It’s All Relative
Another way to differentiate risks and loss situations is to distinguish between systematic losses and losses where your firm ends up in the bottom quartile of worst losses.
You can get to that by way of having a higher concentration of a risk exposure than your peers. Or else you can lose more in proportion to your exposure than your peers.
The reason it can be important to distinguish these situations is that there is some forgiveness from the market, from your customers and from your distributors if you lose money when everyone else is losing it. But there is little sympathy for the firm that manages to lose much more than everyone else.
And worst of all is to lose money when no one else is losing it.
So perhaps you might want to go through each of your largest risk exposures and imagine how either of these three scenarios might hit you.
- One company had a loss of 50% of capital during the credit crunch of the early 1990’s. Their largest credit exposure was over 50% of capital and it went south. Average recoveries were 60% to 80% in those days, but this default had a 10% recovery. That 60% to 80% was an average, not a guaranteed recovery amount. Most companies lost less than 5% of capital in that year.
- Another company lost well over 25% of capital during the dot com bust. They had concentrated in variable annuities. No fancy guarantees, just guaranteed death benefits. But their clientele was several years older than their average competitors. And the difference in mortality rate was enough that they had losses that were much larger than their competitors, who were also not so concentrated in variable annuities.
- Explaining their claims for Hurricane Katrina that were about 50% higher as a percent of their expected total claims, one insurer found that they had failed to reinsure a large commercial customer whose total loss from the hurricane made up almost 75% of the excess. Had they followed their own retention rules on that one case, that excess would have been reduced by half.
So go over your risks. Create scenarios for each major risk category that might send your losses far over the rest of the pack. Then look for what needs to be done to prevent those extraordinary losses.
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