Archive for June 2011

Frequency vs. Likelihood

June 26, 2011

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

June 22, 2011

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

June 19, 2011

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

June 17, 2011

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

June 16, 2011

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

June 15, 2011

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

June 14, 2011

(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.

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