The Year in Risk – 2010

It is very difficult to strike the right note looking backwards and talking about risk and risk management.  The natural tendency is to talk about the right and wrong “picks”.  The risks that you decided not to hedge or reinsure that did not develop losses and the ones that you did offload that did show losses.

But if we did that, we would be falling into exactly the same trap that makes it almost impossible to keep support for risk management over time.  Risk Management will fail if it becomes all about making the right risk “picks”.

There are other important and useful topics that we can address.  One of those is the changing risk environment over the year. In addition, we can try to assess the prevailing views of the risk environment throughout the year.

VIX is an interesting indicator of the prevailing market view of risk throughout the year.  VIX is in indicator of the price of insurance against market volatility.  The price goes up when the market believes that future volatility will be higher or alternately when the market is simply highly uncertain about the future.

Uncertain is the word used most throughout the year to represent the economic situation.  But one insight that you can glean from looking at VIX over a longer time period is that volatility in 2010 was not historically high.

If you look at the world in terms of long term averages, a single regime view of the world, then you see 2010 as an above average year for volatility.  But if instead of a single regime world, you think of a multi regime world, then 2010 is not unusual for the higher volatility regimes.

So for stocks, the VIX indicates that 2010 was a year when market opinions were for a higher volatility risk environment.  Which is about the same as the opinion in half of the past 20 years.

That is what everyone believed.

Here is what happened:

December 6.0%
November -0.4%
October 3.5%
September 8.7%
August -5.3%
July 6.8%
Jun -5.2%
May -8.3%
April 1.3%
March 5.8%
February 2.8%
January -3.8%
Average 1.0%
Std Dev 5.6%

That looks pretty volatile.  And comparing to the past several years, we see below that 2010 was just a little less actually volatile than 2008 and 2009.  So we are still in a regime of high volatility.

So we can conclude that 2010 was a year of both high expected and high actual volatility.

If an exercize like this is repeated each year for each important risk, eventually insights of the possibilities for both expectations and actual risk levels can be formed and strategies and tactics developed for different combinations.

The other thing that we should do when we look back at a year is to note how the year looked in the artificial universe of our risk model.

For example, when many folks looked back at 2008 stock market results in early 2009, many risk manager had to admit that their models told them that 2008 was a 1 in 250 to 1 in 500 year.  That did not quite seem right, especially since losses of that size had occurred two or three times in the past 125 years.

What many risk managers decided to do was to change the (usually unstated) assumption that things had permanently changed and that the long term experience with those large losses was not relevant. Once they did that, the risk models were recalibrated and 2008 became something like a 1 in 75 to 1 in 100 year event.

For the stock market, the 15.1% total return was not unusual and causes no concern for recalibration.

But there are many other risks, particularly when you look at general insurance risks, that had higher than expected claims.  Some were frequency driven and some were severity driven.  Here is a partial list:

  • Queensland flood
  • December snowstorms (Europe & US)
  • Earthquakes (Haiti, Chile, China, New Zealand)
  • Iceland Volcano

Munich Re estimates that 2010 will go down as the sixth worst year for amount of general insurance claims paid for disasters.

Each insurer and reinsurer can look at their losses and see, in the aggregate and for each peril separately, what their models would assign as likelihood for 2010.

The final topic for the year in risk is Systemic Risk.  2010 will go down as the year that we started to worry about Systemic Risk.  Regulators, both in the US and globally are working on their methods for inoculating the financial markets against systemic risk.  Firms around the globe are honing their arguments for why they do not pose a systemic threat so that they can avoid the extra regulation that will doubtless befall the firms that do.

Riskviews fervently hopes that those who do work on this are very open minded.  As Mark Twain once said,

History does not repeat itself, but it does rhyme.”

And for Systemic Risk, my hope is that the resources and necessary drag from additional regulation are applied, not to prevent an exact repeat of the recent events, while recognizing the possibility of rhyming as well as what I would think would be the most likely systemic issue – that financial innovation will bring us an entirely new way to bollocks up the system next time.

Happy New Year!

Explore posts in the same categories: Assumptions, Equity Risk, Financial Crisis, Insurance Risk, Risk, Systemic Risk


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