Archive for the ‘Credit Risk’ category

Management by Onside Kick

June 6, 2016

Many American football fans can recall a game when their team drove the ball 80 or more yards in the waning moments of the game to pull within a touchdown of the team that had been dominating them. Then they call for the on side kick – recover the ball and charge to a win within a few more plays.

But according to NFL stats, that onside kick succeeds only 20% of the time in the waning minutes of the game.

Mid game onside kicks – that are surprises – work 60% of the time.

But mostly it is the successful onside kicks that make the highlights reel. RISKVIEWS guesses that on the highlights those kicks are 80% or more successful.

And if you look back on the games of the teams that make it to the Super Bowl, they probably were successful the few times that they called that play.

What does that mean for risk managers?

Be careful where you get your statistics. Big data is now very popular. Winners use Big Data. So many conclude that it will give better indications. But make sure that your data inputs are not from highlight reels or from the records of the best year for a company.

Many firms use default data collected by rating agencies for example to parameterize their credit models. But the rating agencies would point out that the data is from rated companies only. This makes little difference for rated Bonds. There the bonds are rated from issue to maturity or default. But if you want to build a default model of insurers or reinsurers then you need to know that many insurers and some reinsurers will drop their rating if it falls below a level where it hurts their business. So ratings transition statistics for insurers are more like the highlight reels below a certain level.

Some models of dynamic hedging strategies were in effect taking the mid game success rates and assuming that they would apply in bad times. But like the onside kick, things worked very different.

So realize that a business strategy and especially a risk mitigation strategy may work differently when things have gone all a mess.

And an onside kick is nothing more than putting the ball in play and praying that something good will happen.

Society and the Default Put

September 7, 2011

The idea of the Limited Liability Corporation is one of the innovations that is credited with making capitalism work. The structure allows a person or group to form a business without risking their entire fortune. That is the way that economics textbooks say it. It sounds like all upside.

But wait a minute. Think about it like a risk manager. A real risk manager, not the hucksters who sold the “risk goes away if you split it fine enough” or the “no increase in total risk because of diversification benefits” stories.

A real risk manager knows that a loss is a loss. A dollar (or euro, or pound) is a dollar. Losses do not disappear EVER. Unless you do the work to prevent them.

And limited liability is NOT a loss prevention program. It prevents losses from transmitting to a certain party. The owner of the company. But someone always gets those losses.

Think about it for just a fraction of a second. If a company has obligations that it cannot pay, who has a loss? You figured it out; their counterparties take the loss. It might be customers, suppliers, subcontractors, their bank, or bondholders. The limited liability idea protects only one group – the owners/shareholders. Everyone else has unlimited liability!

What we saw in the crisis, if you owe the bank $100,000 they own you. If you owe the bank $10,000,000 then you own the bank.

This limited liability idea is totally embedded now. Everyone believes that they have the RIGHT to create problems for everyone else that deals with them and JUST WALK AWAY.

In ancient times, the ultimate collateral was the debtor’s personal freedom. A person who defaulted on a debt became an indentured servant of the lender in the case of default. This idea persisted in one form or another until the 1800s when debtors prisons became out of favor. The US was one country that led the way on this movement. The US has always had a much easier attitude to bankruptcy. There has always been much less stigma attached to bankruptcy along with the easier legal climate.

So the system works this way – people and businesses can go bankrupt easily and put their excess losses onto their counterparties. And in reaction to this, counterparties must be careful who they do business with.

That means that Credit Risk Management is a fundamental aspect of the business environment.

However, when you recognize the underlying fundamental reason for that statement, you may question whether the new statistical based Credit Risk Management that has developed over the past 25 years actually satisfies the fundamental need of the system.

Under the statistical approach to CRM, diversification is the key risk management tool. This has replaced the time consuming and labor intensive credit underwriting process.

But it is the underwriting process that works to counter balance the default put that is implicit in the bankruptcy rules.

Without the underwriting, the statistical process will simply not work. It will give totally wrong information. That is because statistics does not work on any old bunch of numbers. Statistics only works on homogeneous sets of numbers.

Let’s review. The default put creates a situation where a person or a firm can take on obligations that they cannot repay AND they will not be held responsible to repay. When people or businesses operate AS IF they were going to pay obligations, then they can receive value from counterparties that is in excess of the value that they will repay. So their counterparties need to police this imbalance.

Statistical CRM means that the lender will make many loans with the expectation that only a few will fail to repay and there will be limited losses from those failures. But once borrowers notice this (or intermediaries who have a better chance to notice) their best outcome is to borrow as much as they can, to leverage up as much as possible. Their upside in the event that everything turns out well is then enormous and they suffer none of the downside.

So statistical CRM leads directly to deterioration in credit quality through excess leverage. No one is actually watching to make sure that the credit risk per loan is staying constant.

And the main risk management tool of diversification fails when the loans themselves become the major source of risk. The correlation between excessive lending and defaults is very high. It is different from the correlation between loans that can be repaid easily.

All this results directly from that default put.  You need to understand the true dynamics of the system if you want to get your risk management right.

Soverign Default Risk

August 7, 2011

Perspective is very important for a risk manager. That is because lack of perspective leads to many of the largest thinking about the cause and likelihood of loss events.

Regarding the US debt ceiling manufactured crisis, there is very interesting perspective on the issue of the US Federal Debt in an article in the NY Times.  The story links the current Tea Party movement all the way back to Jefferson and Madison.  It seems that the US has always had a major faction strongly opposed to big government and government debt.

However, Riskviews would suggest that some have taken a valid disagreement about the size of government and the level of debt and used that to manufacture a crisis that has the potential to create a second major global recession of the size and scope of the one we have not yet recovered from.

But if you have read the story of the 1930’s history, you will see that is exactly what happened then.  Government policy and actions during the 1930’s took several major turns as the economy staggered up and down.  To this day, there is no agreement of whether one set of government actions or the movements in the opposite direction were the cause or the solution to the problem.

We seem destined to repeat the same sort of lurching process to find our way out.

In fact, we will never know which really works – spending or austerity – to help with a bad part of the business cycle.

Another great source of perspective on Sovereign Default is the Reinhart, Rogoff book This Time is Different.  The book goes through hundreds of years of history and dozens of sovereign defaults.  One of their main conclusions is that sovereign default is usually a politically driven event, rather than a financially driven event.  The drama in Greece follows the historical patterns described in the book.  The involvement of the rest of the EU in the Greece situation is unusual, but not at all unique.

Reinhart and Rogoff make the case that sovereign defaults are mostly political, rather than economic.  That is the thinking that seems to motivate S&P in their downgrade decision on the US debt.  S&P says that

we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.

But it is unclear to RISKVIEWS whether there is not also a major long term economic problem for most of the G20 economies.  The demographic imbalances may prove the downfall of one or several of the major economic powerhouses of the past 50 years.

It’s All Relative

November 7, 2010

Another way to differentiate risks and loss situations is to distinguish between systematic losses and losses where your firm ends up in the bottom quartile of worst losses.

You can get to that by way of having a higher concentration of a risk exposure than your peers.  Or else you can lose more in proportion to your exposure than your peers.

The reason it can be important to distinguish these situations is that there is some forgiveness from the market, from your customers and from your distributors if you lose money when everyone else is losing it.  But there is little sympathy for the firm that manages to lose much more than everyone else.

And worst of all is to lose money when no one else is losing it.

So perhaps you might want to go through each of your largest risk exposures and imagine how either of these three scenarios might hit you.

  • One company had a loss of 50% of capital during the credit crunch of the early 1990’s.  Their largest credit exposure was over 50% of capital and it went south.  Average recoveries were 60% to 80% in those days, but this default had a 10% recovery.  That 60% to 80% was an average, not a guaranteed recovery amount.  Most companies lost less than 5% of capital in that year.
  • Another company lost well over 25% of capital during the dot com bust.  They had concentrated in variable annuities.  No fancy guarantees, just guaranteed death benefits.  But their clientele was several years older than their average competitors.  And the difference in mortality rate was enough that they had losses that were much larger than their competitors, who were also not so concentrated in variable annuities.
  • Explaining their claims for Hurricane Katrina that were about 50% higher as a percent of their expected total claims, one insurer found that they had failed to reinsure a large commercial customer whose total loss from the hurricane made up almost 75% of the excess.  Had they followed their own retention rules on that one case, that excess would have been reduced by half.

So go over your risks.  Create scenarios for each major risk category that might send your losses far over the rest of the pack.  Then look for what needs to be done to prevent those extraordinary losses.

Reliance on Risk Management

October 13, 2010

Many life insurance firms may not really be aware of the degree to which they are exposed to risk.

When these firms write a life insurance policy, they are immediately exposed to a significant amount of gross risk.  Looking at the entire liability book, the risk is immense.  Many multiples of capital.

I  am not talking about the fact that face amounts of insurance far exceed premiums.  What I am trying to point out is that there is a very large amount of risk created by accepting premiums with the guarantee of certain surrender values.  (There is somewhat more mortality risk there than many insurers may realize, but it is not significant on a gross basis compared to the interest rate risk on the cash values.)

Insurers tend to forget about this because there is a very longstanding practice of offsetting that risk by investing funds (called the assets) of the life insurer.

The folks who are insisting on market value accounting for insurance liabilities are trying to point out this fact of life.

In many markets, the insurer will then take investment risk – credit or market – with the investments and finally they will do something further that deeply offends the market value folks.

They will split some of the money that they are paid in risk premium with their policyholder/customer.

This practice can probably be traced back to the time when the predominant form of life insurance was mutual life insurance.  Under that structure, the policyholder is thought to share the risk of the insurance company, and it therefore makes sense that they would share in the risk premium.

Non-mutual firms found that they could not compete with this because most customers did not understand that they had the choice of one level of return within their insurance policy at a certain level of risk and a lower level of return with a lower amount of risk. The customers usually just saw the net return.  Risk was not communicated well.  Usually risk was communicated very vaguely while return seemed to be really tangibly conveyed.

So what the market value folks are trying to accomplish is to overcome hundreds of years of confusion about the actual level of risk of an insurer.

You see, risk premiums are usually collected in advance of losses.  If an insurer is paying some fraction of its risk premiums to its customers, and it does not have a loss sharing mechanism as is fundamental to a mutual insurance scheme, then it is acting similarly to a leveraged hedge fund.

The resources of the insurer to absorb losses is the capital, but the exposure to losses extends to a much larger pool of insured funds.

So the market valuing of insurance liabilities is really a risk recognition exercize.  It is trying to make a point, that point being that the practices of insurers have evolved to become much riskier than what they had been in the past.  And the mark to market system would force insurers to acknowledge that additional risk at the point at which they decide to tak on the risk.

Now, it appears that IFRS accounting is heading a different direction.  The IASB seems to be backing away from a full mark to market system for assets.  This will wreck havoc on the balance sheets and income statements of the insurers who will be marking their liabilities but not their assets to market.

Sort of like the mess that has existed in the other direction for some time not, were insurers in many situations have been marking assets, but not liabilities to market.

Insurance has a reputation for totally opaque financial reporting.  It seems that this reputation will continue to be well deserved.

Assumptions Embedded in Risk Analysis

April 28, 2010

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

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

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

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

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

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

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

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

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

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

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

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

Lessons for Insurers (5)

April 26, 2010

In late 2008,  the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis.  This report featured nine key Lessons for Insurers.  Riskviews will comment on those lessons individually…

5. It is important to develop a counterparty risk management system and establish counterparty limits.

Insurers need to fully understand several things about both credit and reinsurance to get this right.

First of all, in a credit or reinsurance situation, the insurer is usually trading uncertainty in the “expected” range of probabilities for a potential loss at a very high attachment point, the failure point for the counterparty.

Second of all, the insurer needs to recognize that the failure of their counterparty usually does not in any way change their obligation.  When an insurer buys a bond, they are usually responsible to make payments to their policyholder regardless of whether the bond is good.  When an insurer buys reinsurance they are still responsible to pay claims whether or not the reinsurer is able to meet its obligations.

Recognize that in almost all cases, the standard risk management terminology is flawed.  Risk is usually not transferred.

The other consideration that is important to insurers is that they need to look for counterparty exposures everywhere in their operations.  In each of their insurance lines as well as in every part of their investment portfolio.  In firms where traditionally insurance and investments are treated as completelyt separate silos, risk managers are finding that both sides of the house are sometimes dealing with the exact same counterparties.  Aggregation and management of these concentrations is key.

And finally to scare you completely, a good way to think of counterparty risk is that you are bring a fraction of the entire balance sheet on to your balance sheet in return for a contingent payment.  So that should make you very interested in transparency.  Or maybe not.  Maybe you close your eyes when you drive around sharp curves also.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

%d bloggers like this: