Archive for the ‘Compensation’ category

Inequality and Lotteries

October 21, 2015

There has been much talk about how unacceptable the degree of financial inequality that there is in the US.  And it seems to be getting worse and worse.

But what we have seems to be exactly what most people want in general.  Probably the only part of it that most people would change is the part where they personally are not one of the fortunate wealthy few.

The lottery is the perfect example of a mechanism to achieve an unequal society.

Everyone buys a ticket for a small amount of money.  The jackpot grows until it reaches $301 million.  The winner is drawn.  The result is one rich person with $301M and everyone else goes back to their regular life and stops dreaming about becoming that one rich person – for a week at least.

If that happens several times a year and everyone is either a winner or has a low to moderate job, then a vastly unequal society develops.

After one year, there will be 3 – 4 multi-millionaires and the entire rest of the population will have wealth that is a tiny fraction of those ultra rich.  After a decade, the ranks of the ultra rich will have grown to 30 or 40.  At that point, the top .000001% of the population will have .03% of the total wealth.

Each year, the country will grow more and more unequal, with a tiny fraction of the population commanding an ever growing proportion of the total wealth.

But that is why there is no uprising against the super rich.  Everyone else believes that they might one day hit the lottery and win their position in that group.  And when that happens, they do not want a tax regime, for instance, that will just take their riches away.


Risk Reporting Conflict of Interest

March 2, 2015

We give much too little consideration to potential for conflict of interest in risk reporting.

Take for instance weather risk reporting.

Lens: Tamron 28-80mmScanned with Nikon CoolScan V ED

"Sneeuwschuiver". Licensed under CC BY-SA 2.5 via Wikimedia Commons

Many of the people who report on Weather Risk have a financial interest in bad weather.  Not that they own snow plowing services or something.  But take TV stations for example.  Local TV station revenue is largely proportional to their number of viewers.  Local news and weather are often the sole part of their schedule that they produce themselves and therefore get all or almost all of the revenue.  And viewership for local news programs may double with an impending snowstorm.  So they have a financial interest in predicting more snow.  The Weather Channel has the same dynamic, but a wider area from which to draw to find extreme weather situations.  But if there is any hint of a possible extreme weather situation in a major metropolitan area with millions of possible viewers, they have a strong incentive to report the worst case possibility.

This past January, there were some terrible snow forecasts for New York and Philadelphia:

For the Big Apple, the great Blizzard of 2015 was forecast to rival the paralyzing 1888 storm, dubbed the White Hurricane. Up to three feet of snow was predicted. Reality: About 10 inches fell.

The forecast in Philadelphia wasn’t any better – and arguably worse. Up to 14 inches of snow were forecast. The City of Brotherly Love tallied roughly 2 inches, about the same as Washington, D.C.

Washington Post,  January 27, 2015

In other cases, we go to the experts to get information about possible disasters from diseases.  But their funding depends very much on how important their specialty is seen to be to the politicians who approve their funding.

In 2005, the Bird Flu was the scare topic of the year.

“I’m not, at the moment, at liberty to give you a prediction on numbers, but I just want to stress, that, let’s say, the range of deaths could be anything from 5 to 150 million.”

David Nabarro, Senior United Nations system coordinator for avian and human influenza

Needless to say, the funding for health systems can be strongly impacted by the fear of such a pandemic.  At them time that statement was made, worldwide Bird Flu deaths were slightly over 100.  Not 100 thousand, 100 – the number right after 99.

But the purpose of this post is not writing this to disparage weather reporters or epidemiologists.  It is to caution risk managers.

Sometimes risk managers get the idea that they are better off if everyone had more concern for risk.  They take on the roll of Dr. Doom, pointing out the worst case potential in every situation.

This course of action is usually not successful. Instead of building respect for risk, the result is more often to create a steady distrust of statements from the risk manager.  The Chicken Little effect results.

Instead, the risk manager needs to focus on being painstakingly realistic in reporting about risk.  Risk is about the future, so it is impossible to get it right all of the time.  That is not the goal.  The goal should be to make reports on risk that consistently use all of the information available at the time the report is made.

And finally, a suggestion on communicating risk.  That is that risk managers need to develop a consistent language to talk about the likelihood and severity of a risk.  RISKVIEWS suggests that risk managers use three levels of likelihood:

  • Normal Volatility (as in within).  Each risk should have a range of favorable and unfavorable outcomes within the range of normal volatility.  This could mean within one standard deviation, or with a 1 in 10 likelihood. So normal volatility for the road that you drive to work might be for there to be one accident per month.
  • Realistic Disaster Scenario.  This might be the worst situation for the risk that has happened in recent memory, or it might be a believable bad scenario that hasn’t happened for risks where recent experience has been fairly benign.  For that road, two accidents in a week might be a realistic disaster.  It actually happened 5 years ago.  For the similar road that your spouse takes to work, there haven’t been any two accident weeks, but the volume of traffic is similar, so the realistic disaster scenario for that road is also two accidents in a week.
  • Worst case scenario.  This is usually not a particularly realistic scenario.  It does not mean worst case, like the sun blowing up and the end of the solar system.  It does mean something significantly worse than what you expect can happen. For the risk of car accidents on your morning commute, the worst case might be a month with 8 accidents.

So the 150 million number above for flu deaths is a worst case scenario.  As were the Great Blizzard predictions.  What actually happened was in line with normal volatility for a winter storm in those two cities.

If you, the risk manager, learn to always use language like the above, first of all, it will slow you down and make you think about what you are saying.  Eventually, your audience will get to learn what your terminology means and will be able to form their own opinion about your reliability.

And you will find that credibility for your risk reporting has very favorable impact on your longevity and compensation as a risk manager.


ERM on WillisWire

December 3, 2013

Risk Management: Adaptability is Key to Success


There is no single approach to risk management that will work for all risks nor, for any one risk, is there any one approach to risk management that will work for all times. Rational adaptability is the strategy of altering … Continue reading →

Resilience for the Long Term

Resilient Sprout in Drought

In 1973, CS Holling, a biologist, argued that the “Equilibrium” idea of natural systems that was then popular with ecologists was wrong.He said that natural systems went through drastic, unpredictable changes – such systems were “profoundly affected by random events”.  … Continue reading →

Management is Needed: Not Incentive Compensation

Bizman in Tie

Many theoreticians and more than a few executives take the position that incentive compensation is a powerful motivator. It therefore follows that careful crafting of the incentive compensation program is all that it takes to get the most out of a … Continue reading →

A Gigantic Risk Management Entertainment System


As video gaming has become more and more sophisticated, and as the hardware to support those games has become capable of playing movies and other media, video game consoles have now become “Entertainment Systems”.  Continue reading →

Panel at ERM Symposium: ERM for Financial Intermediaries

SS Meaning of Risk Mgmt  77408059 April 23 12

Insurance company risk managers need to recognize that traditional activities like underwriting, pricing and reserving are vitally important parts of managing the risks of their firm. Enterprise risk management (ERM) tends to focus upon only two or three of the … Continue reading →

ERM Symposium Panel: Actuarial Professional Risk Management

SS Risk Button - Blank Keys  53606569 April 23

In just a few days, actuaries will be the first group of Enterprise Risk Management (ERM) professionals to make a commitment to specific ERM standards for their work. In 2012, the Actuarial Standards Board passed two new Actuarial Standards of … Continue reading →

Has the Risk Profession Become a Spectator Sport?

The 2013 ERM Symposium goes back to Chicago this year after a side trip to DC for 2012. This is the 11th year for the premier program for financial risk managers. Continue reading →

What to Do About Emerging Risks…


WillisWire has on several occasions featured opinions from a large number of our contributors about what might be the next emerging risk in various sectors. But what can be done once you have identified an emerging risk? Continue reading →

U.S. Insurers Need to Get Ready for ORSA


Slowly, but surely, and without a lot of fanfare, U.S. insurance regulators have been orchestrating a sea change in their interaction with companies over solvency.  Not as dramatic as Solvency II in Europe, but the U.S. changes are actually happening … Continue reading →

Resiliency vs. Fragility


Is there really a choice?  Who would choose to be Fragile over Resilient? Continue reading →

– See more at:

Risk Management for the Real Economy

February 15, 2012

ZURICH—In another move to rein in compensation, UBS AG notified employees it will claw back part of the bonuses due to its best-paid investment bankers, according to a person familiar with the matter.

The action by Switzerland’s largest lender by assets is likely to further upset some top employees at a bank that already has faced problems retaining top talent and is now in the midst of a revamp of its investment bank. The UBS board has decided to take back 50% of share-based bonuses awarded last year to investment bankers whose bonuses exceeded two million Swiss francs.

Wall Street Journal, 9 February, 2012

A claw back of bonuses.  This totally changes the risk reward for employees.

Banker pay is shrinking.  See Forget the big bonuses; a pay squeeze is coming.  Tett puts banker pay into a very long term historical perspective.  It seems that banker pay was previously so high – and is it a coincidence that was right before the Depression.

The reason why banker pay matters so much is that finance does not follow the same economic laws of supply and demand as physical goods.  Many people talk as if they do, but there is at least one major difference that was clearly evidenced in the run up to the financial crisis.  Scarcity does not apply to financial goods.  So there is no natural limiting feedback loop.  Remember what happened with CDOs related to mortgages?  When demand went up, price didn’t.  Supply leaped instead.  Synthetic CDOs filled the need and there is an unlimited supply of synthetic financial assets.

The amount of financial goods compared to the rest of the economy is therefore totally flexible.  Think about it for a minute.  The world cannot be any more wealthy because there are more financial goods.  The sole result of the expansion of financial goods is to tilt the ownership of the wealth of the world away from the real economy and towards the banks and others in finance.

Limiting banker pay limits the incentive to inflate the financial system.  Clawbacks means that when the bankers and others in finance do manage to push those financial goods up anyway, any excess compensation that results can be recovered when the excess of financial goods reverses itself.

So both of these measures are Risk Management for the Real Economy.

What’s Next?

March 25, 2011

Turbulent Times are Next.

At, a feature from Guillermo Felices tells of 8 shocks that are about to slam the global economy.

#1 Higher Food Prices in Emerging Markets

#2 Higher Interest Rates and Tighter Money in Emerging Markets

#3 Political Crises in the Middle East

#4 Surging Oil Prices

#5 An Increase in Interest Rates in Developed Markets

#6 The End of QE2

#7 Fiscal Cuts and Sovereign Debt Crises

#8 The Japanese Disaster

How should ideas like these impact on ERM systems?  Is it at all reasonable to say that they should not? Definitely not.

These potential shocks illustrate the need for the ERM system to be reflexive.  The system needs to react to changes in the risk environment.  That would mean that it needs to reflect differences in the risk environment in three possible ways:

  1. In the calibration of the risk model.  Model assumptions can be adjusted to reflect the potential near term impact of the shocks.  Some of the shocks are certain and could be thought to impact on expected economic activity (Japanese disaster) but have a range of possible consequences (changing volatility).  Other shocks, which are much less certain (end of QE2 – because there could still be a QE3) may be difficult to work into model assumptions.
  2. With Stress and Scenario Tests – each of these shocks as well as combinations of the shocks could be stress or scenario tests.  Riskviews suggest that developing a handful of fully developed scenarios with 3 or more of these shocks in each would be the modst useful.
  3. In the choices of Risk Appetite.  The information and stress.scenario tests should lead to a serious reexamination of risk appetite.  There are several reasonable reactions – to simply reduce risk appetite in total, to selectively reduce risk appetite, to increase efforts to diversify risks, or to plan to aggressively take on more risk as some risks are found to have much higher reward.

The last strategy mentioned above (aggressively take on more risk) might not be thought of by most to be a risk management strategy.  But think of it this way, the strategy could be stated as an increase in the minimum target reward for risk.  Since things are expected to be riskier, the firm decides that it must get paid more for risk taking, staying away from lower paid risks.  This actually makes quite a bit MORE sense than taking the same risks, expecting the same reward for risks and just taking less risk, which might be the most common strategy selected.

The final consideration is compensation.  How should the firm be paying people for their performance in a riskier environment?  How should the increase in market risk premium be treated?

See Risk adjusted performance measures for starters.

More discussion on a future post.

ERM an Economic Sustainability Proposition

January 6, 2011

Global ERM Webinars – January 12 – 14 (CPD credits)

We are pleased to announce the fourth global webinars on risk management. The programs are a mix of backward and forward looking subjects as our actuarial colleagues across the globe seek to develop the science and understanding of the factors that are likely to influence our business and professional environment in the future. The programs in each of the three regions are a mix of technical and qualitative dissertations dealing with subjects as diverse as regulatory reform, strategic and operational risks, on one hand, and the modeling on tail risks and implied volatility surfaces, on the other. For the first time, and in keeping with our desire to ensure a global exchange of information, each of the regional programs will have presentations from speakers from the other two regions on subjects that have particular relevance to their markets.

Asia Pacific Program

Europe/Africa Program

Americas Program


Risk Steering as ERM

July 12, 2010

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Risk Steering.

If you ask most actuaries who are involved in ERM, they would tell you that Risk Steering IS Enterprise Risk Management.

Standard & Poor’s calls this Strategic Risk Management:

SRM is the Standard & Poor’s term for the part of ERM that focuses on both the risks and returns of the entire firm. Although other aspects of ERM mainly focus on limiting downside, SRM is the process that will produce the upside, which is where the real value added of ERM lies. The insurer who is practicing SRM will use their risk insights and take a portfolio management approach to strategic decision making based on analysis that applies the same measure for each of their risks and merges that with their chosen measure of income or value. The insurer will look at the possible combinations of risks that it can take and the earnings that it can achieve from the different combinations of risks taken, reinsured, offset, and retained. They will undertake to optimize their risk-reward result from a very quantitative approach.

For life insurers, that will mean making strategic trade-offs between products with credit, interest rate, equity and insurance risks based on a long-term view of risk-adjusted returns of their products, choosing which to write, how much to retain and which to offset. They will set limits that will form the boundaries for their day-to-day decision-making. These limits will allow them to adjust the exact amount of these risks based on short-term fluctuations in the insurance and financial markets.

For non-life insurers, SRM involves making strategic trade-offs between insurance, credit (on reinsurance ceded) and all aspects of investment risk based on a long-term view of risk-adjusted return for all of their choices. Non-life SRM practitioners recognize the significance of investment risk to their total risk profile, the degree or lack of correlation between investment and insurance risks, and the fact that they have choices between using their capacity to increase insurance retention or to take investment risks.

Risk Steering is very similar to Risk Trading, but at the Total Firm level.  At that macro level, management will leverage the risk and reward information that comes from the ERM systems to optimize the risk reward mix of the entire portfolio of insurance and investment risks that they hold.  Proposals to grow or shrink parts of the business and choices to offset or transfer different major portions of the total risk positions can be viewed in terms of risk adjusted return.   This can be done as part of a capital budgeting / strategic resource allocation exercize and can be incorporated into regular decision making.  Some firms bring this approach into consideration only for major ad hoc decisions on acquisitions or divestitures and some use it all of the time.

There are several common activities that may support the macro level risk exploitation:

  1. Economic Capital. Realistic risk capital for the actual risks of the company is calculated for all risks and adjustments are made for the imperfect correlation of the risks. Identification of the highest concentration of risk as well as the risks with lower correlation to those higher concentration risks is the risk information that can be exploited.  Insurers will find that they have a competitive advantage in adding risks to those areas with lower correlation to their largest risks.  Insurers should be careful to charge something above their “average” risk margin for risks that are highly correlated to their largest risks.  In fact, at the macro level as with the micro level, much of the exploitation results from moving away from averages to specific values for sub classes.
  2. Capital Budgeting. The capital needed to fulfill proposed business plans is projected based on the economic capital associated with the plans. Acceptance of strategic plans includes consideration of these capital needs and the returns associated with the capital that will be used. Risk exploitation as described above is one of the ways to optimize the use of capital over the planning period.
  3. Risk Adjusted Performance Measurement (RAPM). Financial results of business plans are measured on a risk-adjusted basis. This includes recognition of the economic capital that is necessary to support each business as well as the risk premiums and loss reserves for multi-period risks such as credit losses or casualty coverages.
  4. Risk Adjusted Compensation.  An incentive system that is tied to the risk exploitation principles is usually needed to focus attention away from other non-risk adjusted performance targets such as sales or profits.  In some cases, the strategic choice with the best risk adjusted value might have lower expected profits with lower volatility.  That will be opposed strongly by managers with purely profit related incentives.  Those with purely sales based incentives might find that it is much easier to sell the products with the worst risk adjusted returns.  A risk adjusted compensation situation creates the incentives to sell the products with the best risk adjusted returns.

A fully operational risk steering program will position a firm in a broad sense similarly to an auto insurance provider with respect to competitors.  There, the history of the business for the past 10 years has been an arms race to create finer and finer pricing/underwriting classes.  As an example, think of the underwriting/pricing class of drivers with brown eyes.  In a commodity situation where everyone uses brown eyes to define the same pricing/underwriting class, the claims cost will be seen by all to be the same at $200.  However, if the Izquierdo Insurance Company notices that the claims costs for left-handed, brown-eyed drivers are 25% lower than for left handed drivers, and then they can divide the pricing/underwriting into two groups.   They can charge a lower rate for that class and a higher rate for the right handed drivers.  Their competitors will generally lose all of their left handed customers to Izquierdo, and keep the right handed customers.  Izquierdo will had a group of insureds with adequate rates, while their competitors might end up with inadequate rates because they expected some of the left-handed people in their group and got few.  Their average claims costs go up and their rates may be inadequate.  So Izquierdo has exploited their knowledge of risk to bifurcate the class, get good business and put their competitors in a tough spot.

Risk Steering can be seen as a process for finding and choosing the businesses with the better risk adjusted returns to emphasize in firm strategic plans.  Their competitors will find that their path of least resistance will be the businesses with lower returns or higher risks.

JP Morgan in the current environment is showing the extreme advantage of macro risk exploitation.  In the subprime driven severe market situation, JP Morgan has experienced lower losses than other institutions and in fact has emerged so strong on a relative basis that they have been able to purchase several other major financial institutions when their value was severely distressed.  And by the way, JP Morgan was the firm that first popularized VaR in the early 1990’s, leading the way to the development of modern ERM.  However, very few banks have taken this approach.  Most banks have chosen to keep their risk information and risk management local within their risk silos.

This is very much an emerging field for non-financial firms and may prove to be of lower value to them because of the very real possibility that risk and capital is not the almost sole constraint on their operations that it is within financial firms as discussed above.

This post is a part of the Plural Rationalities and ERM project.


July 11, 2010

By Jean-Pierre Berliet

The MBO (Management By Objectives) process translates business objectives into performance targets and drives incentive compensation awards. Certain weaknesses of MBO processes make companies more vulnerable to crises. .

The MBO process is central to crisis prevention.  Weaknesses in the MBO process of an insurance company must be corrected to ensure that management action do not unwittingly exacerbate risk and magnify the impact of crises.

Senior management often takes pride in its tough and disciplined approach to managing performance. This involves setting stretch objectives, rewarding managers who deliver, and punishing those who fall short. It is argued that a “greed and fear” approach is necessary to motivate managers and align their interests with those of shareholders. It is not widely recognized, however, that this approach can increase moral hazard and induce managers to make decisions that reduce the resilience of their company to crises.

In such performance management cultures, managers are incented to exceed management expectations by using all means available.  This may include:

  • Reducing or postponing spending on product or service quality, product leadership, process productivity, or customer service responsiveness
  • Under-pricing risks to increase business volume and earnings
  • Taking on higher investment risks to increase current investment yields
  • Under investing in market growth, thereby increasing short-term earnings but losing market share.

Actions like these can enhance short-term earnings, but they can also undermine a company’s competitive capabilities and value creation potential. This, in turn, can reduce the company’s ability to raise capital and thus its resilience. The introduction of risk adjusted performance metrics into a company’s control framework can help reduce the incidence of actions taken inappropriately to “game” the incentive compensation system. However, it is hard to detect moral hazard because the effects of actions taken can remain latent for years to come.

Moral hazard of this type tends to affect decisions where senior management focuses on reported financial results rather than on underlying operating success factors. Excessive, and sometimes exclusive, emphasis on financial results gives operating managers overly broad discretion to “make the numbers”. In many instances (e.g. AIG, Bear Stearns, Citigroup, Lehman Brothers) such an approach to oversight invited moral hazard with serious consequences. When combined with financial leverage and risk leverage, decisions tainted by moral hazard can result in enormous shareholder losses.

Insurance companies need to revamp their MBO frameworks to reduce the risk of moral hazard.  They need to establish corporate cultures in which discussions about objectives, strategies, and results, while never informed by perfect knowledge and foresight, are guided by “high road” values of trust and loyalty. Revamped MBO frameworks should explicitly include consideration of risk insights produced by ERM and verification of the alignment of actions taken with approved plans and strategies.

To accomplish such a transformation of their cultures, insurers may need to link their ERM and MBO processes through the implementation of:

  • Risk-adjusted financial performance metrics
  • Risk-adjusted performance benchmarks, related to expectations of capital market investors
  • Incentive compensation awards linked to long-term measures of business value, including indicators of operational performance, and current profits.

Since no company operates with perfect foresight, Boards of Directors need to grant adequate discretion and flexibility to senior management for performance management.  Adjusting objectives and targets can be of critical importance when business conditions change unexpectedly. In an uncertain world, rigid enforcement reinforces greed and fear elements of corporate cultures, undermines trust, breeds cynicism and “gaming the system”, and increases moral hazard by inducing behavior that can, in time, fatally weaken an insurance company.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

Increasing the usefulness of ERM

June 27, 2010

By Jean-Pierre Bertiet

Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM frameworks were shown to:

  • Align performance metrics with management’s performance measurement philosophy
  • Integrate ERM into daily management activities

The following two sections discuss these issues and suggest action steps that insurance companies should take to establish ERM as a more robust and valuable management process.

1.  Aligning performance metrics with management’s performance measurement philosophy

To provide useful guideposts for business decisions, the risk adjusted performance measurement framework supporting ERM needs to reflect senior management’s views regarding alignment of responsibilities and performance metrics. Alignment is ensured by i) matching of the structure of the financial management reports to the boundaries of business segment, ii) accurate attribution of capital, premium revenues, investment income and expenses to business segments and iii) segregation in financial reports of the results associated with the current period from the impact of business written in prior years.

This alignment ensures appropriate distinctions between results of current and past decisions and a sharp focus on differences in drivers of performance.

In practice, leading companies are making explicit decisions about the design and features of the financial performance measures they develop by developing customized answers to questions such as the following:

  • Are business segments to be evaluated on a stand alone basis or in a portfolio context (i.e. after attribution of a capital credit for diversification)?
  • Are business segments to be evaluated as if assets they earned risk free, duration matched investment income? Or the average rate of return on the investment portfolio?
  • Are business segments to be evaluated in relation to their ‘consumption” of economic capital? Regulatory capital? Rating agency capital?
  • Should individual business segments bear the cost of “excess” or “stranded” capital?
  • Should performance benchmarks vary across business segments, in line with differences in the volatility of their total risk? Or differences in exposure/premium leverage across lines? Or differences in contribution to corporate debt capacity?
  • How granular does such reporting need to be?
  • Should performance metrics be developed in a policy/underwriting year framework? Would such metrics need to be reconciled with metrics based on fiscal year GAAP reported numbers?
  • How should the period performance of the in-force (or liabilities run off) be measured and separated from the performance of the “new business”? To what extent and how should the performance of “renewal” policies be separated from that of policies written for new customers in property, casualty companies?
  • Should the performance reporting framework provide only period measures of performance or should it be extended to capture the longer term economic value of insurance contracts, such as the change in the embedded value of the business?
  • Should the performance reporting framework be extended to incorporate stochastic performance metrics such as Earnings@Risk or Embedded Value@Risk?

Leading ERM practitioners, especially in Europe, have found that the usefulness, but also the complexity and cost of risk adjusted performance metrics are determined by the desired level of granularity in reporting, and design decisions in i) risk measurement,

ii) capital measurement and, iii) financial reporting. The availability and quality of risk and financial data determine to a significant degree the level of granularity that can be built to support ERM.

In my experience, success in establishing ERM is highly dependent on the level of effort that companies devote to designing a reporting framework that the organization can understand and embrace intuitively, without having to be trained in advanced financial or risk topics. Setting out to develop the most rigorous and actuarially correct framework is likely to result in poor acceptance by operating managers.

2. Integrating ERM into daily management activities

Many senior executives recognize that establishing an ERM process is an obligation that cannot be avoided in today’s environment. They also have a strong intuitive sense that the science of risk measurement and analysis offered by the actuarial profession and other specialists in risk does not yet provide robust answers to many important questions that are asked by people who manage the operations of insurance companies day by day. Differences in perspectives between executives in the corporate center and the managers of business units hamper the effectiveness of ERM. Bridging these differences is a major challenge to the establishment of ERM. This challenge is rooted in fundamental differences in the roles and responsibilities of these actors.

Corporate center executives who operate under oversight of the Board of Directors are highly sensitive to risk concerns of shareholders. It is natural for these executives to take an aggregate view of risk, across the business portfolio. They contribute to corporate performance by  making i) strategic risk management decisions in connection with capacity deployment, reinsurance and asset allocation, ii) operational risk management decisions principally in connection with the management of shared services. Their most important risk decisions, related to capital allocation, involve significant strategic risks.

By contrast, business unit managers have a different outlook. They are typically more focused on meeting the needs of policyholders. They are more likely to view risk as stemming from products and customers.  From their point of view risk management starts with product design, underwriting and pricing decisions, control of risk accumulations and concentrations, product mix and customer mix. With regards to operational risk, their activity places them on the front line to control the “execution risks” elements of operational risk. Business unit managers tend to view requests for support of ERM as distractions from serving policyholders and accomplishing their goals. They believe that they help protect shareholders from value loss by focusing on establishing and maintaining a competitive advantage.

The CFO of a very large insurance group confided to me recently that aligning the perspectives of executives at the corporate center with that of business managers was a challenge of great importance. He expressed the view that results from risk models cannot be used simplistically and that experience and business judgment are needed to guide decisions. Caution and prudence are especially important in interpreting decision signals when model results appear unstable or when complexity makes it difficult to recognize possible biases. He had become interested in using a combination of approaches to develop reliable insights into strategy and risk dynamics in his company.  He was particularly focused on finding ways to bring these insights to bear on the daily activities of employees who manage risk accumulation, risk mitigation and risk transfer activities, on both sides of the balance sheet. In his judgment, borne out by other discussions and my experience with clients, ERM comes to life and creates value best when a top down framework initiated by senior management is embraced bottom up throughout the organization.

Consistent with these considerations, ERM appears to work best in companies in which operating managers have “bought in” ERM and embraced the perspective it provides. In many of these companies, one observes that:

  • Risk management responsibility is owned by operating managers
  • Product definitions and investment boundaries are clear and matched to explicit risk limits
  • Policies and procedures have been co-developed with operating personnel
  • Product approval and risk accumulation are subject to oversight by the central ERM unit
  • Risk and value governance are integrated through a committee with authority to adjudicate decisions about trade-offs between risks and returns
  • Compliance and exceptions are subject to review by senior management

It is important to observe that none of the considerations discussed in the two sections of this note are about the technical components of risk management. Rather, they define a context for accountability, empowerment and appropriate limitations on the activities of people who run day to day operation in insurance companies.

©Jean-Pierre Berliet

Berliet Associates, LLP

(203) 247 6448

Risk Adjusted Performance Measures

June 20, 2010

By Jean-Pierre Berliet

Design weaknesses are an important source of resistance to ERM implementation. Some are subtle and thus often remain unrecognized. Seasoned business executives recognize readily, however, that decision signals from ERM can be misleading in particular situations in which these design weaknesses can have a significant impact. This generates much organizational heat and can create a highly dysfunctional decision environment.

Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM frameworks were shown to produce credible and useful risk adjusted performance measures

Risk adjusted performance measures (RAPM) such as RAROC (Risk Adjusted Return On Capital), first developed in banking institutions, or Risk Adjusted Economic Value Added (RAEVA) have been heralded as significant breakthroughs in performance measurement for insurance companies. They were seen as offering a way for risk bearing enterprises to relate financial performance to capital consumption in relation to risks assumed and thus to value creation.

Many insurance companies have attempted to establish RAROC/RAEVA performance measurement frameworks to assess their economic performance and develop value enhancing business and risk management strategies. A number of leading companies, mostly in Europe where regulators are demanding it, have continued to invest in refining and using these frameworks. Even those that have persevered, however, understand that framework weaknesses create management challenges that cannot be ignored.

Experienced executives recognize that the attribution of capital to business units or lines provides a necessary foundation for aligning the perspectives of policyholders and shareholders.

Many company executives recognize, however, that i) risk adjusted performance measures can be highly sensitive to methodologies that determine the attribution of income and capital and ii) earnings reported for a period do not adequately represent changes in the value of insurance businesses. As a result, these senior executives believe that decision signals provided by risk adjusted performance measures need to be evaluated with great caution, lest they might mislead. Except for Return on Embedded Value measures that are comparatively more challenging to develop and validate than RAROC/RAEVA measures, risk adjusted performance measures are not typically capable of relating financial performance to return on value considerations that are of critical importance to shareholders.

To provide information that is credible and useful to management and shareholders, insurance companies need to establish risk adjusted performance measures based on:

  • A ( paid up or economic) capital attribution method, with explicit allowance for deviations in special situations, that is approved by Directors
  • Period income measures aligned with pricing and expense decisions, with explicit separation of in-force/run-off, renewals, and new business
  • Supplemental statements relating period or projected economic performance/ changes in value to the value of the underlying business.
  • Reconciliation of risk adjusted performance metrics to reported financial results under accounting principles used in their jurisdictions (GAAP, IFRS, etc.)
  • Establishment and maintenance of appropriate controls, formally certified by management, reviewed and approved by the Audit Committee of the Board of Directors.

In many instances, limitations and weaknesses in performance measures create serious differences of view between a company’s central ERM staff and business executives.

Capital attribution


Aligning Interests

May 30, 2010

By Jean-Pierre Berliet

Companies that withstood the crisis and are now poised for continuing success have been disciplined about aligning interests of shareholders and managers

Separation of ownership and control creates conflicts of interests between managers and owners. To mitigate this situation, companies expend much effort to develop and implement incentive compensation systems that align the interests of managers and shareholders. The present crisis demonstrates clearly, however, that such arrangements are imperfect: large incentive payments were made to many people in companies that have performed poorly or even failed. There has been a public outcry.

But there is nothing really new in misalignments of incentives, or weaknesses in incentive designs that produce harmful results: they exist in every company to some degree. In a typical situation, managers are concerned about minimizing financial and career consequences of not achieving their objectives. If the situation requires it, managers will exploit every opportunity to change their operating plans to achieve their targets. They will seek and capitalize on opportunities to convert unreported intangible assets, such as market share, product or service quality, product leadership, plant productivity or customer service responsiveness into current profits by postponing and reducing related expenses. Financial results will look good, and they will be praised for accomplishing their objectives. Actions that they took, however, accelerated uncertain future income to the present period while undermining the company’s competitive capabilities and reducing the sustainability of its performance. This is dangerous. Mitigating this form of moral hazard is difficult because its effects are not readily apparent.

In insurance companies (and banks), business managers have even greater opportunities to “game” incentive plans:  they can increase reported business volume and profit in the current period by slightly under-pricing or increasing risks assumed.  This approach to “making the numbers” is particularly tempting in lines of coverage in which losses can take many years to emerge and develop; it is also particularly dangerous because losses from mispriced policies, especially in lines with high severity/low frequency loss experience can be devastating.  Similarly, investment officers can invest in assets that offer higher yields to increase portfolio performance, while involving risks that can result in significant capital losses later.

Based on these observations, Directors and CEOs of insurance companies need to work with management to:

  • Link incentive compensation payments to the ultimate outcome of business written rather than to current profits (especially when fair value accounting standards cause immediate recognition of profits on contracts).
  • Establish and empower an internal control and audit function to verify that managers’ actions are aligned with business strategies and plans.
  • Verify the integrity of underwriting and investment decisions, in relation to explicitly approved guidelines and processes.

The present crisis has demonstrated how unbundling of risk assumption businesses can increase moral hazard by redistributing risks, gains and potential losses across originators, arrangers of securitization transactions and investors/risk bearers.

Reconstruction of incentive programs and establishment of appropriate oversight and enforcement mechanisms are needed to reduce moral hazard and restore confidence in the financial system, including insurance companies.

©Jean-Pierre Berliet   Berliet Associates, LLC  (203) 972-0256

Risk Impact Thresholds

May 3, 2010

Tipping the ERM Scale Toward Survival


Enterprise risk management experts, and surely even many neophytes, are fairly adept at identifying exposures and events that can impede their organizations. What is much more difficult is measuring the potentially adverse impact of risks, making this the biggest X factor in the ERM process.

Consequently, it is quite challenging to determine how much risk exposure an organization can “tolerate”—that is, the extent of adverse risk impact a company can absorb so that the attainment of its goals will not be jeopardized.

It is equally difficult to assess a company’s “threshold” to absorb these risk consequences—that is, the cross-over points beyond which significant strategic and operational changes need to be made.

What Might Your Stakeholders Do?


  • Financial Outcomes: impact on capital and earnings
  • Business Line inadequacy: products and features, service
  • Business Misconduct and reputational impairment: putting future viability at risk


  • Customers or producers might cease doing business with firm or reduce volume
  • Investors might sell stock lowering the price in the process
  • Board might replace management or reduce compensation
  • Lenders might charge a higher price for capital
  • Rating agencies might downgrade
  • Institutional customers might not be permitted to do business with firm

As a result, it is likely that many organizations are exposed to risks that would materially compromise not only their current course but their very existence. In fact, the events of the last two years have dramatically highlighted this exposure, and many firms have been greatly harmed. Just ask AIG and Lehman Brothers.  Measurement of risk impact—both quantitative and qualitative—is clearly the most critical endeavor to perform accurately in determining an organization’s tolerance for risk.  It is possible for each element of the risk measurement and reporting process to be flawed, as they are often performed in a vacuum—the result can be too narrow and theoretical in scope.  The quantifying component of risk measurement is built upon mathematics and modeling, utilizing:

  • A series of approximations and assumptions.
  • Identification of elements/variables to measure.
  • Determination of the relationship between the various risk factors and the outcomes they might jeopardize

The qualifying component, however, is often built on psychology—its effect on decision-making and the “emotional intelligence” of the individuals making judgments on risk. Consider the following:

  • People work on problems they think they can solve, and they avoid those they don’t think they can solve—due to complexity or political reasons. Elements in the latter category won’t be addressed.
  • They are slow and cautious in reacting to new information and reluctant to admit ignorance or mistaken assumptions. Solutions to risk mitigation may exist, but might not be implemented without inordinate study—paralysis by analysis.
  • They look at fewer as opposed to more perspectives, possibly missing a better solution.
  • They often place greater value on what they themselves have created than on what others have done, and may well miss out on higher-order thinking generated by a group and on the critical perspectives of others.


Skating Away on the Thin Ice of the New Day

April 23, 2010

The title of an old Jethro Tull song.  It sounds like the theme song for the economy today!

Now we all know.  The correlations that we used for our risk models were not reliable in the one instance where we really wanted an answer.

In times of stress, correlations go to one.

That is finally, after only four or five examples with the exact same result, become accepted wisdom.

But does that mean that Diversification is dead as a strategy?

I would argue that it certainly puts a hurt to diversification as a strategy for finding risk free returns.  Which is how it was being (mis) used in the Sub Prime markets.

But Diversification should still reign as the king of risk management strategies.  But it needs to be real diversification.  Not tiny diversification that is observable only under a mathematical microscope.  Real Diversification is where risks have completely different drivers.  Not slightly different statistical histories.

So in Uncertain Times, and these days must be labeled Uncertain Times (or the thin ice age), diversification is the best risk management strategy.  Along with its mirror image twin, avoidance of concentrations.

The banks had given up on diversification as a risk strategy.  Instead they believed that they were making risk free returns by taking lots and lots of concentrated risk that they were either fully hedging or moving the risk off their balance sheets very quickly.

Both ideas failed.  Hedging failed when the counter party was Lehman Brothers.  It succeeded when the counter party was any of the other institutions that were bailed out, but there was an extended period of severe uncertainty about that before the bailouts were finally put into place.  Moving the risks off the balance sheet failed in two ways.  First it failed because they were really playing hot potato without admitting it.  When the music stopped, someone was holding the potato.  And some banks were holding many potatoes.  It also failed because some banks had been offloading the risks to hedge funds and other investors who they were lending funds to finance the purchase.  When the CDOs soured, the loans secured by the CDOs were underwated and the CDOs came back onto the bank balance sheets.

The banks that were hurt the least were the banks who were not so very concentrated in just one major risk.

The cost of the simple diversification strategy is that those banks with real diversification showed lower returns during the build up of the bubble.

So that is the risk reward trade off of real diversification – it will often produce lower returns than the mathematical diversification but it will also show lower losses in proportion to total revenue than a strategy that concentrates in the most profitable risk choices according to a model that is tuned to the accounting or performance bonus system.

Diversification is the risk management strategy for the Thin Ice Age.

Risk Adjusted Compensation Analysis

March 20, 2010

Game Theory suggests that you can get pretty far simply looking at expected values.  But the expected values need to be done right, looking at both upside and downside.

Looking at the consequences of the compensation paid by financial institutions suggests that boards who approved the compensation did not do their Game Theory homework.  Management is given a huge share of the upside and their incentives are thought to be aligned with shareholders because of a stock component to their compensation.

Maybe that works, maybe not.  The math is simple enough.  They should check.  A Game Theory, risk adjusted compensation analysis (simplified for this post) would look like this:

Proposed Transaction:

Upside:  $100,000,000 – likelihood 60%

Downside:  ($100,000,000) – likelihood 40%

Expected Value: $20,000,000

So far so good.  Now the firm already has a risk adjusted compensation system.  Under that system, there is a cost of capital charge assessed against profits before calculating bonus.  In this case, the capital is based upon the $100,000,000 downside.  The cost of capital is 5%, so the “risk adjustment” is 5%.  The bonus formula will pay out 40% of the risk adjusted gain, half in cash and half in stock.  In the past, the compensation committee has seen this process and stopped there. It seems that they took care of every angle.

But this year, one comp committee member hears a lecture on Game Theory and asks for additional analysis:

Risk Adjusted Expected Value Analysis:


Upside:  40% of $100,000,000 less $5,000,000 equals $38,000,000.  Pay $19,000,000 cash and $19,000,000 stock.  Stock is purchased at time of award.  Likelihood 60%

Downside:  Zero Current award.  Loss in value of stock holdings from past awards.  Back to that in a minute.


Upside:  $62,000,000 of gains plus risk charge times 10 equals $620 million. Likelihood of 60%

Downside $$100,000,000 of losses times 10 equals ($1 Billion). Likelihood of 40%

Expected value:  ($2.8 million)

Now back to the employees…

The downside from their 0.1% of stock is ($1 million) so their expected value is $22 million positive.

So a real Game Theory based risk adjusted analysis would show that there is huge upside to management for risky deals and much smaller risk adjusted expectation for the shareholders. (In this example an expected loss).

Perhaps every deal should be presented on this risk adjusted basis.  It might take a few of these presentations, but sooner or later the lopsided deal will sink in.

But then the game will shift.  Already, the game is to present these deals optimistically, so that the likelihood of upside is overstated and the downside is underestimated.  If compensation is skewed as drastically as the above example, highly risky deals look just fine on a risk adjusted expected value basis to employees.  If the board insists that the shareholders really have a positive expected value, then the deals will need to be much less risky – at least on paper.

The stress testing that is being promoted as a major risk management tools (in part because of this very problem of over optimistic risk models) needs to then also be done to the risk adjusted compensation analysis.  The stress tests for this purpose do not need to be as drastic as the stress tests for solvency management.  What you should be looking for is the inflection point where the deal starts to fall into the situation where the management and shareholders are no longer on the same side, where their expected values are of opposite signs.  If that inflection point is found with a stress test that is somewhat close to the base model assumptions, then that is a flashing red light for the risk manager and the board.

Bonus Fury

January 29, 2010

is everywhere.  I am not sure that I have heard anyone actually explain what should be done or why they are furious, other than the general idea that there were bail-outs. 

I can think of two reasons to object to the mega bonuses that can be used to help direct future bonuses:

  1. There is not any evidence of any claw back being applied in the bonus calculations.  It is likely that a significant number of the folks who have the most culpability for the immense losses of the past are no longer there.  Doing a claw back from folks who were not involved would as is pointed out by the bankers be counter productive.  But they are only partly correct.  While many are gone, some do remain.  In addition, there are many folks remaining at the bank who were indirectly responsible (or should have been indirectly responsible) who are in the executive ranks and on the board as well.  There should be claw backs that apply to everyone who is up the chain of command and in a role with significant corporate wide responsibility.  This would be very productive and would send the signal that executives are responsible.  It would reduce the degree to which executives are willing to look the other way when a strong business unit manager insists on doing something that might not be in the best interests of the firm.  In addition, too little is said of board compensation.  Board members of firms that needed to be bailed out should suffer financial consequences.  Strong consideration should be given to reducing board fees in a manner that is commensurate with what is done to claw back bonuses for executives. 
  2. For almost two years now, the Fed has been depressing interest rates to levels that flirt with a zero value.  They do this to help the banks so that the banks will help the economy.  This has created a situation where the banks can operate with a zero cost of good sold.  Any business on the planet could show a profit with zero COGS.  To the extent that banks are taking earnings that result from these low interest rates and turning around and giving the resulting profits to their employees as bonus they are subverting the purpose of the low rates.  This fact has been true for a long time, but the Greenspan Fed that was famous for low interest rates and for ignoring the gross inefficiencies of the approach.   The lower interest rates take money from savers and transfers it to debtors and banks and bankers.  In this case, the interest rates are being kept low both to bolster bank profits as well as to keep money cheap to spur borrowing to encourage spending.  However, credit tightening by the banks has jacked up their effective margins (spread differentials less default losses).  So bank profits are soaring because they are (a) paying a trivial amount for funds and (b) not lending as much of the money to as many businesses and people as they had before.  In addition, in 2008, the banks were able to obtain debt capital at a rate averaging 0.7% with a government guarantee which is expected to rise to 4.7% (per Reuters).  The differential there is purely a gift from the taxpayers, but a gift that was meant to be used to recapitalize the banks to provide funds for loans. And the banks are paying bonuses on these gains, rather than keeping the excess profits to build up balance sheets to be used when they regain the courage to lend.  So this is proving to be a very inefficient way to move the economy.  The flow of funds through the bankers bonuses back into the economy is just too inefficient of a way to stimulate the economy.  Those excess profits that come from both of these interest expense subsidies must be excluded from the bonuses, or else the subsidies must be stopped and the money used in a more efficient manner to stimulate the economy. 

So there are probably several alternatives to make this more efficient and less bothersome.   We just need to figure out exactly what about it that is bothersome and frame it in a way that can direct policy.  Otherwise, we end up with piecemeal solutions aplied in a wack-a-mole approach to problem solving.

Black Swan Free World (10)

November 17, 2009

This is the final post in a 10 part series.

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Of the ten suggestions, this one has the most value by far.  Unfortunately, this one may be the suggestion that has the least chance of being taken up.  No one is talking about any part of this.  We seem to be moving to try to set the world back into the place that is was, or very close to it.

We should be asking “What should be the place of banking in our economy?”  This is not a question of allowing the free market to choose.  The free market has nothing to do with this.  The role of the banking sector is entirely determined by the government.  The banking sector had grown to eat up a huge percentage of all of the profits of the entire economy.  Does that make any sense to anyone?  Banking can be a symbiont with the economy or it can be a parasite or it can be a cancer.  Before the crisis, banking had definitely moved beyond the level of parasite to becoming a harmful cancer.  Too much of all of the profits of all of business activity in the entire economy were being diverted to the banks and with the pay structure of the banks, into the pockets of a very small number of bankers.  Did that make any sense whatsoever?  Is there any way that anyone can show that situation makes for a healthy economy?  The bubbles that happened twice could be seen as the way that bankers justified their huge take from the economy.  If values were growing rapidly, no one seemed to mind that bankers took so much out of the deals.

Finance Share of GDP PhilipponSource:Evolution of the US Financial Sector Thomas Philippon

However, if the economy and the values of businesses and assets in the economy grow at only a sane pace, and bankers try to go back to the level of take from the economy that they have grown accustomed to, then the amount of total profits left for the rest of the economy are bound to be negative.  So unless we re-think things and figure out how to muzzle the banks, then we are headed for more bubbles that will justify their stratospheric incomes.

The financial sector, once it exceeds a certain share of the economy, should be viewed as a tax on the economy.  Many protest the taxes that the government imposes because the money is not well spent.  Well, the money from this tax goes to personal expenditures of the bankers themselves.  There is not even any pretense that this tax will be spent for the common good.

One question that really needs to be answered is how much of this financial “innovation” that is touted as the result is really beneficial to the economy and how much of it is just unnecessary complexity that hides that take of the bankers and hedge funds.  The excuse that is always given is that all of this financial innovation helps to provide lubrication for businesses.  But that is more like an excuse than a reason.  Mostly the financial innovation has fueled bubbles.  It has led to the excessive leverage that feeds into one sided deals for hedge fund managers.

More often than not, financial innovation has helped to fuel the extreme fixation on short term gains in the economy.  Financial innovation has featured hollowing out companies to maximize short term values.  Quite often the companies “helped” by this process turn into worthless shells somewhere along the process.  This destroys that productive capacity of the economy to allow for the extraction of the maximum amount of short term profits.

Financial innovation helps to turn corporate assets into profits and to take those profits out of the firm through leverage.

So Taleb’s suggestion that we think through Capitalism 2.0 is a good and timely one.  But we need to start asking the right questions to figure out what Capitalism 2.0 will be.

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

The Future of Risk Management – Conference at NYU November 2009

November 14, 2009

Some good and not so good parts to this conference.  Hosted by Courant Institute of Mathematical Sciences, it was surprisingly non-quant.  In fact several of the speakers, obviously with no idea of what the other speakers were doing said that they were going to give some relief from the quant stuff.

Sad to say, the only suggestion that anyone had to do anything “different” was to do more stress testing.  Not exactly, or even slightly, a new idea.  So if this is the future of risk management, no one should expect any significant future contributions from the field.

There was much good discussion, but almost all of it was about the past of risk management, primarily the very recent past.

Here are some comments from the presenters:

  • Banks need regulator to require Stress tests so that they will be taken seriously.
  • Most banks did stress tests that were far from extreme risk scenarios, extreme risk scenarios would not have been given any credibility by bank management.
  • VAR calculations for illiquid securities are meaningless
  • Very large positions can be illiquid because of their size, even though the underlying security is traded in a liquid market.
  • Counterparty risk should be stress tested
  • Securities that are too illiquid to be exchange traded should have higher capital charges
  • Internal risk disclosure by traders should be a key to bonus treatment.  Losses that were disclosed and that are within tolerances should be treated one way and losses from risks that were not disclosed and/or that fall outside of tolerances should be treated much more harshly for bonus calculation purposes.
  • Banks did not accurately respond to the Spring 2009 stress tests
  • Banks did not accurately self assess their own risk management practices for the SSG report.  Usually gave themselves full credit for things that they had just started or were doing in a formalistic, non-committed manner.
  • Most banks are unable or unwilling to state a risk appetite and ADHERE to it.
  • Not all risks taken are disclosed to boards.
  • For the most part, losses of banks were < Economic Capital
  • Banks made no plans for what they would do to recapitalize after a large loss.  Assumed that fresh capital would be readily available if they thought of it at all.  Did not consider that in an extreme situation that results in the losses of magnitude similar to Economic Capital, that capital might not be available at all.
  • Prior to Basel reliance on VAR for capital requirements, banks had a multitude of methods and often used more than one to assess risks.  With the advent of Basel specifications of methodology, most banks stopped doing anything other than the required calculation.
  • Stress tests were usually at 1 or at most 2 standard deviation scenarios.
  • Risk appetites need to be adjusted as markets change and need to reflect the input of various stakeholders.
  • Risk management is seen as not needed in good times and gets some of the first budget cuts in tough times.
  • After doing Stress tests need to establish a matrix of actions that are things that will be DONE if this stress happens, things to sell, changes in capital, changes in business activities, etc.
  • Market consists of three types of risk takers, Innovators, Me Too Followers and Risk Avoiders.  Innovators find good businesses through real trial and error and make good gains from new businesses, Me Too follow innovators, getting less of gains because of slower, gradual adoption of innovations, and risk avoiders are usually into these businesses too late.  All experience losses eventually.  Innovators losses are a small fraction of gains, Me Too losses are a sizable fraction and Risk Avoiders often lose money.  Innovators have all left the banks.  Banks are just the Me Too and Avoiders.
  • T-Shirt – In my models, the markets work
  • Most of the reform suggestions will have the effect of eliminating alternatives, concentrating risk and risk oversight.  Would be much safer to diversify and allow multiple options.  Two exchanges are better than one, getting rid of all the largest banks will lead to lack of diversity of size.
  • Problem with compensation is that (a) pays for trades that have not closed as if they had closed and (b) pay for luck without adjustment for possibility of failure (risk).
  • Counter-cyclical capital rules will mean that banks will have much more capital going into the next crisis, so will be able to afford to lose much more.  Why is that good?
  • Systemic risk is when market reaches equilibrium at below full production capacity.  (Isn’t that a Depression – Funny how the words change)
  • Need to pay attention to who has cash when the crisis happens.  They are the potential white knights.
  • Correlations are caused by cross holdings of market participants – Hunts held cattle and silver in 1908’s causing correlations in those otherwise unrelated markets.  Such correlations are totally unpredictable in advance.
  • National Institute of Financa proposal for a new body to capture and analyze ALL financial market data to identify interconnectedness and future systemic risks.
  • If there is better information about systemic risk, then firms will manage their own systemic risk (Wanna Bet?)
  • Proposal to tax firms based on their contribution to gross systemic risk.
  • Stress testing should focus on changes to correlations
  • Treatment of the GSE Preferred stock holders was the actual start of the panic.  Leahman a week later was actually the second shoe to drop.
  • Banks need to include variability of Vol in their VAR models.  Models that allowed Vol to vary were faster to pick up on problems of the financial markets.  (So the stampede starts a few weeks earlier.)
  • Models turn on, Brains turn off.

Coverage and Collateral

October 22, 2009

I thought that I must be just woefully old fashioned. 

In my mind the real reason for the financial crisis was that bankers lost sight of what it takes to operating a lending business. 

There are really only two simple factors that MUST be the first level of screen of borrowers:

1.  Coverage

2.  Collateral

And banks stopped looking at both.  No surprise that their loan books are going sour.  There is no theory on earth that will change those two fundamentals of lending. 

The amount of coverage, which means the amount of income available to make the loan payments, is the primary factor in creditworthiness.  Someone must have the ability to make the loan payments. 

The amount of collateral, which means the assets that the lender can take to offset any loan loss upon failure to repay, is a risk management technique that insulates the lender from “expected” losses. 

Thinking has changed over the last 10 – 15  years with the idea that there was no need for collateral, instead the lender could securitize the loan, atomize the risk, thereby spreading the specific risk to many, many parties, thereby making it inconsequential to each party.  Instead of collateral, the borrower would be charged for the cost of that securitization process. 

Funny thing about accounting.  If the lender does something very conservative (in terms of current standards) and requires collateral that would take up the first layer of loss then there will be no impact on P&L of this prudence. 

If the lender does not require collateral, then this charge that the borrower pays will be reported as profits!  The Banks has taken on more risk and therefore can show more profit! 

EXCEPT, in the year(s) when the losses hit! 

What this shows is that there is a HUGE problem with how accounting systems treat risks that have a frequency that is longer than the accounting period!  In all cases of such risks, the accounting system allows this up and down accounting.  Profits are recorded for all periods except when the loss actually hits.  This account treatment actually STRONGLY ENCOURAGES taking on risks with a longer frequency. 

What I mean by longer frequency risks, is risks that expect to show a loss, say once every 5 years.  These risks will all show profits in four years and a loss in the others.  Let’s say that the loss every 5 years is expected to be 10% of the loan, then the charge might be 3% per year in place of collateral.  So the banks collect the 3% and show results of 3%, 3%, 3%, 3%, (7%).  The bank pays out bonuses of about 50% of gains, so they pay 1.5%, 1.5%, 1.5%, 1.5%, 0.  The net result to the bank is 1.5%, 1.5%, 1.5%, 1.5%, (7%) for a cumulative result of (1%).  And that is when everything goes exactly as planned! 

Who is looking out for the shareholders here?  Clearly the deck is stacked very well in favor of the employees! 

What it took to make this look o.k. was an assumption of independence for the loans.  If the losses are atomized and spread around eliminating specific risk, then there would be a small amount of these losses every year, the negative net result that is shown above would NOT happen because every year, the losses would be netted against the gains and the cumulative result would be positive. 

Note however, that twice above it says that the SPECIFIC risk is eliminated.  That leaves the systematic risk.  And the systematic risk has exactly the characteristic shown by the example above.  Systematic risk is the underlying correlation of the loans in an adverse economy. 

So at the very least, collateral should be resurected and required to the tune of the systematic losses. 

Coverage… well that seems so obvious it doed not need discussion.  But if you need some, try this.

Black Swan Free World (4)

October 3, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

For many years, money managers were paid out of the revenue from a small management fee charged on assets.  The good performing funds attracted more funds and therefore had more gross revenue.  Retail mutual funds usually charged a flat rate.  Institutional funds charged a sliding scale that went down as a percentage of assets as the amount of assets went up.  Since mutual fund expenses were relatively flat, that meant that the larger funds could generate quite substantial profits.

Then hedge funds came along fifty years ago and established the pattern of incentive compensation of 20% of profits fairly early.  In addition, the idea of the fund using leverage was an early innovation of hedge funds.

Another innovation was the custom that the hedge fund manager’s gains would stay in the fund so that the incentives were aligned.  But think about how that works.  The investor puts up $1 million.  The fund gains 20%, the manager gets $400k and the investor gets $160k.  Then the fund drops 50%, the investor’s account is now worth $580k – he is down $420k.  The manager is down to $80k, but still up by that $80k.  The investor is creamed but the manager is well ahead.  Seems like that incentives need realignment.

Taleb may be thinking of a major issue with hedge funds – valuation of illiquid investments.  Hedge funds often make purchases of totally illiquid investments.  Each quarter, the manager makes an estimate of what they are worth.  The manager gets paid based upon those estimates.  However, with the recent downturn, even in funds that have not shown significant losses have had significant redemptions.  When these funds have redemptions, the liquid assets are sold to pay off the departing investors.  Their shares are determined using the estimated values of the illiquid assets and the remaining fund becomes more and more concentrated in illiquid assets.

If the fund manager had been optimistic about the value of the illiquid assets or simply did not anticipate the shift in demand that has ocurred with the financial crisis, there may well be a major problem brewing for the last investors out the door.  The double whammy of depressed prices for the illiquid assets as well as the distribution based upon values for those assets that are now known to be optimistic.

And over payment of the one sided performance bonuses to the manager were supported by the optimistic valuations.

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Black Swan Free World (2)

September 27, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

Most assuredly the socialization of losses and privatization of gains is what has anyone outside of the banking sector furious. Within the sector, everyone seems to believe that they earned their share of the gains. Think about what you hear about the bonus scheme at the banks – the investment banks are said to be paying out about 50% of gains before bonus. I imagine that puts them approximately on par with the hedge funds, if the banks profit figure takes out overhead before calculating the 50% ratio. So the bank incentive comp is based upon the hedge fund incentive comp. Amazingly, the hedge fund managers manage to convince investors to give them their money and lenders to advance them funds to leverage without any hint of a bailout ever in their future. The hedge fund managers generally walk away from the fund when things go wrong and they are no longer have a chance for outsized gains.

Do the bank shareholders understand that they are really investing in a highly leveraged hedge fund? The folks getting those bonuses surely understand that.

Is this the worst of capitalism and socialism? Probably so.

How do we get out of this? It seems that rather than limiting compensation, we ought be assuring shareholders and debt holders of any firms that structure their compensation like hedge funds that they should expect to be treated like hedge funds in the event of failure. Goodbye, no regrets.

One way of looking at the compensation issue is to focus on time frame.  There are four time frames to consider:

1.  The employees – the recipients of the bonuses.  Their time frame looks backwards.  They want to be paid for the value that they created for the firm.  They want to be paid in cash for that value.

2.  The Short Term shareholders.  Their time frame is in quarters.  They are most interested in what will be posted as the next quarterly earnings.  They want to be able to cash out their investment at the point where they believe that the next quarter’s earnings will not grow enough to support future price increases.

3.  The Long Term shareholders.  Their time frame is in years – probably 3 – 5 years.  Which is the expected holding period for a long term shareholder.  They are looking for growth in value compared to share price and will usually sell when they believe that the intrinsic value of the firm starts to catch up with the market value.

4.  The public.  Our time frame is our lifetime.  We need to have a financial system that works our entire lifetime.   The public gets nothing from the changes in value of the financial system but ends up paying off the losses that exceed the capacity of the financial system.

The compensation and prudential capital for banks is a trade-off between the interests of all four of these groups.  In the run up to the crisis, the system tilted in the favor of employees and short term investors to the extreme detriment of the long term shareholders and public.

So the solution is likely to be best if the interests of the long term shareholders are made more important.  Right now, a large, possibly most of the long term shareholders are index funds.  Index funds are extremely unlikely to want to have any say in corporate governance or compensation.

So you could surmise that the compensation aspect of the crisis and the drift of all things corporate to fall under the sway of short term investors is a result of the prevalence of index funds.

Black Swan Free World (10)

Black Swan Free World (9)

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Black Swan Free World (3)

Black Swan Free World (2)

Choosing the Wrong Part of the Office

September 17, 2009

From Neil Bodoff

Researchers have discovered, in the broader corporate landscape, that greater financial rewards accrue to the “line managers” who run a business unit and have responsibility for Profit and Loss; on the other hand, corporate (or “support”) functions such as HR, Legal, etc, receive comparatively less money, prestige, and influence. An acute example occurs on Wall Street, where there is a significant difference between “front office” [traders] and “back office” [risk management, etc]. So if actuaries are going to focus on working in risk management, are they relegating themselves to a position of secondary influence?

Who wins with leverage?

August 29, 2009

Leverage increases apparent returns in best of times but Increases risk considerably in worst of times. Investors do not benefit from leverage over time. Managers benefit greatly from leverage. Derivatives are highly levered. Traders think that it is silly to spend any time thinking about notional amounts of derivatives. Insurers should learn that they need to pay attention to the notional amount of their insurance contracts. Owners of now highly diluted shares of banks (and AIG) now know that the leverage of those organizations did not in the end create value. Insurers, like banks, are by their fundamental nature highly leveraged with capital a tiny fraction of gross obligations. Insurers should take extreme caution when considering activity that increases leverage. And they should make an analysis of the true amount of leverage in their activities an important activity before entering a new activity and periodically as the world turns.

For example, if one investor puts his money in a 2/20 hedge fund that is 10 for 1 levered and that pays 10% interest on its funds. If the returns for the first four years are 20% per year, After 4 years, the investor is up over 400%! The hedge fund manager has been paid over 150% of the original investment and the debtholder has been paid 400%. But then in year 5, the investment loses 20%, giving back just one of those four years of outsized gains. All of a sudden, the investor is down to an 8% cumulative gain!!! while the manager and lender have slightly higher gains than after the four fat years.

The sister of this investor had the same amount of money to invest, but put it into an unlevered fund with the same types of investments and without the 20% profit share for the manager. After four fat years of 10% gains, the sister is up over 35% and the manager has been paid only 7% of the original fund value. Now the market drop hits sis’ fund with a 10% loss and she ends the five years up a respectable 19%. The fund manager gets about 9% of the original fund for his five years of work.

Leverage Illustration

Leverage Illustration

Of course, the illustration can be manipulated to make anyone the supreme winner. But this scenario seems pretty telling. Leverage primarily benefits the fund manager, not the investor in this scenario. In many scenarios they both benefit, but there are no scenarios where the manager does poorly on a leveraged investment fund.

So when you die, pray to come back as a leveraged hedge fund manager.

Maybe MTM isn’t exactly what is needed?

August 22, 2009

Everyone (except corporate boards and managers) seem to agree that short term incentive compensation is one of the key drivers for the excessive risk taking that led to the financial crisis. In an earlier post, it is suggested that one of the reasons is that accounting is less reliable in the short term.

Perhaps the problem is Mark-to-Market accounting. While it is an extremely important discipline to know the market value of positions, MTM has a misleading presumption. In effect, MTM treats a position that has been closed by sale on the day that the financials are set exactly the same as an open position.

Short term compensation based upon such accounting allows traders and managers to take credit for open positions AS IF THEY HAD CLOSED THEM. And I mean truly closed them by Risk Transfer, not simply Risk Offset. This means that the firm settles with the trader for something that the trader has not yet done and that there is no sure indication that the trader could actually accomplish.

That is because the MTM value may or may not be the amount of cash that the trader could get for their position, especially if you include the requirement that the risk is actually really and totally off the books, not simply offset. To know the actual cash equivalent and the difference between that cash equivalent and the MTM value, a firm would need to study each market to understand the trend and liquidity.

This issue is particularly important when valuing the custom non-exchange traded derivatives. Practice is to value those contracts by a replication process, using market traded instruments. There is no attempt to assign any illiquidity premium. This accounting practice is one of the fundamental supports to the practice of trading off market. During the height of the sub prime crisis, it was found that there was no market at all for some of these securities and the MTM process produced completely sham values. Sham because the real clearing value for the securities was much lower than the values that the holders wanted to report.

The difference between the next trade and especially a trade of the size of the position valued and the last trade regardless of the size of the trade is the issue here. And the problem is with treating completely closed positions exactly the same as open positions, by valuing them both as realistic cash equivalents.

Finally, there is the issue of continuing risk. A totally closed (transferred or expired) position has no capital requirement. An open position SHOULD have a capital requirement. Even an OFFSET position should have a capital requirement based upon the basis risk, the counterparty risk.

This discussion reveals an additional risk – the clearing risk.

So the value of the open position needs to reflect one level of clearing risk and the capital needs to reflect a much larger amount of clearing risk.

Lessons From the Financial Crisis

August 15, 2009

Short Term Compensation for long tailed risks – encouraged more and more risk taking. Did not hold anyone responsible for the ultimate losses. Solution is longer term compensation. Some insurers have started to make underwriter compensation payout over multiple years.

In some cases, some people were paid with short term compensation while others were paid with long term incentives. Those being paid short term maximized their comp, blew up the company after cashing their check, leaving those with long term incentives with nothing to show for years and years of incentive comp.

This has become a common conclusion from the crisis. But it does not seem to have seeped into the boardroom. This article tells how executive comp is moving in the opposite direction.

But why is long term better than short term? The main reason is because accounting is unreliable in the short term. In the long term, everything is cash, so accounting is not as troublesome. But short term incentive income invites managers to figure out the flaws in the accounting rules that give the best immediate results regardless of the underlying economics (read long term cash).

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