Archive for January 2013

Real Resilience is not what you think it is

January 30, 2013

There is confusion about the term Resilience.  To many people, it means the ability to withstand stress. To some people, the ultimate resilience comes from thick walls (or huge capital requirements).  The picture above is one of many thousands like it that shows the ultimate result of seeking resilience in a static manner.

The dictionary has something slightly different:

the power or ability to return to the original form, position, etc., after being bent, compressed, or stretched; elasticity.

But Holling, a prominent ecologist, suggests something much more robust.  He suggests that a resilient species will survive all of the stressors that attack it from its environment and thrive when conditions become benign.

“a major strategy selected is not one maximizing either efficiency or a particular reward, but one which allows persistence by maintaining flexibility above all else. A population responds to any environmental change by the initiation of a series of physiological, behavioral, ecological, and genetic changes that restore its ability to respond to subsequent unpredictable environmental changes. Variability over space and time results in variability in numbers, and with this variability the population can simultaneously retain genetic and behavioral types that can maintain their existence in low populations together with others that can capitalize on opportunities for dramatic increase. The more homogeneous the environment in space and time, the more likely is the system to have low fluctuations and low resilience.”  CS Holling, Resilience and Stability of Ecological Systems

Real resilience is ADAPTABILITY.  The ability to change your approach.  To find the way to survive the extreme adverse scenario without devoting so much resources to safety that you miss the chance to “capitalize on opportunities for dramatic increase” as Holling says.

Does your ERM program build walls, thicker and thicker, or does it build adaptability?

How many people in your organization do you think would know what to do in the event of an adverse situation that has never happened before?

But what is this adaptablity?  In two studies in the late 1990’s, researchers studied thousands of crisis situations and identified 8 dimensions of adaptability for individuals.  See study here.

Handling emergencies or crisis situations

Reacting with appropriate and proper urgency in life threatening, dangerous, or emergency situations; quickly analyzing options for dealing with danger or crises and their implications; making split-second decisions based on clear and focused thinking; maintaining emotional control and objectivity while keeping focused on the situation at hand; stepping up to take action and handle danger or emergencies as necessary and appropriate.

Handling work stress

Remaining composed and cool when faced with difficult circumstances or a highly demanding workload or schedule; not overreacting to unexpected news or situations; managing frustration well by directing effort to constructive solutions rather than blaming others; demonstrating resilience and the highest levels of professionalism in stressful circumstances; acting as a calming and settling influence to whom others look for guidance.

Solving problems creatively

Employing unique types of analyses and generating new, innovative ideas in complex areas; turning problems upside-down and inside-out to find fresh, new approaches; integrating seemingly unrelated information and developing creative solutions; entertaining wide-ranging possibilities others may miss, thinking outside the given parameters to see if there is a more effective approach; developing innovative methods of obtaining or using resources when insufficient resources are available to do the job.

Dealing with uncertain and unpredictable work situations

Taking effective action when necessary without having to know the total picture or have all the facts at hand; readily and easily changing gears in response to unpredictable or unexpected events and circumstances; effectively adjusting plans, goals, actions, or priorities to deal with changing situations; imposing structure for self and others that provide as much focus as possible in dynamic situations; not needing things to be black and white; refusing to be paralyzed by uncertainty or ambiguity.

Learning work tasks, technologies, and procedures

Demonstrating enthusiasm for learning new approaches and technologies for conducting work; doing what is necessary to keep knowledge and skills current; quickly and proficiently learning new methods or how to perform previously unlearned tasks; adjusting to new work processes and procedures; anticipating changes in the work demands and searching for and participating in assignments or training that will prepare self for these changes; taking action to improve work performance deficiencies.

Demonstrating interpersonal adaptability

Being flexible and open-minded when dealing with others; listening to and considering others’ viewpoints and opinions and altering own opinion when it is appropriate to do so; being open and accepting of negative or developmental feedback regarding work; working well and developing effective relationships with highly diverse personalities; demonstrating keen insight of others’ behavior and tailoring own behavior to persuade, influence, or work more effectively with them.

Demonstrating cultural adaptability

Taking action to learn about and understand the climate, orientation, needs, and values of other groups, organizations, or cultures; integrating well into and being comfortable with different values, customs, and cultures; willingly adjusting behavior or appearance as necessary to comply with or show respect for others’ values and customs; understanding the implications of one’s actions and adjusting approach to maintain positive relationships with other groups, organizations, or cultures.

Demonstrating physically oriented adaptability

Adjusting to challenging environmental states such as extreme heat, humidity, cold, or dirtiness; frequently pushing self physically to complete strenuous or demanding tasks; adjusting weight and muscular strength or becoming proficient in performing physical tasks as necessary for the job.

The questions that remains are:

Is adaptability of a company anything different from adaptability of the people in the company?

How does a company get adaptable people?  Are people born that way or can they be trained?

2012 Survey for Japanese Risk Managers

January 25, 2013

The following is an excerpt from the Executive Summary of the report:

Defining Risk Management within an Organization:

Results of the 2012 Survey for Japanese Risk Managers

by Kenji Fujii and Yuji Morimoto

This survey was conducted early this year by the Tokyo Risk Managers Association (TRMA) as a follow-up to the TRMA financial crisis questionnaire in 2009. 

Following is the summary of what we learned from the survey result.

  • First of all, the involvement of senior management in risk management has increased.
  • On the other hand, there were many responses stating that effective discussions at Risk Management Committee meetings had not progressed very much; that the status and authority of Chief Risk Officers (CRO) had not been strengthened very much; and that sufficient resources are still not being allocated to Risk Management Divisions. These responses suggest that although senior management are expressing an increased interest in risk management, this interest does notnecessarily tie into concrete reinforcements.
  • Regarding the risk appetite, more than half of respondents were of the opinion that risk should be used as a standard when creating business plans, but at the same time, it became clear that this approach has not penetrated or become entrenched as part of actual operations.
  • Regarding capital management, two opinions were at odds; the opinion that regulatory capital and economic capital are approaching one another, and the opinion that they are drifting apart. Responses also indicated continued struggles with regard to the structure of approaches and frameworks regarding capital management, and a greater number of respondents expressed the opinion that there is meaning in creating recovery and resolution plans.
  • Regarding stress tests, there were indications that integrated stress tests are being employed more broadly, and it appears that reports to management on test results have already become commonplace. The issue raised most frequently with regard to stress tests was the “establishing appropriate scenarios.”
  • Although many respondents indicated that liquidity risk management has improved, these opinions were not yet in the majority. There were also conflicting opinions regarding whether or not the strengthening of liquidity risk regulations reduced liquidity risks.
  • Regarding risk data, although many respondents said that there have been improvements, it became clear that many members are concerned about the fact that this data continues to be stored in various systems in a scattered fashion.

The entire paper is available here.

Five components of resilience – robustness, redundancy, resourcefulness, response and recovery

January 24, 2013

Adapted from the WEF Global Risks 2013 Report  (Minimal editing to focus discussion on “an organization” rather than “a country”)

Resilience Characteristics (Robustness, Redundancy and Resourcefulness)

The following three components of resilience are used to describe an organization’s state of resilience. These components should be designed into a system and, as such, will enable assessments of an organization’s inherent resilience capabilities.  

A. Robustness

Robustness incorporates the concept of reliability and refers to the ability to absorb and withstand disturbances and crises. The assumptions underlying this component of resilience are that: 1) if fail-safes and firewalls are designed into an organization’s critical networks, and 2) if that organization’s decision-making chains of command become more modular in response to changing circumstances, then potential damage to one part of an organization is less likely to spread far and wide.

Example of Attributes

— Monitoring system health: Regularly monitoring and assessing the quality of the subsystem ensures its reliability.

— Modularity: Mechanisms designed to prevent unexpected shocks in one part of a system from spreading to other parts of a system can localize their impact, as happened with the contagion from investment banking to retail banking during the 2007-2008 financial crisis.

— Adaptive decision-making models: Networked managerial structures can allow an organization to become more or less centralized depending on circumstances, such as when branch offices of the Japanese retailer Lawson’s continued operating through the serious disruptions of the Great East Japan Earthquake in 2011.  These measures can include having in place the right investment and incentive structures to overcome competing interests.

B. Redundancy

Redundancy involves having excess capacity and back-up systems, which enable the maintenance of core functionality in the event of disturbances.  This component assumes that an organization will be less likely to experience a collapse in the wake of stresses or failures of some of its infrastructure, if the design of that organization’s critical infrastructure and institutions incorporates a diversity of overlapping methods, policies, strategies or services to accomplish objects and fulfill purposes.

Examples of Attributes

— Redundancy of critical infrastructure: Designing replication of modules which are not strictly necessary to maintaining core function day to day, but are necessary to maintaining core function in the event of crises.

— Diversity of solutions and strategy: Promoting diversity of mechanisms for a given function. Balancing diversity with efficiency and redundancy will enable organizations to cope and adapt better than those that have none.

C. Resourcefulness

Resourcefulness means the ability to adapt to crises, respond flexibly and – when possible – transform a negative impact into a positive.  For a system to be adaptive means that it has inherent flexibility, which is crucial to enabling the ability to influence of resilience.  The assumption underlying this component of resilience is that if organizations can build trust within their networks of suppliers, employees and customers and are able to self-organize, then they are more likely to spontaneously react and discover solutions to resolve unanticipated challenges when larger industry and community institutions and governance systems are challenged or fail.

Example of Attributes

— Capacity for self-organization: This includes factors such as the extent of social and human capital, the relationship between social networks and organizational structures, and the existence of institutions that enable face-to-face networking. These factors are critical in circumstances such as failures of government institutions when organizations need to self-organize and continue to dobtain essential services.

— Creativity and innovation: The ability to innovate is linked to the availability of spare resources and the rigidity of boundaries between disciplines, departments and social groups within the organization.

Resilience Performance (Response and Recovery)

These two components of resilience describe how a system performs in the event of crises. They provide evidence of resilience when actual crises occur.  Response and recovery are dependent on risk, event and time. These components will provide the ability to compare systems and feed the measurements and results to calibrate the resilience characteristics.

D. Response

Response means the ability to mobilize quickly in the face of crises. This component of resilience assesses whether an organization has good methods for gathering relevant information from all parts of society and communicating the relevant data and information to others, as well as the ability for decision makers to recognize emerging issues quickly.

Example of Attributes

— Communication: Effective communication and trust in the information conveyed increase the likelihood that, in the event of a crisis, stakeholders are able to disseminate and share information quickly, and to ensure cooperation and quick response from the audience.

— Inclusive participation: Inclusive participation among all stakeholders can build a shared understanding of the issues underpinning crises and acute risks to the organization, reduce the possibility of important interdependencies being overlooked, and strengthen trust among participants.

E. Recovery

Recovery means the ability to regain a degree of normality after a crisis or event, including the ability of a system to be flexible and adaptable and to evolve to deal with the new or changed circumstances after the manifestation of a risk.  This component of resilience assesses the organization’s capacities and strategies for feeding information throughout the organization,  and the ability for decision-makers to take action to adapt to changing circumstances and  incorporating new situations into business strategies,.

Example of Attributes

— Active “horizon scanning”: Critical to this attribute are multi-stakeholder processes tasked with uncovering gaps in existing knowledge and commissioning research to fill those gaps.

— Responsive feedback mechanisms: Systems to translate new information from horizon-scanning activities into action – for example, defining “automatic policy adjustments triggers” – can clarify circumstances in which policies must be reassessed.

As an example of the overlapping and complementary nature of these attributes, inclusive participation is listed as a key attribute of response, but it is also vital in other areas such as recovery and resourcefulness. Also inherent in all resilience characteristics, though referenced above only in the attribute of adaptive decision-making models, are investment and incentive structures and design requirements to overcome collective action problems and competing interests. There are many individual stakeholders who would benefit from greater shared resilience but currently lack either the incentive or feel too pressed for time and resources to take the necessary actions.

Diversification of Risks

January 22, 2013

There are records showing that the power of diversification of risks was known to the ancients.  Investors who financed trading ships clearly favored taking fractions of a number of ships to owning all of a single ship.

The benefits of diversification are clear.  The math is highly compelling.  A portfolio of n risks of the same size A that truly independent have a volatility that is a fraction of the volatility of totally dependent risks.

Here is a simple example.  There is a 1 in 200 chance that a house will be totally destroyed by fire.  Company A writes an insurance policy on one $500,000 house that would pay for replacement in the event of a total loss.  That means that company A has a 1 in 200 chance of paying a $500,000 claim.  Company B decides to write insurance that pays a maximum of $50,000 in the event of a total loss.  How many policies do you think that Company B needs to write to have a 1 in 200 chance of paying $500,000 of claims if the risks are all totally independent and exactly as prone to claims as the $500k house?

The answer is an amazing 900 policies or 90 times as much insurance!

When an insurer is able to write insurance on independent risks, then with each additional risk, the relative volatility of the book of insurance decreases.  Optimal diversification occurs when the independent risks are all of the same size.  For insurers, the market is competitive enough that the company writing the 900 policies is not able to get a profit margin that is proportionate to the individual risks.  The laws of micro economics work in insurance to drive the profit margins down to a level that is at or below the level that makes sense for the actual risk retained.  This provides the most compelling argument for the price for insurance for consumers, they are getting most of the benefit of diversification through the competitive mechanism described above.  Because of this, things are even worse for the first insurer with the one policy.  To the extent that there is a competitive market for insurance for that one $500k house, that insurer will only be able to get a profit margin that is commensurate with the risk of a diversified portfolio of risks. 

It is curious to note than in many situations, both insurers and individuals do not diversify.  RISKVIEWS would suggest that may be explained by imagining that they either forget about diversification when making single decisions (they are acting irrationally), or that they are acting rationally and believe that the returns for the concentrated risk that they undertake are sufficiently large to justify the added risk.

The table below shows the degree to which individuals in various large companies are acting against the principle of diversification.

concentration

From a diversification point of view, the P&G folks above are mostly like the insurer above that writes the one $500k policy.  They may believe that P&G is less risky than a diversified portfolio of stocks.  Unlike the insurer, where the constraint on the amount of business that they can write is the 1/200 loss potential, the investor in this case is constrained by the amount of funds to be invested.  So if a $500k 401k account with P&G stock has a likelihood of losing 100% of value of 1/200, then a portfolio of 20 $25k positions in similarly risky companies would have a likelihood of losing 15% of value of 1/1000.  Larger losses would have much lower likelihood.

With that kind of math in its favor, it is hard to imagine that the holdings in employer stock in the 401ks represents a rational estimation of higher returns, especially not on a risk adjusted basis.

People must just not be at all aware of how diversification benefits them.

Or, there is another explanation, in the case of stock investments.  It can be most easily framed in terms of the Capital Asset Pricing Theory(CAPM) terms.  CAPM suggests that stock market returns can be represented by a market or systematic component (beta) and company specific component (alpha).  Most stocks have a significantly positive beta.  In work that RISKVIEWS has done replicating mutual find portfolios with market index portfolios, it is not uncommon for a mutual fund returns to be 90% explained by total market returns.  People may be of the opinion that since the index represents the fund, that everything is highly correlated to the index and therefore not really independent.

The simplest way to refute that thought is to show the variety of returns that can be found in the returns of the stocks in the major sectors:

Sectors

The S&P 500 return for 2012 was 16%.  Clearly, all sectors do not have returns that are closely related to the index, either in 2012 or for any other period shown here.

Both insurance companies and investors can have a large number of different risks but not be as well diversified as they would think.  That is because of the statement above that optimal diversification results when all risks are equal.  Investors like the 401k participants with half or more of their portfolio in one stock may have the other half of their money in a diversified mutual fund.  But the large size of the single position is difficult to overcome.  The same thing happens to insurers who are tempted to write just one, or a few risks that are much larger than their usual business.  The diversification benefit of their large portfolio of smaller risks disappears quickly when they add just a few much larger risks.

Diversification is the universal power tool of risk management.  But like any other tool, it must be used properly to be effective.

This is one of the seven ERM Principles for Insurers

Should we be concentrating regulatory attention on Systemic Risk?

January 1, 2013

Think of it somewhat like the town that just suffered a very bad winter season with huge snowfalls that they were unprepared for clogging up everything for weeks on end. They spend the spring fixing up and deciding what to do. Their conclusion is to have all town employees carry snowshovels at all times and to keep snow plow trucks patrolling the streets all day and all night through the entire summer. Sometime in early fall, they decide that was a waste of time and sell all the shovels and trucks by the end of the fall.

RISKVIEWS does not think that our situation will include any systemic risks that we will anticipate. We will not repeat the exact same mistakes. Systemic risk oversight will in the end be a fixed Maginot Line defense.

What we need is

  1. to figure out how to distinguish between creation of wealth by new innovation and by extraction from past innovation so that we can encourage the former and discourage the later. The former widely distributes increases in wealth while the latter concentrates it.  The former creates growth while the latter captures the benefits of future growth now – which means that we will not have them later.
  2. to understand leverage better. Look at the Minsky Financial Instability Model myself. Often, we are not honest with ourselves on the extent of debt. RISKVIEWS favors full disclosure over regulations. For example, firms should disclose the amount of debt that is implicit in derivative positions. And disclose the counterparties for that debt.
  3. to figure out how we are going to find the next big thing that will employ all of the people who are now permanently, structurally unemployed. We can keep hoping for something that increases wealth, something that merely decreases wealth less than the current situation or something that decreases wealth but employs people.
  4. to orient research into how to operate an economy in the long term with much less or no growth. Most of our economic expectations are built off of a constantly growing economy. With population about to start falling, we will necessarily experience much less growth. We don’t collectively even have any idea of what the shift to large retired populations will do to our economies.

The regulators need to focus on whatever is within their purview that gets in the way to accomplishing those things.

For the town above, that means storing the snow shovels to the winter and looking at the problems of the summer heat. They still need to keep an eye out for the next winter. But that does not mean it needs to be a primary focus NOW.


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