Exceeding Risk Limits – – 10 Investor Questions (8)

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

This sounds like a “when did you stop beating your wife” type question.  But it isn’t.  In fact it is the opposite.

The wrong answer is “we didn’t have any positions in excess of limits.  That answer indicates that the limits are not effective.  They are too high or else, the company has a Berlin Wall type limit system – they shoot anyone who gets close.  That sort of limit system discourages thoughtful risk taking.  It insists on fearful risk taking.  Everyone will be so afraid of getting near the limits that each person will invent their own checkpoint that is lower than the limit.  They will stay below the checkpoint instead of the limit.  The Berlin Wall type of limit system ends up encouraging everyone in the company to create their own checkpoints.  It takes the decision making on risk out of top management hands.

The right answer is that the CEO knows that there have been breaches of the limits and knows why and knows what happened as a result of the breach.  The breaches are not a problem is they are low in both frequency and severity.

Having a few breaches means that the people who are empowered to take risks are also looking to find the best opportunities for the firm and are making every effort to make good deals.  They are working as hard as they can to win and they are sometimes a little over enthusiastic.  The company has a system that finds these instances and communicates them all the way up to the top, which they should.  Another reason why the CEO might say that there are no breaches is because the CEO is never told about the breaches.

And the consequences of breaches are important as well.  One firm once told RISKVIEWS that whenever there was a breach of a limit that management reacted by raising the limit!!!

That is equivalent to having no limits.  It might be a good result to raise the limit occasionally.  But the main reaction to breaching a limit should be to work to get the situation back to within the limit.  For market traded investments, the easiest option is to put on a hedge or to sell the position.  For insurance risk, the option is to obtain reinsurance.  Another reaction might be to cease to accept similar risks until that risk class is within the limit.  Finally, there may be a reaction that is some sort of sanction on the person who caused the breach.  In some cases the breach may be so significant and so clearly against the policies of the company that termination might be the sanction.  That is an unusual situation.  In some cases, a person is transfered either temporarily or permanently to a different position.  In some cases, the sanction might be an adjustment to bonus.  Most common is a reprimand.

The situations where the reaction is to raise the limit might be those where the limit breach was for a transaction that is clearly of exceedingly favorable prospects – one where the risk reward prospects are clearly superior.

In a company with a really vibrant risk management culture, the CEO might want to tell you a story as long and nuanced as the above.  Give that CEO extra points.

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