Risk models can be used primarily to answer two very important questions for an enterprise whose primary activity is the risk business.
- How did we do?
- What should we do?
The “how did we do” question looks backwards on the past, usually for 90 days or a full year. For answering that question properly for a firm in the risk business it is absolutely necessary to have information about the amount of risk that the firm is exposed to during that period.
The “what should we do” question looks forward on the future. The proper time period for looking forward is the same as the length of the shadow into the future of the decision. Most decisions that are important enough to be brought to the attention of top management or the board of a company in the risk business have a shadow that extends past one year.
That means that the standard capital model with its one year time frame should NOT be the basis for making WHAT SHOULD WE DO? decisions. That is, unless you plan on selling the company at the end of the year.
Let’s think about it just a little bit.
Suppose the decision is to buy a laptop computer for the business use of one of the employees of an insurer. You can use two streams of analysis for that decision. You can assume that the only use of that computer is what utility that can be had from the computer during the calendar year of purchase and then you plan to sell the computer, along with the rest of the company, at the end of the calendar year. The computer is valued at the end of the year at a fair market value. Or you can project forward, the utility that you will get from that employee having a computer over its useful life, perhaps three years.
The first calculation is useful. It tells us “HOW DID WE DO?” at the end of the calendar year. But it not a sensible basis to make the decision about whether to buy the computer or not. The reason for that is not because there is anything wrong with the calendar year calculation. In theory, you could even run your company by deciding at the end of each calendar year, whether you wanted to continue running the company or not. And then if you decide to continue, you then must decide whether to sell every laptop or not, and similarly to sell every part of your business or not.
Most companies will automatically make the decision to continue, will not consider selling every part of their company, even if they have gone through the trouble of doing a “for sale” valuation of everything. That approach fits better with Herbert Simon’s “Satisficing” idea than with the theory of maximizing value of the enterprise.
But from a less theoretical point of view, putting absolutely everything on the table for a decision could be very time consuming. So what most companies is to imagine a set of conditions for the future when a decision is made and then as the future unfolds, it it does not deviate significantly from those assumptions, decisions are not reopened. But unfortunately, at many companies, this process is not an explicit conscious process. It is more vague and ad hoc.
Moving away from laptops to risk. For a risk decision, first notice that almost all risk decisions made by insurers will have an effect for multiple years. But decision makers will often look forward one year at financial statement impact. They look forward one year at a projection of the answer to the “How DID WE DO? question. This will only produce a full indication of the merit of a proposal if the forward looking parts of the statement are set to reflect the full future of the activity.
The idea of using fair value for liabilities is one attempt to put the liability values on a basis that can be used for both the “How did we do?” and the “What should we do?” decisions.
But it is unclear whether there is an equivalent adjustment that can be made to the risk capital. To answer “How did we do?” the risk capital needed has been defined to be the capital needed right now. But to determine “What should we do?”, the capital effect that is needed is the effect over the entire future. There is a current year cost of capital effect that is easily calculated.
But there is also the effect of the future capital that will be tied up because of the actions taken today.
The argument is made that by using the right current year values, the decisions can really be looked at as a series of one year decisions. But that fails to be accurate for at least two reasons:
- Friction in selling or closing out of a long term position. The values posted, even though they are called fair value rarely reflect the true value less transaction costs that could be received or would need to be paid to close out of a position. It is another one of those theoretical fictions like a frictionless surface. Such values might be a good starting point for negotiating a sale, but anyone who has ever been involved in an actual transaction knows that the actual closing price is usually different. Even the values recorded for liquid assets like common equity are not really the amounts that can be achieved at sale tomorrow for anyone’s actual holdings. If the risk that you want to shed is traded like stocks AND your position is not material to the amounts normally traded, then you might get more or less than the recorded fair value. However, most risk positions that are of concern are not traded in a liquid market and in fact are usually totally one of a kind risks that are expensive to evaluate. A potential counterparty will seek through a hearty negotiation process to find your walk away price and try to get just a litle bit more than that.
- Capital Availability – the series of one year decisions idea also depends on the assumption that capital will always be available in the future at the same cost as it is currently. That is not always the case. In late 2008 and 2009, capital was scarce or not available. Companies who made commitments that required future capital funding were really scrambling. Many ended up needing to change their commitments and others who could not had to enter into unfavorable deals to raise the capital that they needed, sometimes needing to take on new partners on terms that were tilted against their existing owners. In other time, cheap capital suddenly becomes dear. That happened when letters of credit that had been used to fulfill offshore reinsurer collateral requirements suddenly counted when determining bank capital which resulted in a 300% increase in cost.
RISKVIEWS says that the one year decision model is also just a bad idea because it makes no sense for a business that does only multi year transactions to pretend that they are in a one year business. It is a part of the general thrust in financial reporting and risk management to try to treat everything like a bank trading desk. And also part of a movement led by CFOs of the largest international insurers to seek to only have one set of numbers used for all financial decision-making. The trading desk approach gave a theoretical basis for a one set of numbers financial statement. However, like much of financial economics, the theory ignores a number of major practicalities. That is, it doesn’t work in the real world at all times.
So RISKVIEWS proposes that the solution is to acknowledge that the two decisions require different information.