Archive for April 2011

Is Your Company HQ located in Denial?

April 29, 2011

Denial is a popular place for companies to locate.  That is because Denial is a much more economical location than living in reality.

Companies who are headquartered in Denial do not have to think consciously about risk management.  It is inherent in their everyday business practices.  They do not need to appoint anyone to be their risk officer.  They do not need to schedule sessions with their board to ever talk about risk.  They always talk about risk with their boards.

True ERM has a very difficult time getting started in a firm headquartered there.  That is because of the cost structure in Denial.  Those firms are used to paying exactly zero for risk management.  They get to realize ALL of the profits of their choices, without deduction for risk management drag.

If you propose ERM to a firm that is located in Denial, you will have them ask for you to:

Show me how ERM adds to value.

Usually, with a smirk on their face, because they are sure that you cannot.

But for those who live outside Denial, they might ask the opposite question:

Show me how ignoring risk adds to value.

To them it is pretty obvious that a firm that has gone out of business has zero value.  So any strategy that reduces the chance of going out of business has the potential to have a positive impact on firm value.

Some prefer to live all the time in Denial, some just visit occasionally.

Football is about more than just Shoes

April 28, 2011

Of course it is. The equipment never wins the game. It never runs the game.  But a team that shows up without proper equipment has only a slim chance of prevailing.

And ERM is about more than just models.  Some people have mistakenly equated ERM with Economic Capital or VAR models.  That makes no more sense than the idea that football is all about the shoes.

Football is about having the right team, assigning the the right roles, setting the strategy and finally mostly about execution.  If you asked 1000 experts about football, few if any of them would even list the shoes.

But for ERM, you do need to also find the right people, assign the the right roles, set the risk strategy and execute.

So why have models found their way into the debate about ERM in financial affairs?

Models in general and Economic Capital in specific has become central to the ERM process because insurers and banks have traditionally used very crude and very different approaches to measuring risks, when they actually did try to measure them.  It is difficult to believe that an industry that exists by taking on risks from others like insurance would not have a clear tradition of measuring how much risk it was taking on in any clear and consistent way.

The methods that tended to be employed by insurers worked when the risks that they were taking stayed the same over time.  When the risks could be adequately tracked by reference to something that indirectly tracked with the level of the risk.  But when businesses and people and markets are changing the nature and level of risk constantly, those old relationships completely broke down.

The promise of economic capital and VaR models is to replace the old rules of thumb with timely and consistent scientific assessments of risk.

But even if that promise is achieved, the insurer or bank has only then got to the point of buying shoes for their football team.  Now they need to start training and coaching the team and watching to see how the team performs, providing feedback and constantly making adjustments as the other teams adjust their teams and strategies.

So the model is a start but it is the start of the football season, not even the start of the playoffs.

You have the shoes now play the game.

Lucas Fayne Highly Recommends this Blog

April 24, 2011

The New York Times reported today that Lucas Fayne can be found on over 50 websites around the web endorsing the services of home remodeling contractors.  Riskviews did intensive research (i.e. a single Google search) and found a dozen references to the syndicated NYT article AND some of those endorsements.  Riskviews found that Fayne had home remodeling work done in Lexington Kentucky, San Marcos Texas, Irving Texas, Belmont Tennessee, Belmont New Hampshire, Minneapolis Minnesota before getting tired of researching.

So Riskviews decided to post his recommendation of this Blog.

Reality can be a much better teacher than Blogs.  Maybe there really is a Lucas Fayne who has had some much home remodeling work done all over the country.  Maybe he is such a consistent speaker that he has exactly the same thing to say about each and every contractor.

And maybe this story is a good lesson about due diligence.  And letting someone else provide your due diligence.

Riskviews seems to have actually done a little more research than the NYT.  Because Riskviews has discovered that there are other serial recommenders.  Nan Carlisle and Gillian Lee have also made statements about contractors in multiple states.  Lucas’ brother William seems to like the work that he had done also.

In this particular case, it was easy enough to find that these recommendations are probably bogus.  But you might want to keep this story in mind whenever you are tempted to be satisfied with a simple web based reference for someone or some service.

In the early days of computers, many unsophisticated managers were fooled into thinking that computer reports were by nature more accurate than hand typed reports.   More than one computer savvy person took advantage of that by getting the computer to simply print whatever they wanted a report to say, rather than doing what was assumed – getting the computer to actually determine an answer with its vast calculation power.

Few people who know how the internet works would fall for that sort of trick nowadays.  But how many people actually understand how the internet works?

Overreliance on the internet as an unchecked source of information is a risk to every business.  The risk manager should make sure that there are protocols to eliminate recommendations from the Faynes, Carlisles and Lees.

But in case you are someone who does not worry about things like that, here is the recommendation of this Blog:

We were very satisfied with the service and efficiency of your blog.  Getting the quote was quick and easy, and your staff started on time each day and worked hard. We are very confident with the job you did and have been recommending you to all our neighbors. Riskviews became a good friend to our family by the end of our project. He is a class act all the way!    Lucas Fayne (yourtown, yourstate)

Do we always underprice tail risk?

April 23, 2011

What in the world might underpricing mean when referring to a true tail risk? Adequacy of pricing assumes that someone actually can know the correct price.

But imagine something that has a true likelihood of 5% in any one period.  Now imagine 100 periods of randomly generated results.

Then for each of three 100 period trials look at 20 year periods. The tables below show the frequency table for the 80 observation periods.

20 Year Observed Frequency Out of 80
0 45
5% 24
10% 12
15% 0
20% 0
20 Year Observed Frequency Out of 80
0 9
5% 28
10% 24
15% 8
20% 7
20 Year Observed Frequency Our of 80
0 50
5% 11
10% 20
15% 0
20% 0

if the “tail risks” are 1/20 events and you do not have any information other than observations of experience, then this is the sort of result you will get. The observed frequency will jump around.

If that is the situation, how would anyone get the price “correct”?

But suppose that you then set a price for this tail risk. Let’s just say you picked 15% because that is what your competitor is doing.

And you have a very patient set of investors. They will judge you by 5 year results. So then we plot the 5 year results.

And you see that my profits are quite a wild ride.

Now in the insurance sector, what seems to happen is that when there are runs of good results people tend to cut rates to pick up market share. And when the profits run to losses, people tend to raise rates to make up for losses.

So again we are stymied from knowing what is the correct rate since the market goes up and down with a lag to experience.

Is the result a tendency to underprice?  You be the judge.

Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis

April 22, 2011

A second series of essays from the actuarial profession about the financial crisis.  Download them  HERE.

A Tale of Two Density Functions
By Dick Joss

The Systemic Risk of Risk Capital (Or the "No Matter What" Premise)
By C. Frytos &I.Chatzivasiloglou

Actuaries and Assumptions
By Jonathan Jacobs

Managing Financial Crises, Today and Beyond
By Vivek Gupta

What Did We Learn from the Financial Crisis?
By Shibashish Mukherjee

Financial Reform: A Legitimate Function of Government
By John Wiesner

The Economy and Self-Organized Criticality
By Matt Wilson

Systemic Risk Arising from a Financial System that Required Growth in a World with Limited Oil Supply
By Gail Tverberg

Managing Systemic Risk in Retirement Systems
By Minaz Lalani

Worry About Your Own Systemic Risk Exposures
By Dave Ingram

Systemic Risk as Negative Externality
By Rick Gorvette

Who Dares Oppose a Boom?
By David Merkel

Risk Management and the Board of Directors–Suggestions for Reform
By Richard Leblanc

Victory at All Costs
By Tim Cardinal and Jin Li

The Financial Crisis: Why Won't We Use the F(raud) Word?
By Louise Francis

PerfectSunrise–A Warning Before the Perfect Storm
By Max Rudolph

Strengthening Systemic Risk Regulation
By Alfred Weller

It's Securitization Stupid
By Paul Conlin

I Want You to Feel Your Pain
By Krzysztof Ostaszewski

Federal Reform Bill and the Insurance Industry
By David Sherwood

Leave Something on the Table

April 19, 2011

What was the difference between the banks and insurers with high tech risk management programs that did extremely poorly in the GFC from those with equally high tech risk management programs who did less poorly?

One major difference was the degree to which they believed in their models.  Some firms used their models to tell them exactly where the edge of the cliff was so that they could race at top speed right at the edge of the cliff.  What they did not realie was that they did not know, nor could they know the degree to which the edge of that cliff was sturdy enough to take their weight.  Their intense reliance on their models, most often models that focused like a lazer on the most important measure of risk, left other risks in the dark.  And those other risks undermined the edge of the cliff.

Others with equally sophisticated models were not quite so willing to believe that it was perfectly safe right at the edge of the cliff.  They were aware that there were things that they did not know.  Things that they were not able to measure.  Risks in the dark.  They took the information from their models about the edge of the cliff and they decided to stay a few steps away from that edge.

They left something on the table.  They did not seek to maximize their risk adjusted returns.  Maximizing risk adjusted return in the ultimate sense involved identifying the opportunity with the highest risk adjusted return and taking advantage of that opportunity to the maximum extent possible, then looking to deploy remaining resources to the second highest risk adjusted return and so on.

The firms who had less losses in the crisis did not seek to maximize their risk adjusted return.

They did not maximize their participation in the opportunity with the highest risk adjusted return.  They spread their investments around with a variety of opportunities.  Some with the highest risk adjusted return choice and other amounts with lesser but usually acceptable return opportunities.

So when it came to pass that everyone found that their models were totally in error regarding the risk in that previously top opportunity, they were not so concentrated in that possibility.

They left something on the table and therefore had something left at the end of that round of the game.

Rents vs. Risk and Reward

April 16, 2011

Many people talk and write as if risk and reward were the true trade-offs in a capitalist system.  It certainly makes risk management important if that were true.

But unfortunately for us risk managers, and fortunately for business managers, choosing among risky alternatives is not the best choice for business success.

In fact, the natural tendency of capitalism is directly away from risk and towards Competitive Advantage.  If a business can find a competitive advantage, their first choice forever after is to strengthen that advantage and to reduce their risk.

A business with a total competitive advantage, also called a monopoly, is crazy to then take any risk.  Economists call their income a rent.  The income from risk taking is called a risk premium.  All businesses prefer rents to risk premiums under that definition.

So the risk managers who talk all of the time about the risk and reward continuum and about the efficient frontier of risk taking are talking nonsense to any business person who knows the story of any of the most successful businesses.  The most successful businesses all made fortunes for their founders by collecting rents.

What we should be talking about is the Rent / Risk continuum.  If you want to be really successful, you need to find a way to collect rents.  If you want to get mediocre returns, then you can go out and take risks.

Many years ago, Riskviews was producing risk reports for return on risk capital for an insurer.  The insurer had some fee for service business.  This business did not fit into the risk reward framework.

Investment Banks had at one time been mostly fee for services businesses.  Then for a time, they decided that they could make more money taking risks.  It turns out that they were largely wrong.  The “profits” that they were recording on their risk taking were risk premiums for taking very large risks that were “in the dark“.  According to Taleb, they were being massively underpaid for those large but infrequent risks.

Some reinsurers that make their business taking on large amounts of catastrophe risks can be shown to be taking a significant amount of their value from the “default put” that is created because they collect premiums for all expected claims under their reinsurance contracts, but they do not intend to pay off on the largest catastrophes because they will have defaulted.

Risk taking is a questionable way to make profits.

So risk managers need to work to identify rents and properly reflect the superior place that rents should have in business goals.  Risk managers should be slow to claim that any risk taking behavior will make a profit and not just mistaken accounting of risks that are waiting in the dark and growing stronger to take back all of the so called profits from risk taking.

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