Archive for November 2010

Watch your Own Wallet

November 14, 2010

Polling the people who work at the New York banks that were at the center of the financial crisis, people were asked which of the following statements that they agreed with the most:

  1. We did it and we need to do something differently.
  2. They did it and they need to do something differently.
  3. Space Aliens did it and we hope that they do not do it again.

The poll results are in and the findings are:

  • No one answered that they agreed with 1.
  • The innocent all were able to answer that they agreed with 2.
  • Those who were directly involved in the problems that led to the crisis all answered 3.

So the conclusion that you should reach from this survey is that nothing will be different in the future.  The financial system will be run mostly the same as it had been run.

Your only protection is to WATCH YOUR OWN WALLET.  That is, pay attention yourselves to things that might turn into the next set of systemic risks.  Those things will all tend to be very large systematic risks.

So you need to use the emerging risks type process on the largest systematic risks.  You need to assess periodically whether your firm’s exposures to these risks might in a crash result in firm ending losses.  (Or you can prepare your application for a bailout – good luck on that).

Then you need to have a heart to heart discussion with your board.  Stories of the firms that did the worst in the crisis tell that their boards urged them to take more and more risk.

Risk managers need to know whether it is their board’s wishes to be dancing up until the band sinks below the water or to stop perhaps a few songs before and leave the ship ahead of the crash.

Is it Better to Be Lucky than Smart?

November 8, 2010

It certainly is cheaper and easier.  But is it BETTER?

The main difference between lucky and smart is that smart is more likely to be able to repeat than luck.

But I think that there are two different types of smart, and one is much better than the other.

  • The first type of smart is able to discern patterns and trends.  This type of smart can do momentum trading.  They figure out what works in this phase of the cycle of the part of the world that they are in and they discern how to take advantage of one aspect of the trend.
  • The second type of smart is able to discern not just the trend, but they can see that the trend will not last.  So they can plan for the change in trend.  This type of smart is adaptable.
  • The lucky see nor care about trends or changes in trends.  What they choose works.  Some of the lucky are able to convince themselves and those around them that their “gut” can really pick out the right answers.  Those are the dangerous lucky.

If you are led by the lucky, your firm might fail at any time.  The formerly lucky CEO will not have a clue as to why they failed. Over time, they will have relied on their gut more and more and their success will get them more and more authority and autonomy.  People forget that if all business decisions were random coin tosses, someone will guess the right toss 10 times in a row with nothing more than luck behind their string.

If you are led by the Momentum leader, your firm will thrive as long as the wave that they identified keeps going.  In some cases, the leader and the firm come to believe that the trend that you follow IS the way that they world will be forever.  More and more of the company becomes dependent on the assumption that the trend continues.  When the trend fails, the company will falter or fail.  If enough people and enough firms have been following that same trend, the entire economy might falter.  If a trend last long enough, then it is quite likely that more and more people and firms will notice the trend and start to work on the assumption that the trend will continue.

But if you are working in a firm with an adaptable leader, then the firm will not do as well as peers during the peak of the trend.  Your firm will not be putting all of your eggs into the basket of trend immortality.  Your firm will be looking around for things that will work even if the trend changes.  Your firm will have the resilience to weather the change in trend and perhaps some business activity planned that will work even in a new environment.  Your firm will be working smart towards the long term.

So is it better to be lucky than smart?  Not in the long run, not in my mind.

It’s All Relative

November 7, 2010

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.

ERM, not just a good idea, Its the Law

November 2, 2010

IAIS Adopts ICP 16 on ERM

The International Association of Insurance Supervisors (IAIS) has adopted ERM as an Insurance Core Principle (ICP).

ERM is an acknowledged practice and has become an established discipline and separately identified function assuming a much greater role in many insurers’ everyday business practices. Originally, risk management only facilitated the identification of risks, and was not fully developed to provide satisfactory methods for measuring and managing risks, or for determining related capital requirements to cover those risks.
ERM processes being developed today by insurers increasingly use internal models and sophisticated risk metrics to translate risk identification into management actions and capital needs. Internal models are recognised as powerful tools that may be used, where it is proportionate to do so, to enhance company risk management and to better embed risk culture in the company. They can be used to provide a common measurement basis across all risks (e.g. same methodology, time horizon,  risk measure, level of confidence, etc.) and enhance strategic decision-making, for example capital allocation and pricing.

By this time next year, they expect to have revised the full set of ICPs.  All insurance supervisors are expected to reflect the revised ICPs in their legal frameworks and supervisory practices.  All G20 insurance supervisors will be expected to undertake a self-assessment against the new ICPs by early 2012.

Link to ICP 16

Europeans will notice that ICP 16 is very similar to Pillar 2 of Solvency 2.  Folks in the US will notice that this is very similar to documents that the NAIC has exposed for comment in the last year.

Riskviews has visited a number of non-G20 countries in the past six months and insurers there have all said that their regulators are starting to talk about ERM requirements or have already put them in place.

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