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.

Explore posts in the same categories: Enterprise Risk Management, Modeling


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One Comment on “Volume Variances and Rate Variances”

  1. You are quite correct.

    Imagine a two-dimensional distribution, volume crossed with price.

    Specifically, say a utility is at risk for excess demand. IF the temperature is high, then they need extra oil for electricity to run all the air conditioners….

    What then is their real risk? That BOTH the temperature is high AND the price of oil is high,

    If the weather is hot but oil is cheap, no problem. And if the price of oil soars but the weather is mild so there is not extra demand, then again the utility is ok.

    The real stress only occurs in the lower-right-hand corner; high temperature (read demand) PLUS high oil prices.

    Now there are many firms that will hedge oil prices, 100%. And there are a few markets that will insure you against high average daily temperature. But until now, there have not been any markets able to protect against the joint distribution=high oil price AND high temperature/demand.

    That sort of bet is only feasible under actuarial (stochastic modeling) pricing, NOT “what was the last trade?” mark-to-market stock-ticker pricing.

    That is the essence of the low-beta market place.

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