competition.  This situation attracted many additional insurers into the market, flattening the profitability.  The next phase in the market was to offer additional benefits to customers at prices below market cost.  These additional benefits were in the form of out of the money puts – guarantees against adverse experience of the investments underlying the product.  And the risk premium charged for these benefits was often booked as a profit.

One of the reasons for the confusion between risk premium and profit is the way in which we recognize profits on risks where the period of the risk occurrence is much longer than the period for financial reporting.

The analysis of source of profits can be a powerful tool to help risk managers to both see those around the corner risks and to communicate the possible around the corner risks before them become immanent.

Did you accept your data due to Confirmation Bias?

Confirmation bias (also called confirmatory bias or myside bias) is a tendency for people to favor information that confirms their preconceptions or hypotheses regardless of whether the information is true. As a result, people gather evidence and recall information from memory selectively, and interpret it in a biased way. The biases appear in particular for emotionally significant issues and for established beliefs. For example, in reading about gun control, people usually prefer sources that affirm their existing attitudes. They also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and/or recall have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a stronger weighting for data encountered early in an arbitrary series) and illusory correlation (in which people falsely perceive an association between two events or situations).

From wikipedia

Today’s New York Times tells a story of Japanese longevity data.  Japan has long thought itself to be the home of a large fraction of the world’s oldest people.  The myth of self was that the Japanese lifestyle was healthier than that of any other people and the longevity was a result.

A google search on “The secret of Japanese Longevity” turns up 400,000 web pages that extol the virtues of Japanese diet and lifestyle.  But the news story says that as many as 281 of these extremely old Japanese folks cannot be found.  The efforts to find them revealed numerous cases of fraud and neglect.  This investigation started after they found that the man who had been on their records as the longest lived male had actually been dead for over 20 years!  Someone had been cashing his pension checks for those years and neglecting to report the death.

The secret of Japanese Longevity may well be just bad data.

But the bad data was accepted because it confirmed the going in belief – the belief that Japanese lifestyle was healthier.

The same sort of bad data fed the Sub Prime crisis.  Housing prices were believed to never go down.  So data that confirmed that belief was readily accepted.  Defaults on Sub Prime mortgages were thought to fall within a manageable range and data that confirmed that belief was accepted.

Data that started to appear in late 2006 that indicated that those trends were not going to be permanent and in fact that they were reversing was widely ignored.  One of the most common aspects of confirmation bias is to consider non-confirming data as unusable in some way.

We try to filter out noise and work only with signal.  But sometimes, the noise is a signal all its own.  And a very important signal to risk managers.

An Unusually Uncertain Economy

Economists sometimes admit that the economy has different phases.  I think that they are now up to three:  Boom, Bust and Normal.

Most of the Economics literature of the past 30 years relates solely to the Normal environment.

There may be economics literature relating to the Boom phase, but who would know.  No one ever listens to an economist during a boom.

Keynes provided the theories for the Bust phase.  His ideas had been discredited up until they were needed again.  Now many economists are again looking at the Bust phase.

But on July 22, Bernanke said that the recovery was “unusually uncertain”.

There just do not seem to be any economic theories about this “uncertain” environment.  Perhaps that is why no one seems to know what to do.  They have prescriptions that would work if the environment was still in a Bust.  So maybe a double dip recession is needed to take the economy back into a phase where there are economic theories.

What economics needs is a theory of the Uncertain Environment. There are definitely theories in the minds of consumers and business leaders.  Here is one:

In the face of massive uncertainty, hedging your bets and keeping your options open is almost always the right strategy.

Jim Manzi

And that is mostly what we see businesses and individuals doing right now.  Keeping their options open.  Hence the massive buildup of corporate cash and the paydown of individual debt.

I do not have a full economic theory for the Uncertain times, but I can suggest that economists need to start treating this as a true phase of the economy and developing a theory.

Full Spectrum Risk Management

Lately, risk management authorities
including regulators and rating
agencies have been trying to
tell firms how they should think about
and manage risk. Actuaries who have
labored in risk management through
the boom period before the crisis—a
period when risk managers were largely
ignored—are very happy that those
authorities may finally be empowered
to force firms to get with the program.
But, such decrees are not necessarily
working and will not work in the long
run, because individuals and companies
have risk perspectives that cannot be
changed by fiat—any more than mandating
a favorite color for everyone would
change anyone’s real favorite color.

Read the rest at The Actuary Magazine

Why All Risk Models Understate Risk?

There are three types of reasons:  mechanical, psychological and market.

Mechanical Reasons

Parameter Risk – all of the parameters of risk models are uncertain.  That fact is usually ignored.

Residual Risk – there are two parts to this one.  Within the range of the data and outside the range.  Within the range, the process of modeling always produces smoother results than the actual observed results.  This understates risk.  Outside the range, the method might over state or understate risk.  Possibly by orders of magnitude.

Randomness – many of the risks that we model with random variables are not at all random.  They are causal, but we do not know how to follow the casual chain to its conclusion.  Reality of these risks will involve much more discontinuities that are usually included in our continuous risk models.

Psychological

Humans are hard wired to have a better memory of good times than bad times.  This manifests itself in many of the biases chronicled by psychologists.

Many of those biases boil down to the fact that we all tend to see the world as we want it to be, rather than as it is.

Market

Because of the above, the market tends to underprice risk.  You often do not get paid enough for the real risk, you get paid for the risk in the model.  Those few who look past the models and come the closest to understanding the real risk will simply not play.  So the markets are dominated by folks with models that understate risk.

The place to play is identified clearly above.  Did you notice?

Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications

The 2009 call for essays, “Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications,” which was published in early 2009, contained 35 short essays . Over half of those essays were contributed by folks who were on the INARM email group.

The Joint Risk Management Section of the Society of Actuaries (SOA), the Casualty Actuarial Society (CAS), and the Canadian Institute of Actuaries (CIA) in collaboration with the SOA Investment Section, the International Network of Actuaries in Risk Management (“INARM”) and the Enterprise Risk Management Institute International (“ERM-II”), propose publishing a second series of essays as a follow-up to the first to address “Risk Management: Part Two – Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis.”

Systemic risk is the risk of the collapse of an entire financial system or market as opposed to risk associated with any one individual entity. Risk systems consist of social institutions, laws, processes and products designed to facilitate the transfer, sharing, distribution and mitigation/hedging of risks between various buyers and sellers. Examples of risk systems include insurance, banking, capital markets, exchanges, and government and private health and retirement programs. Historically, these risk systems are rarely analyzed in a manner that looks at the ability of the system to survive extreme risk events and still carry out their function – creating an ongoing market for the exchange of risk. The failure of a risk system may be due to asymmetric information, unbalanced incentives of its participants and/or the failure of trust amongst its participants. In reflecting on the events of the last two years, is it possible to effectively develop early warning indicators that trigger intervention in advance of a complete collapse of an entire financial system or market? Does it make sense to have a chief risk officer of, say, the United States of America, whose role it would be to manage/mitigate this risk?

We invite the submission of essays to address these questions, and to offer thought leadership on the ERM discipline and the essential elements needed to maintain risk transfer systems in times of unusual stresses and unlikely events.

This topic has been intentionally left broad to allow essays that address industry-specific issues or a wide range of issues across industries. Each essay should be no more than two pages (1,500 words or less) and should be submitted no later than Friday September 15, 2010. Depending on the response, we may limit the number of essays that are published. SOA/CAS resources will be utilized to publish and promote the resulting publication. Publication is planned for Fall of 2010. Submit your essay here .

Awards for worthy papers:

1st Place Prize – $500
2nd Place Prize – $250
3rd Place Prize – $100

Feel free to pass along any questions to Robert Wolf , FCAS, CERA, ASA, MAAA, Staff Partner- Joint Risk Management Section and Investment Section, who will be coordinating the publication.

Lightning or Lightning Bug

Mark Twain once observed that there was a difference between Lightning and Lightning Bug. An important difference.

The difference between the almost right word & the right word is really a large matter–it’s the difference between the lightning bug and the lightning.

Might there be a similar difference between Risk Management System and Risk Management?

A Risk Management System is composed of org charts, policy statements, Reports, meetings,committees, computer models, powerpoints and dashboards.

Risk Management means making tough decisions and taking unpopular actions that more than 9 out of 1o times will not look like they were the right calls after the facts.

But decisions and actions that every once in a long while will save the firm.

So can Risk Management happen inside of a Risk Management system?

But think about it.  Can you think of an example of a situation outside of a risk management system where getting more people involved results in MORE of the tough decisions being made?  Or MORE unpopular actions being taken?

So how should one go about creating a risk management system that actually does Risk Management?

Start with the tough decisions and unpopular actions that are sometimes needed.  Can you identify them?

Start there.  Find a person who has the qualities of discernment, judgment, balance, toughness and experience with the risk to make those tough decisions and to make sure that the unpopular actions happen.  Build the risk management system so that the person gets the information and authority and protection that they need to get the job done.

That would be difficult if that was all that was needed.  But this person, if they are doing their job, will be reversing some business decisions that might otherwise make some money.  So you also need an information system that assures top management that the risk manager is making the right tough decisions.

That system needs to help to identify whether the risk manager is making either Type I or Type II errors.  And if you want to keep a good risk manager and avoid keeping a bad risk manager, you need to have a realistic tolerance for the errors that your information system identifies.

Oh Hell.  It is much easier to just do the pretty risk management system and try to just take as much risk as everyone else.

Must be why so little Risk Management actually happens.

And Lightning Bugs are so pretty on a summer night.

Risk Management Adds to Value

It always seems like the same argument.

One the one side, you have the folks who say that risk management is an expensive waste of time, and on the other the folks who see risk management as vital to the survival of the firm.

The folks in the first group pull out their trump card…

OK, if risk management is so good, show me a demonstration of the value added.

And what they are looking for is a clear example where all that money spent on risk management resulted in some clear cut benefit.

The risk managers will sometimes be able to show a benefit.  But usually the best examples are somewhat difficult to claim clear credit for:

1. Remember when Risk Management suggested that we reduce our stock market exposure in 2007?  Well, we cut it in half and saved the company millions.  (Or do you look at that as keeping half and losing millions???)
2. Or that time when we stopped that trade that if it had gone through the firm would have lost a million.

Firms of all, viewed in that manner, risk management “accomplishments always seem negative.  Always seem like they are all about stopping business.

Second, it is quite possible that in good times, risk management will not have any stories like this at all to talk about.

In the best of times, risk management does seem like a complete drag.  The folks who had weak risk management seem to do better than the folks with strong risk management.  That is because even the bad trades make money in the best times.

Risk management needs to avoid getting sucked into this discussion.

That is because the primary benefit of risk management is purely prospective, not retrospective.  It is pure luck whether risk management advice has resulted in positive benefits during any period of time.

Risk management has benefit and provides value in the way that it shapes the FUTURE.

The value of risk management is that it creates a future that has the risk profile that is what management and the board wants.  A firm with good risk management has potential for failure and potential for success.  Those potentials have been deliberately balanced by consciously balanced by management and the board.

The value of risk management is the value of a known balance compared to the value of an unknown balance.

The management of a firm is betting on a roulette wheel.  The firm with risk management knows how many numbers are on the wheel and can choose how many it wants to cover.  The firm without risk management does not even know how many numbers are on the wheel and may not even know the extent of its bets on any one spin of the wheel.

With that idea in mind, risk managers should be asking how the opponents of risk management would propose that they can value their own future.

18,000 in a year

That’s how many different pageviews there have been of Riskviews in the first year of operation as a blog.  The best month in that first year was the last month, July 2010.

Thanks.  This will continue.

Riskviews is one of 141 million blogs operating on the web.  Riskviews has stayed on its theme of Risk and Risk Management. There were approximately 4 new posts per week over that first year.  Thanks to the many people who provided guest posts and especially to the “Regular Contributors”

To celebrate this first anniversary of the start of the blog, I decided to feature one post from each month of that first year:

1. ERM only has value to those who know that the Future is Uncertain (August 2009)  Explains how ERM must be valued prospectively, not retrospectively.
2. Custard Cream Risk – Compared to What??? (September 2009) Talks about how risk assessments needs to have an anchor to be meaningful.
3. An Al-Chet for Risk Managers (October 2009) Gives a litany of common shortcomings of risk managers as we are all human.
4. Diversification Causes Correlations (November 2009)  Focuses on the risk contagion that comes out of the risk choices of major firms.
5. Does Bloomberg Understand Anything about Risk Management? (December 2009)  Risk managers do not stand a chance if even the financial press characterized hedges as bets.
6. All Things Being Equal (January 2010)  Talks about the danger that arises because the “standard assumptions” are rarely stated, let alone tested for validity.
7. Burn out, Fade Away …or Adapt (February 2010)  The landscape of risk keeps changing.  Risk management needs to be adaptable if the firm is going to survive over the long run.
8. Is ERM Ethical? (March 2010) Tries to tie risk management and other points of view commonly found within firms to different schools of ethics, rather to “right and wrong”.
9. Skating Away on the Thin Ice of the New Day (April 2010)  The theme song for the current environment of high uncertainty is from Jethro Tull.
10. Window Dressing (May 2010)  Suggests an alternative basis for determining regulatory capital.
11. Regulatory Risk Management (June 2010) The extreme pitfalls of a high degree of regulatory involvement in risk management.
12. Crippling Epistemology (July 2010)  Be careful that that expensive and impressive risk information system do not actually obscure the information needed to make risk decisions.