Open or Closed?

Moorad Choudry provides a good description of how banks think about ALM in a new article in The Actuary, Asset/liability management: solid as a rock?.  

But he misses one very important point that to RISKVIEWS explains the difference between banks and insurer/pension plans with regard to ALM.  That difference is the title of this piece.

The bank ALM model assumes that the bank will remain Open.  Therefore, the bank always has the option to obtain the funds that are needed to pay near term liabilities.  Unless the unfortunate occurrence of a liquidity problem.  The second part of this story is that banks do not mark their banking book of assets to market.  The banking book supports their “maturity transformation” business.  By keeping from that MTM step the bank keeps its large mismatch “off the books”.  This position has been the case, according to Choudry, since the the first banks.

Insurer and Pension ALM assumes that the company/fund becomes Closed and no longer has any access to new funds.  The new idea, that is a part of IFRS accounting that an insurer will mark everything to market is entirely consistent with the assumption that the company is assumed to be Closed.

That Closed company assumption along with the approach to ALM that insurers now use crept into insurance practice in the past 40 years with application of ideas that were no more than 75 years old.  One source speaks of these ideas as Anglo-American practices.  And in the discussions of Solvency II, one of the thorny topics goes back to this assumption since the German life insurance industry tends to favor an Open company approach.

The insurance company adoption of Closed company ALM started after some insurers suddenly went into the maturity transformation business in a big way only to learn that there was a definite limit to the amount of maturity transformation that could be done by an insurer relative to the capital and operations of the insurer.  Some insurers, notably The Equitable, experienced very large losses and had their business severely disrupted.  Almost 20 years later, as if to prove the necessity of the Closed company approach, General American also experienced massive losses when most funds were withdrawn from their maturity transformation business.

Looking at the ALM topic in this manner allows one to see the real and fundamental difference between the two approaches and in a non-pejorative manner.

In one sense, the insurers seem to be much too restrictive, too risk adverse, in their approach to ALM by adopting a full Closed.  Of course, insurers are not all planning on Closing,  on going out of business.  So preparing for this risk as if they were seems like extreme over caution.

On the other hand, banks, over the centuries have been subject to numerous runs and mass failures.  The Open company approach leaves a bank subject to a large contagion risk.  Once one bank has a problem, all banks may become subject to excessive withdrawals and all but the most secure banks that had been run with an Open company approach will experience severe trouble which could lead to a cascade of failures.  That is the reason why one of the fundamental functions of the Central Banks is to provide emergency liquidity to banks that are fundamentally sound.

If insurers shifted to an Open company approach to ALM, then insurers would also be subject to the same sort of fragility as the banks.  Insurers are in a different business from banks, usually providing longer term promises that require a much higher degree of confidence in their ability to be able to fulfill those promises under extremely stressful circumstances.  If insurers were operated with the same degree of fragility as banks, it is quite possible that their business model would fail completely.

Trimming Risk Positions – 10 ERM Questions from Investors – The Answer Key (6)

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:

There are a number of issues relating to this question.  First of all, does the insurer ever trim a risk position?  Some insurers are pure buy and hold.  They never think to trim a position, on either side of their balance sheet.  But it is quite possible that the CEO might know that terminology, but the CFO should.  And if the insurer actually has an ERM program then they should have considered trimming positions at some point in time.  If not, then they may just have so much excess capital that they never have felt that they had too much risk.

Another issue is whether the CEO and CFO are aware of risk position trimming.  If they are not, that might indicate that their system works well and there are never situations that need to get brought to their attention about excess risks.  Again, that is not such a good sign.  It either means that their staff never takes and significant risks that might need trimming or else there is not a good communication system as a part of their ERM system.

Risks might need trimming if either by accident or on purpose, someone directly entered into a transaction, on either side of the balance sheet, that moved the company past a risk limit.  That would never happen if there were no limits, if there is no system to check on limits or if the limits are so far above the actual expected level of activity that they are not operationally effective limits.

In addition, risk positions might need trimming for several other reasons.  A risk position that was within the limit might have changed because of a changing environment or a recalibration of a risk model.  Firms that operate hedging or ALM programs could be taking trimming actions at any time.  Firms that use cat models to assess their risk might find their positions in excess of limits when the cat models get re-calibrated as they were in the first half of 2011.

And risk positions may need to be trimmed if new opportunities come along that have better returns than existing positions on the same risk.  A firm that is expecting to operate near its limits might want to trim existing positions so that the new opportunity can be fit within the limits.

SO a firm with a good ERM program might be telling any of those stories in answer to the question.

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.

Assumptions Embedded in Risk Analysis

The picture below from Dour VanDemeter’s blog gives an interesting take on the embedded assumptions in various approaches to risk analysis and risk treatment.

But what I take from this is a realization that many firms have activity in one or two or three of those boxes, but the only box that does not assume away a major part of reality is generally empty.

In reality, most financial firms do experience market, credit and liability risks all at the same time and most firms do expect to be continuing to receive future cashflows both from past activities and from future activities.

But most firms have chosen to measure and manage their risk by assuming that one or two or even three of those things are not a concern.  By selectively putting on blinders to major aspects of their risks – first blinding their right eye, then their left, then by not looking up and finally not looking down.

Some of these processes were designed that way in earlier times when computational power would not have allowed anything more.  For many firms their affairs are so very complicated and their future is so uncertain that it is simply impractical to incorporate everything into one all encompassing risk assessment and treatment framework.

At least that is the story that folks are most likely to use.

But the fact that their activity is too complicated for them to model does not seem to send them any flashing red signal that it is possible that they really do not understand their risk.

So look at Doug’s picture and see which are the embedded assumptions in each calculation – the ones I am thinking of are the labels on the OTHER rows and columns.

For Credit VaR – the embedded assumption is that there is no Market Risk and that there is no new assets or liabilities (business is in sell-off mode)

For Interest risk VaR – the embedded assumption is that there is no credit risk nor new assets or liabilities (business is in sell-off mode)

For ALM – the embedded assumption is that there is no credit risk and business is in run-off mode.

Those are the real embedded assumptions.  We should own up to them.

Making Better Decisions using ERM

Max Rudolph provided a lecture on ERM for the University of Waterloo and the Waterloo Research institute in Insurance, Securities and Quantitative finance (WatRISQ).

Key Points:

ERM’s Role in Strategic Planning

• Understanding the Risk Profile
• Solutions are Unique
• Using Quantitative and Qualitative Tools

ERM is Not:

• A Checklist Exercize
• A Rating Agency Exercize
• Just About Risk Mitigation

Have You ever heard of the Financial Crisis?

And Much more…

Max Rudolph