Frequency vs. Likelihood

Much risk management literature talks about identifying the frequency and severity of risks.

There are several issues with this suggestion.  It is a fairly confused way of saying that there needs to be a probabilistic measure of the risk.

However, most classes of risks – things like market, credit, natural catastrophe, legal, or data security will not have a single pair of numbers that represent them.  Instead they will have a series of pairs of probabilities and loss amounts.

The word frequency adds another confusion.  Frequency refers to observations.  It is a backwards looking approach to the risk.  What is really needed is likelihood – a forward looking probability.

For some risks, all we will ever have is an ever changing frequency.

So what do we do?  With some data in hand and a view of the underlying nature of the risk, we form a likelihood assumption.  With that assumption, we can then develop an actual gain and loss distribution that gives our best picture of the risk reward trade-offs.

For example, the following is three sets of observations of some phenomena.

On this example, the 1s represent the incidence of major loss experiences.  There are at least four ways that these observations might be interpreted.

1. One analyst might say that the average of all 60 observations is 2 (or a 10% frequency) so that is what they will use to project the forward likelihood of this problem.
2. Another analyst might say that they want to be sure that they account for the worst case, so they will focus on the first set of observations and use a 15% likelihood assumption.
3. A third analyst will focus on the trend and make a likelihood assumption below 5%.
4. The fourth analyst will say that there is just not enough consistent information to form a reliable likelihood assumption.

Then the next 20 observations come up all zeros.  How do the four analysts update their likelihood assumptions?

In fact, this illustration was developed with random numbers generated from a binomial distribution with a 5% likelihood.

The math is simple to determine that probability of frequency observations from 20 trials with a likelihood of 5% are:

• 0 – 36%
• 1 – 38%
• 2 – 19%
• 3 –  6%
• 4 –  1%

To be responsible in setting your likelihood assumptions, you should be fully aware of the actual distributions of possibilities based upon the frequency observations that you have to work with. So the first set of observations had a 6% likelihood, the second with 2 observations had a 19% likelihood and the third with 1 observations had a 38% likelihood.

That is when we know the actual likelihood.  Usually you do not.  But you can look at this sort of table for each possible assumption for likelihood.

Here we actually had 60 observations.  The same sort of table for the 60 trials and for different assumptions of likelihood:

This type of thinking will only make sense for the first analyst above.  The other three will not be swayed.  But for that first analyst, some more detailed reflection can help them to better understand that their assumptions of likelihood are just that, assumptions; not facts.

Focusing on the Extreme goes Against the Grain

It is very common that people just totally discount risks that are remote.

There is only a 1% chance of that happening so I am just not going to worry about it.

Is commonly how that might be expressed, or even suggesting that something remote is “never going to happen”.

Buying a lottery ticket is seen as simply playing.  Almost no one makes serious plans around the possibility of winning the lottery.  But many will dream.

Life insurance is an unattractive product in most of Europe and the interest in it wanes in the US, supported only by a large tax incentive.  Perhaps that is possibly due to the remote likelihood that is being insured against.  For most ages of working people the mortality rate is less than 1 in 1000.  A very remote event.

This is one way of thinking about risk tolerance.  If people (including the people who run companies) are not concerned about events with a 1/100 or 1/1000 likelihood, then the risk tolerance should be stated in terms of a likelihood that they are concerned about – say 1/20.  Then the risk tolerance can be the amount of loss that they can tolerate at the level of likelihood that they are willing to actively consider.

Part of the barrier to forming a risk tolerance statement may be the focus on the remote – on a remote level that is beyond the concerns of the people who are being asked to form this opinion.

Resilience Realism

There are two parts to identifying and understanding whether something is a risk to your organization. The first part is to understand what might happen in the world and within your organization that might cause an adverse result. The second part is to understand the resilience of your organization to the adversity.

Consider the situation of New Orleans. For the Big Easy to be properly prepared for a major hurricane, they need to have both a realistic view of what sorts of hurricanes could hit the city AND they needed to be realistic about the resilience of their city to the impact of the hurricane.

Riskviews has featured the Plural Rationalities view that there are four different views of risk many times.  In addition to the view of risk, resiliency can follow the pattern of four different points of view.  In fact, it may well be a combination of the view of resiliency and the view of risk that makes up the four risk paradigms.

Conservators believe that the world is risky AND they are not very resilient.

Maximizers believe that the world is low risk AND that they are very resilient.

Managers believe that the world is moderately risky AND that they can be appropriately resilient if the work at it and apply the correct expertise.

Pragmatists believe that they do not know how risky that the world is and they also cannot tell whether they will be sufficiently prepared.

Consider the residents of the Atchafalaya Spillway area where the water from the flooding Mississippi River was diverted by the Army Corps of Engineers.  Some of those folks fled immediately when asked to evacuate.  They doubted that they had the resilience to face the flood.  Others stayed put because they had always survived floods before and they felt that their resilience was fine.  A few folks stayed and built up their own defenses.  You may have seen the TV footage of homes in their own little islands of recently added sandbags.  The Pragmatists may have been in any one of those three groups but for entirely different reasons.)

The feeling of resilience comes from experience – from the feedback that people get from their experiences.  And it helps to form their current approach to risk.

We do what we can

Recently, Riskviews read a parable that ended with one person coming upon a small animal, perhaps a cat, lying on the ground with their feet up in the air.  When asked why, the cat explained that it had heard that the sky was falling.  The person laughed and said that the cat couldn’t stop the sky from falling.  The cat replied, “we do what we can”.  (Anyone who can help with the source please add to comment.)

“We Do What We Can” would be a good motto for risk managers.  Contrary to popular belief, Risk managers do not know the future any better than anyone else.  But with the twin handicaps of no prescience and popular belief that they possess it, risk managers can have a positive effect.

Risk Managers can have an impact on frequency of damaging losses.  Though they cannot eliminate them.  Many risk managers have been fired because they failed to stop 100% of all damaging losses.  But many others keep on working to reduce the likelihood that the firm will experience a damaging loss.  One important part of having an impact on frequency of damaging losses is to recognize the changing likelihood over time.

The other place where risk managers do what they can is in the area of firm resilience.  Good work in previous crises only makes the risk manager’s job harder.  Survival of past crises can foster a feeling of invulnerability and complacency towards risk management.  The risk manager needs to work to maintain vigilance.  It must be done carefully to avoid the chicken little syndrom.

 

Cavalcade of Risk

If you, like Riskviews, enjoys reading about risk, you will love the Cavalcade of Risk.  The Cavalcade of Risk focuses on how people and businesses deal with the element of uncertainty in their lives, weekly presenting a wide ranging list of links to blogs and other places where all different aspects of risk are being discussed.

 

Cavalcade of Risk 133

Cavalcade of Risk 56 

Cavalcade of Risk  131

Cavalcade of Risk 128

With a little effort, you can track down all of them.

 

 

 

 

 

 

 

 

 

Hedging Longevity Risk might be the least of our worries

From a mechanical perspective, finding something to “hedge” against longevity risk, i.e. the risk that pension payouts will increase due to improving mortality, is not particularly difficult.  It is necessary to determine investment possibilities that will benefit from increased life expectancy.

Businesses that serve the aged such as nursing homes and medical products companies will be some of the sorts of things that will prosper in an increasingly aged economy.

Clever quants will be able to show that while the hedge is far from perfectly effective, it can be used to reduce the capital requirements of pensions and annuity exposures.

But there is a much larger question that is not likely to be addressed in looking at capital requirements for insurers and pension plans.

That is the issue of whether the economy will be able to sustain the aggregate effects of the aging of the populations in Japan, the US, Europe and China.  Those investments in elderservice providers and elderproduct firms will provide a relative hedge.  Those firms may do relatively better than the rest of the economy.

But on the whole, the economy might well be in the dumps, making the potential to earn the returns on investment needed to support the base level of pensions extremely difficult.  We may well find out that it is not viable for an economy to both maintain its base promises to elders AND maintain a healthy economy at the same time.

Robert Schiller has described this problem well in a NYT Op Ed piece last spring.  He describes an autonomous family farm where they must decide how to treat the family elders who are no longer able to work.  If the farm has a bad year and harvest is poor, do they continue to feed the elders the same as in the good years and therefore starve the working members of the family?  Or would that create a spiral that brought the entire family to ruin?

It would be good if we knew what happens to an economy that doubles the amount of total resources that are directed towards its non-productive elders.  If there is a point where an economy would stop being viable, then the concerns about minor increases to pension benefits due to longevity increases are immaterial.  The ruined economy sill simply not be able to pay the basic benefits.

It seems highly likely that the systems that were imagined in the last 100 years will not stand up to the pressures of the aging Baby Boomers.  The discussion that at least in the US is not happening about funding for retiree medical and income needs may well be the wrong discussion.  The discussion that is needed is to ask how the economy will survive the strain of the very large pool of elders.

Schiller’s family farm example leads to an immediate suggestion.  One that many people are coming to privately, even if there is little public discussion.  That suggestion is a complete rethinking of retirement and employment for elders.  An honest evaluation of the real economic impact of the exploding numbers of elders is very likely to reveal that it is just not practical for an economy to provide for 20 – 25 years of leisure to a large fraction of its population.

This is a situation where our simple extrapolatory approach to assessing risk is inadequate.  The future will most certainly be different from an extrapolation of the past.

ERM in a Low Interest Rate Environment

(Excerpts from presenation at Riskminds USA)

A discussion of how the current low interest rate environment impacts choices for (1) interest rate risk, (2) other risks and (3) Enterprise Risk Management.
How an insurer might react to low interest rates depends to a large extent on risk taking strategy and their point of view about interest rate risk.  There are four primary strategies for interest rate risk:

• Minimize Risk
• The Classic ALM approach is designed to minimize risk.  Duration mismatch is a measure of the degree to which you failed to achieve risk minimization.  Most ALM programs allow for an acceptable level of mismatch which might be an operational risk acceptance or it might be an option to take some interest rate risk tactically.  Risk is evaluated compared to Zero (matched position).
• Accumulate Risk
• The classic approach of banks to interest rate risk is to accumulate it.  The Japan carry trade is an interest rate accumulation trade.  Life Insurers usually Accumulate Mortality Risk.  Non-Life Insurers usually Accumulate attritional Risks  Accumulation of risk usually means that there is no limit to the amount of the risk that may be taken if it is priced right.  Risk is evaluated compared to expected cost using Utility theory – accept risk if expected value >0.
• Manage Risk
• The New ERM approach to Risk is to Manage Risk by looking at Risk vs. Reward for the portfolio of risks including diversification effects.  Taking a Strategic or Tactical approach to making choices – Return Targets “Over the Cycle” or “Every Year”.  Risk is evaluate with an Economic Capital model.  Risk means increase in total enterprise Economic Capital.
• Diversify Risk
• Many firms pay attention to diversification, but few make it the cornerstone to their ERM.  Firms focused on diversification will accumulate a risk as long as it does not come to dominate their risk profile and if it is expected to be profitable, often taking a purely  Tactical approach to which risks that they will accumulate.  They may not even have a chosen Long Term Strategic view of most risks.  They evaluate each risk in comparison to other risks of the enterprise.  The target is to have no single large risk concentration.

There are two aspects of Point of View that you need to be clear about:

• Long Term Strategic vs. Short Term Tactical

  • You might ignore both and imply avoid a risk

  • You might ignore Strategic and take risks tactically that might not make sense in the long run

  • You might Strategically decide to take a risk and ignore Tactical which means you take the risk no matter the environment

  • You might pay attention to both and always take the risk but vary the amount of the risk

• Going Concern vs. Going out of Business

  • Classic ALM (and Economic Capital models) use a “going out of business” model

  • But the “Going Concern” model is much more complicated and requires assumptions about future business and should include a going out of business assumption

With these questions resolved a company can go about setting their strategy for interest rate risk taking in a low interest environment.
To do that they may want to look at three scenarios:

·Scenario 1 – Interest Rates stay low

·Scenario 2 – Interest Rates increase slowly

·Scenario 3 – Interest Rates increase quickly
For each scenario, look at the implications for both interest rate risk as well as all of the other aspects of their risk profile and their business strategy.  If a scenario shows results that are unacceptable, then the planners and risk managers need to develop strategies to avoid or mitigate the projected problem, should that scenario come to pass as well as triggers for initiating those activities should the scenario appear imminent.

Echo Chamber Risk Models

The dilemma is a classic – in order for a risk model to be credible, it must be an Echo Chamber – it must reflect the starting prejudices of management. But to be useful – and worth the time and effort of building it – it must provide some insights that management did not have before building the model.

The first thing that may be needed is to realize that the big risk model cannot be the only tool for risk management.  The Big Risk Model, also known as the Economic Capital Model, is NOT the Swiss Army Knife of risk management.  This Echo Chamber issue is only one reason why.

It is actually a good thing that the risk model reflects the beliefs of management and therefore gets credibility.  The model can then perform the one function that it is actually suited for.  That is to facilitate the process of looking at all of the risks of the firm on the same basis and to provide information about how those risks add up to make up the total risk of the firm.

That is very, very valuable to a risk management program that strives to be Enterprise-wide in scope.  The various risks of the firm can then be compared one to another.  The aggregation of risk can be explored.

All based on the views of management about the underlying characteristics of the risks. That functionality allows a quantum leap in the ability to understand and consistently manage the risks of the firm.

Before creating this capability, the risks of each firm were managed totally separately.  Some risks were highly restricted and others were allowed to grow in a mostly uncontrolled fashion.  With a credible risk model, management needs to face their inconsistencies embedded in the historical risk management of the firm.

Some firms look into this mirror and see their problems and immediately make plans to rationalize their risk profile.  Others lash out at the model in a shoot the messenger fashion.  A few will claim that they are running an ERM program, but the new information about risk will result in absolutely no change in risk profile.

It is difficult to imagine that a firm that had no clear idea of aggregate risk and the relative size of the components thereof would find absolutely nothing that needs adjustment.  Often it is a lack of political will within the firm to act upon the new risk knowledge.

For example, when major insurers started to create the economic capital models in the early part of this century, many found that their equity risk exposure was very large compared to their other risks and to their business strategy of being an insurer rather than an equity mutual fund.  Some firms used this new information to help guide a divestiture of equity risk.  Others delayed and delayed even while saying that they had too much equity risk.  Those firms were politically unable to use the new risk information to reduce the equity position of the group.  More than one major business segment had heavy equity positions and they could not choose which to tell to reduce.  They also rejected the idea of reducing exposure through hedging, perhaps because there was a belief at the top of the firm that the extra return of equities was worth the extra risk.

This situation is not at all unique to equity risk.   Other firms had the same experience with Catastrophe risks, interest rate risks and Casualty risk concentrations.

A risk model that was not an Echo Chamber model would be any use at all in these situation above. The differences between management beliefs and the model assumptions of a non Echo Chamber model would result in it being left out of the discussion entirely.

Other methods, such as stress tests can be used to bring in alternate views of the risks.

So an Echo Chamber is useful, but only if you are willing to listen to what you are saying.

Risk Assessment is always Opinion

Risk Assessment is most often done with very high tech models.

There is a cycle for risk models though.  The cycle starts with a simple model and progresses to ever more sophisticated models.  The ability to calculate risk at any time of the day or night becomes an achievable goal.

But just as the models get to be almost perfect, something often happens.  People start to doubt the model.  Then it shifts from sporadic doubt to rampant disbelief.  Then the process reaches its final stage and the model is totally ignored and abandoned.

What is the cause of that cycle?  It is caused by the fact that the process of modeling is always built on an opinion.  But as the model gets more and more sophisticated, the modelers forget the basic opinion.  They come to feel that the sophistication makes the model a machine that is capable of producing ultimate truth.

But folks who are not involved in the modeling, who are not drawn in to the process of creating greater and greater refinement to the risk assessments, will judge the model by the degree to which it helps with managing the business.  By the results of management judgements that are informed by the models.

The models will of course be perfectly fine when they deal with events that occur within one standard deviation of the mean.  Those events happen fairly frequently and there will be plenty of data to calibrate the frequency for those events.

But that is not where the real risk is located – within one standard deviation.

Real risk is most often found at least 2 standard deviations out.

Nassim Taleb has indicated that it is important to notice that the most significant risks are always out so far in the distribution that there is never enough data to properly calibrate the model.

But Taleb would only be correct if the important information about a risk is the PAST frequency.

That is not correct.  The important thing about risks is the FUTURE frequency.  The future frequency is unknowable.

But you can have an opinion about that frequency.

1. Your opinion could be that the future will be just like the past.
2. Your opinion could be that the future will be worse than the past.
3. Your opinion could be that the future will be better than the past.
4. Your opinion could be that you do not know the future.

You may form that opinion based on the opinion that seems to be implied by the market prices, or by listening to experts.

The folks with opinion 1 tend to build the models.  They can collect the data to calibrate their models.  But the idea that the future will be just like the past is simply their OPINION.  They do not know.

The folks with opinion 2 tend to try to avoid risks.  They do not need models to do that.

The folks with opinion 3 tend to take risks that they think are overpriced from the folks with opinions 1 & 2.  Models get n their way.

The folks with opinion 4 do not believe in models.

So the people who have opinion 1 look around and see that everyone who makes models believes that the future will be just like the past and they eventually come to believe that it is the TRUTH, not just an OPINION.

They come to believe that people with opinions 2,3,4 are all misguided.

But in fact, sometimes the future is riskier than the past.  Sometimes it is less risks.  And sometimes, it is just too uncertain to tell (like right now).

And sometimes the future is just like the past.  And the models work just fine.

Cellphone Danger

The WHO has just released a statement about possible cancer risk from cell phones.

Cell Phones are definitely dangerous.  Just try walking down any street.  Watch people suddenly stop walking or erratically change their pace of walking, even in a crowded sidewalk.  Invariably they have a cell phone up to their ear.  It is clear that cell phones suck the self preservation part of the brain right out of the ear.

And much more risky is the effect of cell phones on driving.  Some safety experts attribute as many as half of the auto accidents in the US to cell phones.  Cell phones seem to prevent people from noticing red lights, stop signs, stopped vehicles and pedestrians in their way. Thousands of deaths and millions of damage.

The cancer risk is the least part of the risk of cell phones.

Volume Variances and Rate Variances

There is only one reason why you might think that you really need to frequently use a complex stochastic model to measure your risks.  That would be because you do not know how risky your activities might be at any point in time.

Some risks are the type where you might not know what you got when you wrote the risk.  This happens at underwriting.

Some risks are the type that do not stay the same over time.  This could be reserve risk on long tailed coverages or any risk on any naked position that is extended over time.

Others require constant painstaking adjustment to hedging or other offsets.  Hedged positions or ALM systems fall into this category.

These are all rate variances.  The rate of risk per unit of activity is uncontrolled. Volume variances are usually easy to see.  They are evidenced by different volumes of activities.  You might easily see that you have more insurance risk because you wrote more insurance coverages.

But uncontrolled Rate variances seems to be a particularly scarey situation.

It seems that the entire purpose of risk management is to reduce the degree to which there might be uncontrolled rate variances.

So the need for a complex model seems to be proof that the risk management is inadequate.

A good underwriting system should make it so that you do know the risk you are writing – whether it is higher or lower than expected.

For the risks that might change over time, it you have no plans other than to stay long, then you are using the model to tell you how much to change your plans because of a decision to write and then not further manage long tailed risks.  The existence of a model does not make that practice actually risk management.  It seems like the tail wagging the dog.  Much better to develop management options for those long tailed risks.  Has anyone done any risk reward analysis on the decision to keep the long tailed exposure  looking at the opportunity risk that you will sometime in the future need to do less profitable business because of this strategy?

For the risks that are managed via hedging and/or ALM,  what is needed is a good system to making sure that the retained risk never ever exceeds the risk tolerance.  Making sure that there never is a rate variance.

The complex risk model does not seem to be a need for firms unless they suspect that they have these serious flaws in their risk management program or thinking AND they believe that they are able to control their model risk better than their actual risk.

The entire concept seems suspect.

Riskviews would suggest that if you think that your firm has uncontrolled rate variances, then you should not sleep until you get them under control.

Then you will not need a complex model.

Bet they do not believe in preparing for the future

The New York Times uses the word “bet” extremely frequently. In almost every situation where they are describing someone making a choice about the future, they describe that choice as “betting” on a particular outcome.

It seems that in the world view, someone cannot possibly make a careful, sober choice of course of action.  They can only “bet” on one outcome or another.

Riskviews noticed this when reading the nth story about a financial firm.  Of course, in the NYT language ALL hedge activity is betting.  Even if a firm is already long a risk, if they short that same exact risk to offset their long position, then they are described as “betting” against the risk that they were previously long.

Of course, if you had simply retained your long position and it either gained or lost money, then your “bet” would have been either a winner or a loser.

, via Wikimedia Commons”]In terms of Plural Rationalities, that means that the NYT has a purely PRAGMATIST point of view towards risk.  A PRAGMATIST believes that no one knows the future so any decision about the future is exactly the same as a bet on the spin of a roulette wheel, a gamble.  If you do not believe me, go to their website and do a search on the word “bet”.  You will be amazed at how many times it comes up and you will see that they are always using it to describe these choice about the future.

Now Plural Rationalities suggests that there are three other points of view about the future and risk in the future:

• Maximizers – believe that things are self correcting so if you keep your head there is little risk in the long run.
• Conservators – believe that there is a great deal of risk so you should keep away from taking very much risk
• Managers – who believe that there is a moderate amount of risk and if you are careful, you can take risks and get ahead

That a major voice in our country has gone over to the Pragmatist point of view is a sign of the times.  Things have been very uncertain for several years now.  It is very difficult to tell which way the economy is going.  So being a Pragmatist may just be their temporary reaction to the environment.

When things get more predictable, perhaps they will shift their point of view to that of the Manager.  And over time, as the Managers show more and more success, they may take up the viewpoint of the Maximizer as the next bubble forms somewhere.  Which makes way for the Conservator viewpoint as the bubble bursts.

And so it goes.

When Imagination Fails

Most often when there is a regime change. Many work to change things back to the way that they were. Others simply wait for things to return to normal.

It is often a failure of imagination.  People cannot imagine that the world is not going to be what it was.

As many folks are fighting changes that came about as a result of the Global Financial Crisis, they are pushing and pushing for things to go back to the way that they were.  They understand that world, they even think that they understand how to prosper in that world.  They believe that if you take away the single thing that went sooo bad, the sub prime mortgages, that everything else will go back to being just as it was.

Nothing could be further from the truth.  Things will never go back to how they were.  Much of how things were was supported by the excess wealth that we all thought that we had because of the inflated values of our homes.

And does going back to the world of 2005 but without sub prime mortgages make any sense anyway?  Do we really think that we know which of the many things that happened prior to the Crisis were the actual causes?

Many things changed in the 78 years between Global FInancial Crises.  Some of them were the reason for the increases to global wealth and some were the causes of the abrupt reversal of the favorable economic trends.

The changes that are resulting from the 2008 GFC could be the start of the next regime.  Or else, we coud go through a start and stop process as the US did in the 1930’s where government policymakers shifted back and forth in their approach to the economy and to financial market and financial market participants.  Eventually they settled on a system.  The economy went through good growth under that system until the late 1960’s when a new set of major changes were made and a new regime was started.  The 1970’s were a period of financial turmoil into the early 1980’s until that regime settled into a stable situation.

A few will adapt quickly and thrive in the new regimes.  Others cling to the idea that somehow someway, the good old days will come back.

Take a look at the past experience.  It is time for a new regime.  It has taken ten years or more for a new regime to settle.  We have five or six years to go.

Use your imagination.  Imagine a new future regime.

 

Preparing for the Zombie Apocalypse

The CDC now has a page with preparedness tips for the next Zombie Apocalypse.

If you read that closely, you might notice that the preparedness tips are exactly the same as their tips for Hurricanes or Pandemics.

So maybe this is a good way to get folks to pay attention to disaster preparedness?

Must be better than the way that that some office buildings make preparedness into a mind numbing drill that is certain to take the edge off of any possible hint of preparedness.

Perhaps a suggestion for your next fire drill – have zombies show up and find out how many people were ready and how many got eaten by the zombies.