Archive for the ‘Financial Crisis’ category

Collective Approaches to Risk in Business: An Introduction to Plural Rationality Theory

December 18, 2013

New Paper Published by the NAAJ
http://www.tandfonline.com/doi/abs/10.1080/10920277.2013.847781#preview

This article initiates a discussion regarding Plural Rationality Theory, which began to be used as a tool for understanding risk 40 years ago in the field of social anthropology. This theory is now widely applied and can provide a powerful paradigm to understand group behaviors. The theory has only recently been utilized in business and finance, where it provides insights into perceptions of risk and the dynamics of firms and markets. Plural Rationality Theory highlights four competing views of risk with corresponding strategies applied in four distinct risk environments. We explain how these rival perspectives are evident on all levels, from roles within organizations to macro level economics. The theory is introduced and the concepts are applied with business terms and examples such as company strategy, where the theory has a particularly strong impact on risk management patterns. The principles are also shown to have been evident in the run up to—and the reactions after—the 2008 financial crisis. Traditional “risk management” is shown to align with only one of these four views of risk, and the consequences of that singular view are discussed. Additional changes needed to make risk management more comprehensive, widely acceptable, and successful are introduced.

Co-Author is Elijah Bush, author of German Muslim Converts: Exploring Patterns of Islamic Integration.

Resilience for the Default

October 17, 2013

In a speech given at the NY Stock Exchange, RISKVIEWS said that there are four paths to Resilience, depending upon the economic environment:

  • Boom – During the boom, the best resilience strategy is to grow!
  • Bust – Triage is the strategy best-suited resilience strategy for the bust.
  • Moderate – During the moderate phase steadily improving is the best strategy.
  • Uncertain – And the best strategy during uncertain times, as you have all figured out the hard way, is to diversify your business.

Many people and companies have been sticking with the Uncertain stage strategy – some for several years now.  The political uncertainty has made that the sanest strategy.  But when there is an actual default situation, we will all be faced with assuming that we will be continuing on with the drabness of the Uncertain stage or will we be popping into the Bust stage?

It makes a big difference to corporate and personal actions.

Under a continuation of the Uncertain phase, the best strategy is to continue with the small decisions to incrementally grow or shrink operations.  Not making any big commitments or any big decisions.  The firms that emerge successfully when the economy finally climbs out of Uncertainty are those who are already doing something that becomes a booming growth area.  But only if they quickly recognize that the Uncertainty has ended and they shift into growth mode.

If the default creates a Bust environment, the companies who will be best off will be those who most quickly realize that and who immediately start to trim their less successful activities and associated expenses.  These firms will deplete less of their resources defending a losing business and be better prepared to protect their core business through the Bust period.  The ultimate winners will also need to recognize the end of the Bust and still have the resources to support the slow (or fast) growth that marks the end of the Bust.

This is where those scenarios come in handy.  A company that has worked its way through the scenarios of the changes in environment will be better prepared to make these decisions about shifts in the environment.

 

Default Scenarios

October 16, 2013

What are the scenarios that you have been thinking about with the US Government Default situation?

NBC News has seven.

1.  Depression and Unemployment

2.  Dollar down, prices and rates up

3.  Down go investments

4.  Social security payments halt

5.  Banking operations freeze

6.  Money market funds break

7.  Global markets walloped

If you are a risk manager, you have probably already worked through your nightmare scenario and have at least some ide of what you might do.

But if you are like the rest of us, you are probably just betting the they will work it out in the end.

Deep in our hearts, we would all choose a scenario with no surprises.  Peter Wack, the father of scenario planning at Shell

My personal scenario is a muddle through.  Just like in the situation of the Lehman default, where the decision was not to act until they saw the repercussions of the default ripple through global financial markets, the US Congress fails to reach a deal until some payments are delayed.  The Treasury goes forward with the deferral process – paying bills in order of when they were due once they have the money.  This goes on for a week or two and several of the NBC scenarios start to happen all at once.  Then Congress finally acts and extends the debt ceiling.

They are still all wrapped up in their own world though and they only pass an extension that will work for several months.  This turns out to be not enough to calm the markets and the chaos continues, even though the US is now paying its bills.

Ultimately, it results in the development of an alternate structure for the global reserve currency.  This results in a permanent rise in the cost of funds for the US government.  Which is itself catastrophic given the historically high debt levels and the long term government funding crisis.

But wait, discounting to the rescue.  With interest rates higher, the future value of many long term obligations, especially at the state and local level suddenly shifts downwards.  The funds that did the least to immunize themselves to interest rate shifts are saved by the power of compound interest as pension obligations magically shrink.

In the end, we – that is the developed countries that depend upon the modern financial system for our wealth – are all poorer by a third or more.  And the US eventually votes one party or the other into a majority position and we try one of their solutions for a time.

But that drop in wealth is only recovered over a generation.

G20 Risk Management Directive 2008

September 11, 2013

RISKVIEWS sometimes remarks that ERM is the only management system that has been endorsed by the heads of state of the 20 largest economies (G20).  The following is an excerpt from the G20 directive from the fall of 2008.

Risk Management

Immediate Actions by March 31, 2009

•  Regulators should develop enhanced guidance to strengthen banks’ risk management practices, in line with international best practices, and should encourage financial firms to reexamine their internal controls and implement strengthened policies for sound risk management.

•  Regulators should develop and implement procedures to ensure that financial firms implement policies to better manage liquidity risk, including by creating strong liquidity cushions.

•  Supervisors should ensure that financial firms develop processes that provide for timely and comprehensive measurement of risk concentrations and large counterparty risk positions across products and geographies.

•  Firms should reassess their risk management models to guard against stress and report to supervisors on their efforts.

•  The Basel Committee should study the need for and help develop firms’ new stress testing models, as appropriate.

•  Financial institutions should have clear internal incentives to promote stability, and action needs to be taken, through voluntary effort or regulatory action, to avoid compensation schemes which reward excessive short-term returns or risk taking.

•  Banks should exercise effective risk management and due diligence over structured products and securitization.

Looking at this list several years on and from outside of banking, we can ask if other financial institutions can get anything from these points.  So we rephrase these points as questions (and provide preliminary answers for the insurance sector):

  1. Are firms aware of risk management best practices?  Most of the larger firms are aware.  Quite a number of small to medium sized firms are not aware of best practices. 
  2. Are firms managing liquidity risk?  Most insurers have provided for a very large range of liquidity needs. 
  3. Are firms managing concentration risks?  Cat modeling provides information to most insurers about their property concentrations.  Other concentrations may not be as well attended to. 
  4. Do firms assess their risk models?  Insurers that had risk models before the crisis are much more wary of those models now.  The insurance sector in the US has been slow in general to adopt a full company modeling approach.  Insurers in Europe and in much of the rest of the world have adopted full company models for Solvency II compliance purposes.  With the delay of Solvency II implementation, it remains to be seen whether those models will be used or shelved until required.  Actions taken purely to satisfy regulation tend to be less effective. 
  5. Are firms using stress tests?  Most firms are using stress tests.  AM Best is urging all those who do not to develop the capability.
  6. Do compensation programs incent decreasing or increasing stability?  Most incentive programs do not reflect risk and therefore may incent increasing instability. 
  7. Do firms apply special diligence to more complicated risk structures?  Most non-life insurers do not tend to participate in complicated risk structures.  Many life insurers do manufacture and sell products with complicated embedded options and took large losses from those products in both 2001 and 2008 because they either did not try to hedge the risks (2001) or had hedging programs that did not perform as needed (2008).  All who offer these products have made serious adjustments to their offering, their hedging or both, but it remains to be seen whether that situation will hold until the next financial crisis disrupts things in an unanticipated manner.

So five years later, the insurance sector seems to have acted on the six points made by the G20 in 2008.  But there are many other elements to a fully effective ERM program.  The ongoing theme of the G20 follow through on risk management through the Financial Stability Board is extremely bank centric.  Insurers who rely upon this source of motivation for ERM will have the elements of ERM for their risks that line up with banks and little ERM for the insurance risks that predominate their operations.

In addition, banks and their supervisors do not seem to be even thinking about a true enterprise wide view of risk.  Insurers that have taken up ERM are adamant about such a view being central to their ERM program.

Has the risk profession become a spectator sport?

April 3, 2013

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.   April 23 and 24th.

This year’s program has been developed around the theme, ERM: A Critical Self-Reflection, which asks:

  • Has the risk profession become a spectator sport? One in which we believe we are being proactive, yet not necessarily in the right areas.
  • For the most significant headlines during the past year, how was the risk management function involved?
  • Since the financial crisis, has there been genuine learning and changes to how risk management functions operate?
  • What are the lessons that have been learned and how are they shaping risk management today? If not, why?
  • Does risk management have a seat at the table, at the correct table?
  • Are risk managers as empowered as they should be?
  • Is risk management asking the right questions?
  • Is risk management as involved in decision making and value creation as it should be, at inception of ideas and during follow through?

On Wednesday, April 24 Former FDIC Chairman Sheila Bair will be the featured luncheon speaker

Sheila C. Bair served as the 19th chairman of the Federal Deposit Insurance Corporation for a five-year term, from June 2006 through July 2011. Bair has an extensive background in banking and finance in a career that has taken her from Capitol Hill to academia to the highest levels of government. Before joining the FDIC in 2006, she was the dean’s professor of financial regulatory policy for the Isenberg School of Management at the University of Massachusetts-Amherst since 2002.

The ERM Symposium and seminars bring together ERM knowledge from the insurance, energy and financial sectors.  Now in its 11th year, this premier global conference on ERM will offer: sessions featuring top risk management experts; seminars on hot ERM issues; ERM research from leading universities; exhibitors demonstrating their ERM services.  This program has been developed jointly by the Casualty Actuarial Society (CAS), the Professional Risk management International Association (PRMIA) and the Society of Actuaries (SOA).

Riskviews will be a speaker at three sessions out of more than 20 offered:

  • Regulatory Reform: Responding to Complexity with Complexity – Andrew Haldane, executive director of Financial Stability at the Bank of England, recently made a speech at the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Policy Symposium titled “The Dog and the Frisbee” warning that the growing complexity of markets and banks cannot be controlled with increasingly complex regulations. In fact, by attempting to solve the problem of complexity with additional complexity created by increased regulation, we may be missing the mark—perhaps simpler metrics and human judgment may be superior. Furthermore, in attempting to solve a complex problem with additional complexity, we may not have clearly defined or understand the problem. How does ERM fit into the solutions arsenal? Are there avenues left unexplored? Is ERM adding or minimizing complexity?
    • We are drowning in data, but can’t hope to track all the necessary variables, nor understand all or even the most important linkages. Given the wealth of data available, important signals may be lost in the overall “noise.”
    • Unintended consequences maybe lost/hidden in the maze of complexity thereby magnifying the potential impact of future events.
    • The importance of key variables changes throughout time and from situation to situation, so it’s not possible to predict in advance which ones will matter most in the next crisis.
    • We experience relatively few new crises that are mirror images of prior crises, so we really have limited history to learn how to prevent or to cure them.
    • Complex rules incent companies and individuals to “manage to the rules” and seek arbitrage, perhaps seeding the next crisis.
  • Actuarial Professional Risk Management  -  The new actuarial standards for Risk Evaluation and Risk Treatment bring new help and new issues to actuaries practicing in the ERM field. For new entrants, the standards are good guidelines for preparing comprehensive analyses and reports to management. For more experienced practitioners, the standards lay out expectations for a product worthy of the highly-qualified actuary. However, meeting the standards’ expectations is not easy. This session focuses on clarifying key aspects of the standards.
  • Enterprise Risk Management in Financial Intermediation  -  This session provides a framework for thinking about the rapidly evolving, some would say amorphous, subject of ERM, especially as applied at financial institutions and develops seven principles of ERM and considers their (mis)application in a variety of organizational settings. The takeaways are both foundational and practical.

Please join us for some ERM fun and excitement.

 

 

What’s Next?

October 27, 2011

Buttonwood suggests that there are four paths forward from the global debt crisis:

  1. Grow out of the problem
  2. Inflate the debt to a more manageable level
  3. Default
  4. Extended Stagnation

These four paths happen to coincide exactly with the four views of risk from Plural Rationalities.

The Maximizer will be sure that we can just Grow Out of It if the government will just get out of the way and let the market work its magic.

The Managers will believe that a careful process of gradual inflation will bring the economy back into line with the debt.  This process will work if the expert government economists who really understand the problem are given their freedom to manage this. In the meantime, they will also want to increase the laws and regulations so that this sort of thing will not happen again.

The Conservators believe that since default is inevitable, then we might as well take our lumps and get it out of the way quickly.  They will not be convinced, even after the default that anything has been completely solved and will continue to worry that there is more bad news just around the corner.  So they will be preparing for the next shoe to drop. They will probably favor cutting spending to make sure that things come back into balance.

The Pragmatist will believe that there is not really a good way out and that the economy will be stuck in this stage of uncertainty for an extended period.  They may even believe that the efforts of the others to try to solve the problems might extend that uncertain period even longer.

Looking back on the 1930′s we see that in various countries at various times during that decade that all four paths were tried by various governments.

What worked then?  Well, you can find that there are four different opinions on what was the exact reason that we came out of the depression…..

Mitigating “Margin Call” risks

October 27, 2011

New movie about 24 hours in the life of a troubled bank at the height of the financial crisis, Margin Call.

Read a review from the point of view of a risk manager here.

10 ERM Questions from an Investor – The Answer Key (2)

July 6, 2011

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

2.  One of the large banks that is no longer with us had, on paper, a complete ERM system with a board risk committee that they reviewed their risk reports with every quarter.  But in 2007, when the financial markets were starting to crack up, their board risk committee had not met for more than six months.  The answer to this question is the difference between a pretend ERM system and a real risk system.  The time spent should be proportionate to the complexity of the risk positions of the firm.  For the banks with risk positions that are so complex that they feel that they cannot possibly find enough paper to disclose them, there needs to be much more board time spent, since investors are relying on board oversight rather than market discipline to police the risk taking.  Ask Bernie what you can get away with if there is no disclosure and no oversight.

Many CEOs will tell you that the board has always spent plenty of time talking about risk.  This might be true.  But the standard now is for boards to have a formal risk committee.  Boards that have simply added risk to the Audit committee’s agenda ends up short changing either audit or risk or both.  The Audit Committee had a full plate before the Risk responsibility was added.

And for a larger complex firm, a single annual risk briefing on risk is definitely not sufficient.  For a firm with an ERM program, the board needs to review the risk profile, both actual and planned for each year, approve the risk appetite, approve the ERM Framework and policies of the firm, review the risk limits and be informed of each breach of the limits or policies of the firm.  If the firm has an economic capital model, the model results need to be presented to the board risk committee each year and updated quarterly. Risks associated with anything new that the company is doing would be presented as well.

Does that sound like anything other than a full committee?  So your follow up question, if the CEO gives a vague answer is to ask about whether the board reviewed each of the items listed in the preceding paragraph in the past year.

Back to that former bank.  Their risk reports showed a massive build up in risk in violation of board approved limits.

And the board risk committee saved time by not meeting during the period of that run up in risk.

When Imagination Fails

June 2, 2011

Most often when there is a regime change. Many work to change things back to the way that they were. Others simply wait for things to return to normal.

It is often a failure of imagination.  People cannot imagine that the world is not going to be what it was.

As many folks are fighting changes that came about as a result of the Global Financial Crisis, they are pushing and pushing for things to go back to the way that they were.  They understand that world, they even think that they understand how to prosper in that world.  They believe that if you take away the single thing that went sooo bad, the sub prime mortgages, that everything else will go back to being just as it was.

Nothing could be further from the truth.  Things will never go back to how they were.  Much of how things were was supported by the excess wealth that we all thought that we had because of the inflated values of our homes.

And does going back to the world of 2005 but without sub prime mortgages make any sense anyway?  Do we really think that we know which of the many things that happened prior to the Crisis were the actual causes?

Many things changed in the 78 years between Global FInancial Crises.  Some of them were the reason for the increases to global wealth and some were the causes of the abrupt reversal of the favorable economic trends.

The changes that are resulting from the 2008 GFC could be the start of the next regime.  Or else, we coud go through a start and stop process as the US did in the 1930′s where government policymakers shifted back and forth in their approach to the economy and to financial market and financial market participants.  Eventually they settled on a system.  The economy went through good growth under that system until the late 1960′s when a new set of major changes were made and a new regime was started.  The 1970′s were a period of financial turmoil into the early 1980′s until that regime settled into a stable situation.

A few will adapt quickly and thrive in the new regimes.  Others cling to the idea that somehow someway, the good old days will come back.

Take a look at the past experience.  It is time for a new regime.  It has taken ten years or more for a new regime to settle.  We have five or six years to go.

Use your imagination.  Imagine a new future regime.

 

Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis

April 22, 2011

A second series of essays from the actuarial profession about the financial crisis.  Download them  HERE.

A Tale of Two Density Functions
By Dick Joss

The Systemic Risk of Risk Capital (Or the "No Matter What" Premise)
By C. Frytos &I.Chatzivasiloglou

Actuaries and Assumptions
By Jonathan Jacobs

Managing Financial Crises, Today and Beyond
By Vivek Gupta

What Did We Learn from the Financial Crisis?
By Shibashish Mukherjee

Financial Reform: A Legitimate Function of Government
By John Wiesner

The Economy and Self-Organized Criticality
By Matt Wilson

Systemic Risk Arising from a Financial System that Required Growth in a World with Limited Oil Supply
By Gail Tverberg

Managing Systemic Risk in Retirement Systems
By Minaz Lalani

Worry About Your Own Systemic Risk Exposures
By Dave Ingram

Systemic Risk as Negative Externality
By Rick Gorvette

Who Dares Oppose a Boom?
By David Merkel

Risk Management and the Board of Directors–Suggestions for Reform
By Richard Leblanc

Victory at All Costs
By Tim Cardinal and Jin Li

The Financial Crisis: Why Won't We Use the F(raud) Word?
By Louise Francis

PerfectSunrise–A Warning Before the Perfect Storm
By Max Rudolph

Strengthening Systemic Risk Regulation
By Alfred Weller

It's Securitization Stupid
By Paul Conlin

I Want You to Feel Your Pain
By Krzysztof Ostaszewski

Federal Reform Bill and the Insurance Industry
By David Sherwood

Countercyclical Capital Regime

April 4, 2011

There has been much talk about the procyclicality of the Basel II and Solvency II type capital regimes.

There is a very simple alternative that was used for many years in Canada that would work most of the time.

The system was very simple.  It applied to common stocks as well as real estate.  In the following discussion, the common stock application will be the focus. It was not thought of as a risk capital system.  But it can be used for such, and can be quite effective to create a capital regime that accumulated more capital during booms and that can require less capital after a bust.  That is what is wanted for a Countercyclical Capital Regime.

For common stocks, the process was to add all capital gains and losses to the requires capital balance and then to release a steady percentage of the required capital balance into earnings each year.

To illustrate, lets look at a firm that in 1991 acquires $100M of equities in a S&P500 index fund that beats the index by exactly its expenses each year.  They use those assets to fund $65 M of fixed liabilities that for this illustration never change in amount.

Each year, they intend to dividend out 90% of the funds that they are not required to hold to support the $65 Million of liabilities or the required capital.   Their returns are as follows:

Now if the regulatory regime says that they need to hold 34% of their position as capital each year.  That regime is PRO CYCLICAL because when they have losses, they will also need to find funds somewhere to add to their capital in the years when they have large losses.  This sort of system usually means that they will need to liquidate some risky assets somewhere to release capital to fund this or some other shortfall.  They might just choose to stop funding this liability with equities therefore meaning that they sell their entire position into a down market thereby adding to the sales that drive down prices.

The table below shows what happens in that situation.

Now with the counter cyclical system that is described above, that situation does not happen.  For this illustration, the rule is set that the initial capital requirement is the same 34% as the previous example.  But after that, the capital requirement moves up and down with the gains and losses and releases from the capital.   The same rule of paying dividends with 90% of excess assets.

With this COUNTERCYCLICAL CAPITAL REGIME, you can see two things.  (1) What sort of countercyclical rule might have worked and (2) Why there will never ever be anywhere near enough will for an adequate countercyclical regime to actually be put into place.

  • The sort of regime that is needed is one that will build up capital in good times and allow lower capital in bad times.  In this illustration, the capital build up went as high as 72.3% of assets in 1999.  The bursting of the dot com bubble losses were all absorbed by the enormous capital cushion.  Then the Global Financial Crisis bubble burst in 2008 was also absorbed by the capital, driving the capital level down below 20%.
  • And that is why it will never happen.  Regulators will never be able to withstand the pressure to allow release more of the capital when it gets as high as 70%.  And they will never be able to agree that less than 20% capital is sufficient right after the market has shown that it can lose 37% in a calendar year (almost 50% for the 365 day maximum peak to trough.)

So here is a simple, practical countercyclical capital regime that was actually part of the Canadian system for many years.  It can work.

But if you try to propose something along these lines to one of the regulators who claim to be seeking an answer to this problem, they will say that they do not want something this formulaic.  They want there to be some discretion.

Does that mean that they think that they will be able to do better than this simple tested process?

Or are they simply being realistic and admitting that they have no political chance of staying the course with such a system so there is no reason to adopt.

It’s the Jobs, Stupid

March 29, 2011

Some time ago, economists noticed that people, or consumers in their terminology, are important to the economy.

What would we see if we assumed that it is not markets, or traders, or businesses, but people that was the only important factor in understanding the economy?

Here are some thoughts:

  • The Great Depression was a symptom of a problem that people had.  That problem was that there was no place in the economy for a large fraction of the population.  The introduction of the tractor and the combine harvester greatly improved the productivity of agriculture.  The flip side of productivity is a reduction in the need for laborers.  The massive unemployment of the Great Depression was not due to an irrational contraction in demand.  There was a rational contraction of jobs.
  • The efforts to stimulate economic activity during the depression failed because there was literally nothing for the vast numbers of unneeded farm workers to do.  Nothing that they had the training or the experience doing.
  • When WWII came, the war effort resulted in America becoming the factory of the Allied efforts.  Americans were trained en mass to work in the modern factories.  This changed the labor situation in the US drastically.
  • During WWII, the other large advanced economies in the world destroyed each other’s economies.  When the war was over, the American economy was able to quickly switch over to peacetime manufacturing and the global competition was busy rebuilding.  So America had a period of time to create a huge lead in its capabilities.  The manufacturing economy created great wealth and when the European and Japanese economies came back up to speed, there was more than enough for all to be wealthy.
  • Starting in the 1990′s another wave of productivity enhancement started with the internet and other electronic media.  At the same time, many of the advanced manufacturing jobs started to shift to China as it opened up to trade with the outside world.  The China wage for manufacturing was originally 10% of the American wage for manufacturing work.  India did the same for office work providing a source of office labor at 25% of the American wage.
  • In the first decade of 2000, the housing boom masked the situation.  Many people found that they had enough wealth to spend for what they wanted from the inflated values of their homes.  Many people were employed in the housing construction business, building homes that were ultimately found to be unwanted.  White collar jobs were also created by the housing boom selling houses and processing the mortgages that turned out to be so, so bad.
  • The Financial Crisis can be seen as another situation like the Great Depression.  There are no jobs for a large fraction of the population in several countries including the US.  Without jobs, because there is not enough work in those economies for their skills.
  • The unemployment problem will be not be solved by simple stimulus.  The manufacturing and construction skills of a large segment of the working age population are no longer valuable enough to support a middle class lifestyle in the advanced economies.
  • At the same time, there is a demographic issue.  Well known.  The retiring Baby Boomers may cause a major shift of spending further away from investing and into consumption.  Satisfying their needs will probably solve the short term employment issues in the economies of all of the advanced nations.  Growth of economies has been driven in part by growth of populations.  There is no model for operating a segment of the world economy with a shrinking population that is favorable to that segment.
  • The advantage that America had because of WWII has by now completely dissipated.

This related to risk and risk management because of the relationship between leverage and risk.  One of the solutions that has been a reaction to the slow growth is leverage.  And slow growth plus leverage is the recipe for disaster.  More on the relation of risk and leverage in another post.

Crossroad of ERM

March 18, 2011

The ninth ERM Symposium in Chicago was the crossroads of ERM for a few days.

Heard there:

  • The Financial crisis was not the failure of regulators, except perhaps the OTS.
  • Compliance culture of risk management in banks contributed to the crisis
  • 85% of bank losses were from the structured finance area.
  • Securitization was 30 years old, but there was a quantum jump of complexity.
  • Banks were supposed to have been sophisticated enough to control their risks.
  • Discussion of subsidization of housing was broadly blamed.
  • Riskviews suggests that only a tiny part of the fault is with housing policy.  Rest is simply finger pointing at best and deliberate misdirection at worst.  Losses and problems in banks were 400% or more higher than actual losses in mortgages, possibly 1000% or more higher.  Severe losses resulted from using housing as the basis for gambling.  They could have just as easily have bet on rainfall.  Then would they blame the weather for the losses?  Securities in play far exceeded the amount of mortgages.  And the multiple layers of bets concentrated on the worst stuff.
  • Regulators need to keep up with innovation and excessive leverage from innovation.
  • Riskviews:  No evidence that regulators have even started to deal with excessive leverage except in the crudest manner.  It is still possible to derivatives to skip right past leverage rules.  If you can replicated a highly levered position with a derivative position, then the derivative position IS A HIGHLY LEVERED POSITION.
  • German regulator requires that banks have a Risk Controller who reports directly to the board.
  • ERM is not an EASY button from Staples.
  • Energy firms that had excessive trading losses were allowed to fail.
  • Banking suffered from concentrated opacity.
  • The board has to challenge management about risk.  Masters of the Universe approach or the smartest guys in the room tries to intimidate the board into feeling too stupid if they ask any questions.
  • There will need to be major cultural changes for ICAAP/ORSA to be effective.
  • Many banks and insurers should be failing the use test for ERM regulation to be effective.
  • Stress testing is becoming a major tool for regulators.
  • European regulators could not apply real stress tests because that would have meant publicly asking banks to look at a scenario of major sovereign defaults in Europe.
  • Regulators need to be able to pay competitive market salaries
  • Cross boarder collaboration among regulators has broken out.
  • Difficult for risk managers to operate under multiple constraints of multiple regulators, accounting systems.
  • Riskviews: It would be much faster to reach wrong conclusions if there were only one system to worry about.  That is not the way to go if there is really a concern about risk.  The multiple points of view encourage true understanding of the underlying risks.
  • Banks are natural oligopolies
  • Nice tree/forest story:  Small trees take resources from the forest.  Large trees shade smaller trees making it harder for them to get sunlight.  Old trees die and fall crashing through the forest taking out smaller trees.
  • Riskviews:  This story illustrates to me that there is too much worry and manipulation to try to fix short term issues.  Natural processes work fairly well.  But interference has allowed a few trees to grow so large that little else can gro making the forest unhealthy.  Solution is to trim largest trees and plant/encourage new smaller trees.
  • Things that people say will never go wrong will go wrong.
  • Compliance should be the easy part of ERM, not the whole thing
  • Asking dumb questions should be seen as good for firm.  10th dumb question might reveal something that no one else saw.
  • There is a lack of imagination of adverse events.  US has cultural optimism.  Culture is risk seeking.
  • Swiss approach to regulating banks is for their banks to hold the most capital.  Credit Swisse has signaled that they will seek lower return on capital.  Using that as marketing advantage – they are the most secure banks.
  • 90% of Risk Management professionals believe that Dodd Frank will push the risks of the financial system out of regulated banks into unregulated financial enterprises. (Hedge Funds)
  • Trade-off between liquidity and transparency is not true
  • Requirements to post collateral may not increase costs at all for non-financial firms.  The dealers were changing them for the lack of collateral.  Prices may go down net of all costs.
  • Bear Stearns was well capitalized.
  • People understand and prefer principles based regulation.  But when trust is gone everything moves towards rules.
  • Riskviews:  MTM should be adjusted for illiquidity.  Much larger adjustment than being contemplated for illiquid insurance liabilities.  Need to compare position size to trading volume.  If position is much larger than trading volume then liquidity adjustment needs to reflect possible price movements during the time needed to liquidate.
  • Many CROs have been given the role of minimizing capital required for the firm.
  • Insurers are moving rapidly to the bank model for this.
  • The range of ERM practices are narrowing
  • Riskviews: Narrow range of practices is only a good thing if the next large risk event is cooperative with practices that everyone is using.  Diversity is much, much healthier.
  • Need to get rid of arb between trading and banking books in banks.
  • FSA wants the whole world on one standard
  • Riskviews: Solves one problem.  Creates another that is doubtless much, much larger.
  • Difficult to explain decisions when there are multiple accounting and regulatory systems.
  • Investors need to do their own due diligence
  • Counterparties are not your friends.
  • Supervisors need to learn to say no.
  • Caveat Emptor
  • Riskviews: Modern US society has moved in the opposite direction of Caveat Emptor.  It is always someone else’s fault.  Risk Management needs to overcome this tendency.
  • Businesses need to learn to say no to non-core activities, no matter how good they look.  They usually do not have the expertise to really examine them, not to manage them.
  • A risk metric that makes you more effective makes you special.
  • Do we overtrade?
  • Reduction of ROE target would take off pressure to take excessive risks.
  • Regulators put 80% weight on model and 20% weight on judgment.  Should be the other way around.
  • We have shifted to being too focused on risk, need to balance business need for returns.
  • There will be unintended consequences from the major shifts in regulation.
  • Must not freeze in a crisis.  Need to act and act approximately correctly.
  • Moral Hazard was a major issue.  Some people should be put in jail because of the crisis.
  • Riskviews: The losses to bank executives and employees were enormous.  People look at salaries of remaining bankers, forgetting that there are now 10% to 20% less of them.  Shareholders of Citi are still off 90% from the peak.  Execs whose net worth was largely in stock holdings and stock options are still out quite a large amount of money.  Riskviews has trouble understanding the moral hazard argument.  It does not match up well with any facts except the bail outs.  Moral hazard ONLY seems to have impact on creditors of banks.  Not unimportant but not the largest driver in bank activities.
  • SIFI do get GSE level cost of borrowing.
  • Riskviews: My question is why it is good public policy for monetary policy to transfer so much money to the shareholders and employees of banks?  They have been able operate at approximately zero cost of goods sold for four years now.  Their lending rates do not pass all of those savings along.  Why does it make sense for the banks to find themselves to be so smart and well paid when they are being totally supported by monetary policy.  In any other business you would have to be totally brain dead to not succeed if someone gave you your raw materials for free.
  • More market discipline is needed.
  • Riskviews:  AMEN

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
http://www.soa.org/professional-development/event-calendar/event-detail/erm-economic/2011-01-14-ap/agenda.aspx

Europe/Africa Program
http://www.soa.org/professional-development/event-calendar/event-detail/erm-economic/2011-01-14/agenda.aspx

Americas Program
http://www.soa.org/professional-development/event-calendar/event-detail/erm-economic/2011-01-12/agenda.aspx

Registration
http://www.soa.org/professional-development/event-calendar/event-detail/erm-economic/2011-01-12/registration.aspx

The Year in Risk – 2010

January 3, 2011

It is very difficult to strike the right note looking backwards and talking about risk and risk management.  The natural tendency is to talk about the right and wrong “picks”.  The risks that you decided not to hedge or reinsure that did not develop losses and the ones that you did offload that did show losses.

But if we did that, we would be falling into exactly the same trap that makes it almost impossible to keep support for risk management over time.  Risk Management will fail if it becomes all about making the right risk “picks”.

There are other important and useful topics that we can address.  One of those is the changing risk environment over the year. In addition, we can try to assess the prevailing views of the risk environment throughout the year.


VIX is an interesting indicator of the prevailing market view of risk throughout the year.  VIX is in indicator of the price of insurance against market volatility.  The price goes up when the market believes that future volatility will be higher or alternately when the market is simply highly uncertain about the future.

Uncertain is the word used most throughout the year to represent the economic situation.  But one insight that you can glean from looking at VIX over a longer time period is that volatility in 2010 was not historically high.

If you look at the world in terms of long term averages, a single regime view of the world, then you see 2010 as an above average year for volatility.  But if instead of a single regime world, you think of a multi regime world, then 2010 is not unusual for the higher volatility regimes.

So for stocks, the VIX indicates that 2010 was a year when market opinions were for a higher volatility risk environment.  Which is about the same as the opinion in half of the past 20 years.

That is what everyone believed.

Here is what happened:

Return
December 6.0%
November -0.4%
October 3.5%
September 8.7%
August -5.3%
July 6.8%
Jun -5.2%
May -8.3%
April 1.3%
March 5.8%
February 2.8%
January -3.8%
Average 1.0%
Std Dev 5.6%

That looks pretty volatile.  And comparing to the past several years, we see below that 2010 was just a little less actually volatile than 2008 and 2009.  So we are still in a regime of high volatility.

So we can conclude that 2010 was a year of both high expected and high actual volatility.

If an exercize like this is repeated each year for each important risk, eventually insights of the possibilities for both expectations and actual risk levels can be formed and strategies and tactics developed for different combinations.

The other thing that we should do when we look back at a year is to note how the year looked in the artificial universe of our risk model.

For example, when many folks looked back at 2008 stock market results in early 2009, many risk manager had to admit that their models told them that 2008 was a 1 in 250 to 1 in 500 year.  That did not quite seem right, especially since losses of that size had occurred two or three times in the past 125 years.

What many risk managers decided to do was to change the (usually unstated) assumption that things had permanently changed and that the long term experience with those large losses was not relevant. Once they did that, the risk models were recalibrated and 2008 became something like a 1 in 75 to 1 in 100 year event.

For the stock market, the 15.1% total return was not unusual and causes no concern for recalibration.

But there are many other risks, particularly when you look at general insurance risks, that had higher than expected claims.  Some were frequency driven and some were severity driven.  Here is a partial list:

  • Queensland flood
  • December snowstorms (Europe & US)
  • Earthquakes (Haiti, Chile, China, New Zealand)
  • Iceland Volcano

Munich Re estimates that 2010 will go down as the sixth worst year for amount of general insurance claims paid for disasters.

Each insurer and reinsurer can look at their losses and see, in the aggregate and for each peril separately, what their models would assign as likelihood for 2010.

The final topic for the year in risk is Systemic Risk.  2010 will go down as the year that we started to worry about Systemic Risk.  Regulators, both in the US and globally are working on their methods for inoculating the financial markets against systemic risk.  Firms around the globe are honing their arguments for why they do not pose a systemic threat so that they can avoid the extra regulation that will doubtless befall the firms that do.

Riskviews fervently hopes that those who do work on this are very open minded.  As Mark Twain once said,

History does not repeat itself, but it does rhyme.”

And for Systemic Risk, my hope is that the resources and necessary drag from additional regulation are applied, not to prevent an exact repeat of the recent events, while recognizing the possibility of rhyming as well as what I would think would be the most likely systemic issue – that financial innovation will bring us an entirely new way to bollocks up the system next time.

Happy New Year!

A Wealth of Risk Management Research

December 15, 2010
The US actuarial profession has produced and/or sponsored quite a number of risk management research projects.  Here are links to the reports: 

Action and Inaction

December 14, 2010

Running a successful business requires doing something almost constantly.

But successful risk management may require doing very little for long stretches of time.

“Just because they say “ACTION” doesn’t mean you have to do anything”  Al Pacino

Good risk management means picking your times and picking your actions.

But there is much for the new risk manager to do between the day when they are first given their charge (the call of ACTION) and the day when they must take their first ACTION.

Many new risk managers get completely caught up in the process of creating a risk management system and the idea of ACTION gets moved into some sort of bureaucratic haze.  The risk management systems that are described in many textbooks and articles make it seem like ACTIONs will simply happen on their own if the system is all in place.

But any risk manager who has worked through the financial crisis or through any other major loss making crisis will tell you that the ACTIONs that take care of themselves through the system are only the easiest part of the ACTION that is really needed, that really adds value to the organization.  The really difficult ACTIONs are the ones that are not so clearly indicated, or the ACTIONs that come after a long period of inaction.

Those actions include things like stopping the growth of a profitable risk, stopping writing a particular risk or even shrinking risk positions.

“Every great mistake has a halfway moment, a split second when it can be recalled and perhaps remedied.”
Pearl Buck

There is a time as well when it is too late for the ACTION.  That is because it is usually in the late stages of a boom that the firm takes on the risks that end up making the largest losses.

And when the problem starts to become evident, it is usually much too expensive to lay off the risk positions.  The best you can hope for is to stop growing the positions.

So there are times, during a boom, when the most important but most difficult ACTION for a risk manager to take is to stop the growth of an overheated risk.

But there are many other times when the risk manager can concentrate on inaction.  Just letting the risk control system do its work.

Pick the Targets before You Start Judging

October 4, 2010

In a Oct. 3 FT article, it says that just 30% of 465 executives surveyed said that “they were able to tap risk management programmes to prepare for and minimize the negative outcomes” of the recession.

But I wonder whether minimizing impact of a recession was among the targeted risks of those risk management programs.

And in addition, I wonder whether the risk managers would have been permitted to even think seriously about the impact of a recession as serious as the one that we have (and continue to) experienced.

Financial firms that would have been very well prepared for this recession would have been doing quite a bit more hedging than their peers and the cost of that hedging would have severely reduced earnings prior to the recession.

Non-Financial firms that would have been well prepared would have been running with very low inventories and with loads of unfilled positions, running tons of expensive  overtime prior to the flop.

The article also said that “only 44 percent said that they had adequately captured the potential problems before the downturn.

Some of that may be risk managers being slammed for being poor fortune tellers.   They did not foresee the size of this recession so they missed it.

I would suggest that these survey results are a case of risk management as scape goat.

Don’t get me wrong.  There are times when risk management gets it wrong.

But if you want risk managers to be focused upon minimizing the impact of a once in 75 year recession, then you ought to tell them that before the recession hits, not after.

And if accurate predictions of the economy are required of risk managers, then you ought to completely change your ideas about how much risk managers should be paid.

By the way, if you know now what sort of result you would have wanted from the recession, then that information should be used to set the firm’s risk tolerance – which should be done in advance, not after the fact.

But in fact, 80% of the firms have never agreed on a risk tolerance.  Quite often the reason for not picking one is a reluctance of management to have their options restricted by such a limit, to allow the board into decisions that they want to make without the help of the board.

Financial Reform & Risk Management (2)

September 12, 2010

An AP summary of the negotiated consolidated Financial Reform act of 2010, there are 9 major provisions.  These posts will feature commentary on the Risk Management implications of each.

2. CONSUMER PROTECTION A Consumer Financial Protection Bureau within the Federal Reserve would police lending, taking powers now exercised by various bank regulators.

The current financial crisis is not unique in the financial history in that the major banks took it on the chin.

But while there are many troubling stories of consumers who are suffering hardships as a result of transactions that they entered into during the run up to the crisis, Roger Lowenstein admitted in a recent Sunday New York Times magazine article that try as they might, journalists have not been able to find a story of a truly innocent consumer who was taken advantage of.  In fact, if you look at most situations where folks seem to have been hurt, they either went into the situation with their own greedy motives to get something for nothing (house flippers) or were able to live in much better housing often at a lower price than before the crisis.  As the crisis hit and housing prices fell and refinancing opportunities evaporated, many consumers lost the houses that they could not afford in the first place.  But in fact if you look at the details of what happened, they usually got more than their money’s worth in terms of housing during the time they had a house.  What they lost were their unrealistic expectations.

To be brutally honest, the consumers did ok not well, but ok, and the bankers got hosed.

So as a result, Congress has decided to protect the consumers from any such future abuse.

And to again be brutally honest,  the motives of this “consumer” protection seems to be to protect banks from themselves.

But motives and consequences will doubtless be different.  The consequences of this part of the financial reform act will likely be the erosion of the margins of banks and other financial organizations that deal with consumers.

The margins that banks and others were getting from the sub prime mortgage business were so great that they generated their own myth of the actual viability of that business.  That self justifying myth can be thought of as the actual driver of the crisis.  To anyone who was not caught up in the wave of activity of the housing market, the myth may have seemed as somewhat unrealistic and benign.  But belief in the myth of unending appreciation of real estate enabled people at all levels to justify the behavior that now can be seen to be clearly outrageous.

But getting back to consumer protection, the new Consumer Protection Bureau will clamp down on abuses large and small that have helped to drive the bloated profitability of banks over the past 10 years.

The Risk Management consequences of this are that banks will not stand still and watch their earnings get savaged.  If they did that, then their stock values would either stay low or erode further.  So their reaction will be to seek other sources of revenue to replace the loss of the various fees and charges to consumers that are now found to be abusive.

And why is that a Risk Management concern?  It is because the new activity that will be undertaken to replace the lost revenues adds uncertainty to the system.  Some of that activity will fall inbetween the cracks of the regulatory system.  It will create risks that are not recognized in Basel III.   Some banks will act as if they believe Basel III and run these new activities as if there is no need for capital and end up adding significantly to their actual leverage.

So beware the unintended consequences of this new regulation.  The danger will only pass when banks have accepted the fact that they are fundamentally only 5% to 10% ROE businesses.  As long as they believe that they are 20% to 25% ROE businesses, they will end up finding the risks that will allow them to post those ROEs.

Forget you ever read this

August 30, 2010

I just read a great post that may be a key to understanding both the course of the economy and the public sentiment about government policies.

http://alephblog.com/2010/08/28/queasing-over-quantitative-easing-part-iii/

David Merkel suggests that people are unhappy with the unfairness of government policies.

I would go even further.  People have overwhelmingly come to the conclusion that they need to reduce their own debt.  Many, many people are enduring what they think of as hardship (by ceasing to spend money that they do not have) to bring down their personal debt level.  At the same time, they see the government adding to the public debt.  People are not stupid.  They think of the government debt as THEIR debt.  So they are economizing for naught if for every dollar of debt that they reduce, the government adds a dollar of debt.

Perhaps some day someone will discover a Pelzman effect like mechanism at work with regard to debt.  During the credit bubble that led up to the financial crisis, people where almost totally insensitive to the level of debt.  But now there is a high degree of sensitivity.  So if people feel that there is a right level of debt, then they will take actions to get to that level.  If the government works against that effort, then they will adjust their personal targets so that the aggregate of personal and public debt comes into line with their perceived optimal level of debt.  This may not be because they set a specific target, but because the rising level of public debt makes people uncomfortable and they express that discomfort in the way of looking for more security and less debt.

So maybe the extreme cutting of government spending that is happening in the UK is what is actually needed.  Because the government actions do not exist in some “all things being equal” economics textbook argument.  Government policy and the economy exist in and among the people of the world.

It is widely known that household consumption is a large fraction and major driver of the GDP in the US.  So if we want the GDP to grow, we need to do the things that will get households spending again.  Not in an all things being equal world, but in the real world with real people.

An interesting wrinkle to this is that the Keynesian ideas of using government spending to get out of the Great Depression did not work until the spending for WWII came along and the war spending did the trick.  Some economists have suggested that showed that a larger amount of government spending was needed than was tried prior to WWII.  But the ideas above – that the government spending will not be effective if the people want to save may have kept the earlier spending from working.  The spending for WWII may have worked though BECAUSE people thought of that spending as having its own merits.  WWII spending was necessary.

So perhaps government spending cannot go against the grain of public sentiment to overcome the Paradox of Thrift, unless the public believes that the spending is necessary.

And now to finally link this discussion to risk and risk management…

Perhaps Greenspan is right when he says that he did not know how to pop a bubble.  Maybe that is because he did not believe that he could have changed public opinion about the value of an asset class.  He could take actions that might temporarily hurt the value of an asset class, but it was quite possible that the public attitude would swing right back and keep inflating the bubble in spite of the actions of the Fed.

The same thing certainly has been true within firms.  When the risk manager finds him/her self at odds with the prevailing idea in a firm about a risk, he/she is more likely to lose their job than to change the prevailing opinion.

So in all three cases, in the general economy in severe recession, in an asset bubble and in a company overconfident about a particular risk. the only actions that can be effective will be actions that are not obviously going against the grain.  The actions will need to be designed so that they appear to go with the popular sentiment even when they are really intended to change the fundamentals with regard to that sentiment.

So, I now realize that I need to keep this secret.  So please forget you ever read this.

On The Top of My List

August 28, 2010

I finished a two hour presentation on how to get started with ERM and was asked what were my top 3 things to keep in mind and top 3 things to avoid.

Here’s what I wish I had said:

Top three hings to keep in mind when starting an ERM Program:

  1. ERM must have a clear objective to be successful.  That objective should reflect both the view of management and the board about the amount of risk in the current environment as well as the direction that the company is headed in terms of the future target of risk as compared to capacity.  And finally, the objective for ERM must be compatible with the other objectives of the firm.  It must be reasonably possible to accomplish both the ERM objective and the growth and profit objectives of the firm at the same time.
  2. ERM must have someone who is committed to accomplishing the objective of ERM for the firm.  That person also must have the authority within the firm to resolve most conflicts between the ERM development process and the other objectives of the firm. And they must have access to the CEO to be able to resolve any conflicts that they do not have the authority to resolve personally.
  3. Exactly what you do first is much less important than the fact that you start doing something to develop an ERM program.   Doing something that involves actually managing risk and reporting the activity is a better choice than a long term developmental project.  It is not optimal for the firm to commit to ERM, to identify resources for that process and then to have those people and ERM disappear from  sight for a year or more to develop the ERM system.  Much better to start giving everyone in management of the firm some ideas of what ERM looks and feels like.  Recognize that one product that you are building is confidence in ERM.

Things to Avoid:

  1. Valuing ERM retrospectively taking into account only experienced gains and losses.  (see ERM Value)  A good ERM program changes the likelihood of losses, but in any short period of time actual losses are a matter of chance.  On the other hand, if your ERM programs works to a limit for losses from an individual transaction, then it IS a failure if the firm has losses above that amount for individual transactions.
  2. Starting out on ERM development with the idea that ERM is only correct if it validates existing company decisions.  New risk evaluation systems will almost always find one or more major decisions that expose the company to too much risk in some way. At least they will if the evaluation system is Comprehensive.
  3. Letting ERM routines substitute for critical judgment.  Some of the economic carnage of the Global Financial Crisis was perpetuated by firms where their actions were supported by risk management systems that told them that everything was ok.  But Risk managers need to be humble.

But in fact, I did get some of these out. So next time, I will be prepared.

Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications

August 8, 2010

The 2009 call for essays, “Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications,” which was published in early 2009, contained 35 short essays . Over half of those essays were contributed by folks who were on the INARM email group.

The Joint Risk Management Section of the Society of Actuaries (SOA), the Casualty Actuarial Society (CAS), and the Canadian Institute of Actuaries (CIA) in collaboration with the SOA Investment Section, the International Network of Actuaries in Risk Management (“INARM”) and the Enterprise Risk Management Institute International (“ERM-II”), propose publishing a second series of essays as a follow-up to the first to address “Risk Management: Part Two – Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis.”

Systemic risk is the risk of the collapse of an entire financial system or market as opposed to risk associated with any one individual entity. Risk systems consist of social institutions, laws, processes and products designed to facilitate the transfer, sharing, distribution and mitigation/hedging of risks between various buyers and sellers. Examples of risk systems include insurance, banking, capital markets, exchanges, and government and private health and retirement programs. Historically, these risk systems are rarely analyzed in a manner that looks at the ability of the system to survive extreme risk events and still carry out their function – creating an ongoing market for the exchange of risk. The failure of a risk system may be due to asymmetric information, unbalanced incentives of its participants and/or the failure of trust amongst its participants. In reflecting on the events of the last two years, is it possible to effectively develop early warning indicators that trigger intervention in advance of a complete collapse of an entire financial system or market? Does it make sense to have a chief risk officer of, say, the United States of America, whose role it would be to manage/mitigate this risk?

We invite the submission of essays to address these questions, and to offer thought leadership on the ERM discipline and the essential elements needed to maintain risk transfer systems in times of unusual stresses and unlikely events.

This topic has been intentionally left broad to allow essays that address industry-specific issues or a wide range of issues across industries. Each essay should be no more than two pages (1,500 words or less) and should be submitted no later than Friday September 15, 2010. Depending on the response, we may limit the number of essays that are published. SOA/CAS resources will be utilized to publish and promote the resulting publication. Publication is planned for Fall of 2010. Submit your essay here .

Awards for worthy papers:

1st Place Prize – $500
2nd Place Prize – $250
3rd Place Prize – $100

Feel free to pass along any questions to Robert Wolf , FCAS, CERA, ASA, MAAA, Staff Partner- Joint Risk Management Section and Investment Section, who will be coordinating the publication.

Mitigating Crises

July 21, 2010

ERM Central to Restoring Capital Adequacy

By Jean-Pierre Berliet

It is easy to blame CROs (Chief Risk Officers) and ERM (Enterprise Risk Management) for the impact of the crisis on companies, but such blame is often unfair and disingenuous. In few companies did CROs have the power to prevent the execution of strategies that, although fraught with risk, were pursued to deliver on investor profit expectations and management incentive targets.

The primary objective of crisis mitigation must be to realign risk exposures with risk bearing capital and to improve capital adequacy.  Realigning exposures with capital (and implied “risk capacity”) enhances insurance strength ratings and the confidence of investors and customers. Without such confidence, a company’s business and franchise would erode rapidly.

In response to the present crisis, many companies improved capital adequacy by (a) cutting expenses, (b) decreasing dividend payments, (c) discontinuing share repurchase programs, and (d) selling assets and non-strategic operating subsidiaries, all to preserve or increase capital. There are few buyers during a crisis, however, and so divestitures and asset sales are at lower prices than in normal times (e.g. sale of HSB Group by AIG) and are therefore very expensive sources of capital.

Realignment strategies also involve retrenchment from businesses with substandard returns on capital. Typical outcomes are: (a) sales of blocks of business and renewal rights, (b) cessation of certain coverage types, (c) sales of entire subsidiaries, (d) changes in underwriting limits, terms, and exclusions, (e) reinsurance strategies, etc. ERM risk analysis models provide a basis for assessing the relationship between capital needs and value contributions of various businesses. Without that assessment, it is hard to align risk exposures with available capital.

Estimates of capital requirements based on risk measures over a one-year horizon (typical of solvency regulations) are not credible during a crisis because they assume that fresh “recovery” capital can be raised. Rating agencies, regulators, and investors, however, know that many solvent companies cannot raise fresh capital during a crisis. Capital is only adequate if it can sustain the company’s operations on a “going concern” basis in the absence of access to recovery capital, but with credit for capital generated internally.

Companies need robust insights from ERM to assess their capital needs (on or off balance sheet, including contingent capital) and to develop effective mitigation strategies. Their ERM must:

  • Measure capital consumption by activity and risk type
  • Identify the relative value creation of individual businesses, with appropriate recognition for differences in risk
  • Demonstrate the impact and future value creation of alternative retrenchment strategies

Through such ERM informed views of capital utilization, capital adequacy, and value creation, insurance companies can chart effective strategies to restore their capital adequacy and mitigate the impact of crises.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

Crippling Epistemology

July 17, 2010

Google the term crippled epistemology and you get lots of articles and blog posts about extremists and fanatics and also some blog posts BY the extremists and fanatics.

Crippled epistemology means that someone cannot see the truth.

Daniel Patrick  Moynahan is reported as saying “Everyone is entitled to his own opinion, but not his own facts.”

But there are just too many facts.  Any one person cannot attend to ALL of the facts.  They must filter the facts, choose the facts that are more important.  We all filter the facts that we pay attention to.

But sometimes, those filters become too strong.  Things went along in a certain pattern for a length of time, so we filtered out of our consideration many of those things that either failed to evidence any variability or that had totally predictable variability.

Those filters take on the aspect of a crippling epistemology.  Our approach to knowledge keeps us from understanding what is actually happening.

Sounds pretty esoteric.  But in fact it is one of the most important issues in risk management.

We need to have systems that work on a real time basis to provide the information that drives our risk decisions.  But we must be careful that that expensive and impressive risk information system does not actually obscure the information that we really need.

For the investors in sub prime mortgages prior to 2007, they had developed an epistemology, an approach to their knowledge of the markets.  Ultimately that epistemology crippled them, because it did not allow them to see the real underlying weakness to that market.

So a very important step to be performed periodically for risk managers is an Epistemology Review.  Making sure that the risk systems actually are capturing the needed information about the risks of the firm.

REDUCING MORAL HAZARD

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

jpberliet@att.net

RECOVERING FROM CRISIS

July 5, 2010

By Jean-Pierre Berliet

The VBM process helps companies compare the value contribution of alternative strategies and select a course that would increase company value,

Weaknesses in its VBM process can prevent an insurance company from restoring its risk capacity through earnings retention or the raising of additional capital. Such weaknesses thereby limit its ability to resume growing and recover from a crisis

Access to capital is a critical strategic advantage during a financial crisis.

Companies with a strong reputation for value creation can raise new “recovery” capital without excessive shareholder dilution (e.g. Goldman Sachs). Others find it more difficult, or impossible, to access the public market. This makes them vulnerable to inroads by competitors or unsolicited tender offers. The primary purpose of VBM frameworks and processes is to ensure that companies consistently meet investor value creation expectations and survive crises.

VBM frameworks help managers compare alternatives, so that they can direct capital towards uses that would support the achievement of a sustainable competitive advantage, and also create value. This is challenging in the insurance industry because competitors can duplicate innovations in product features, service delivery, or operational effectiveness in relatively short times and can redirect capital at the stroke of a pen. Such competitive dynamics call for companies to compete by developing organizational capabilities that (a) are tougher to duplicate by competitors and (b) provide a pricing or cost advantage based on service quality, underwriting insights, investment performance, and risk and capital management

Because risk drives capital utilization in insurance businesses, the integration of ERM and VBM frameworks is required in order to develop strategies and plans that meet value expectations. Integration rests on (a) superior insights into risk exposures and capital consumption and (b) consistent risk metrics at the level of granularity needed to achieve a loss ratio advantage (possibly on the same level of granularity as loss ratios are calculated). In practice, these insights and metrics lead to decisions to reject businesses and strategies that will not create value. They provide a foundation for:

  • Measuring capital utilization by line, by market, and in aggregate
  • Driving a superior, more disciplined underwriting process
  • Optimizing product features
  • Maintaining pricing discipline through the underwriting cycle
  • Pricing options and guarantees embedded in products fairly
  • Controlling risk accumulation, by client and distribution channel
  • Managing the composition of the book of business
  • Driving marketing and distribution activities
  • Optimizing risk and capital management strategies

Achieving superior shareholder returns is critical for a company to earn investor trust and maintain access to affordable capital. Having access to capital during a financial crisis may well be the ultimate indicator of success for a company’s VBM framework.

Anecdotal evidence suggests that insurance companies that consistently trade at significant premiums over book value have such insights about risk and maintain a highly disciplined approach to writing business.

The present crisis has increased the cost of capital dramatically, but not equally for all insurers. Capital remains most affordable to those with a strong record of value creation and adequate capital as a result of good risk management. Conversely, it has become prohibitive for those with a lesser record of value creation and who lost credibility as stewards of shareholders’ interests. The latter are at risk of forced mergers or liquidation, which may be punishment for not integrating ERM and VBM processes more effectively.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

Risk Velocity

June 17, 2010

By Chris Mandel

Understand the probability of loss, adjusted for the severity of its impact, and you have a sure-fire method for measuring risk.

Sounds familiar and seems on point; but is it? This actuarial construct is useful and adds to our understanding of many types of risk. But if we had these estimates down pat, then how do we explain the financial crisis and its devastating results? The consequences of this failure have been overwhelming.

Enter “risk velocity,” or how quickly risks create loss events. Another way to think about the concept is in terms of “time to impact” a military phrase, a perspective that implies proactively assessing when the objective will be achieved. While relatively new in the risk expert forums I read, I would suggest this is a valuable concept to understand and more so to apply.

It is well and good to know how likely it is that a risk will manifest into a loss. Better yet to understand what the loss will be if it manifests. But perhaps the best way to generate a more comprehensive assessment of risk is to estimate how much time there may be to prepare a response or make some other risk treatment decision about an exposure. This allows you to prioritize more rapidly, developing exposures for action. Dynamic action is at the heart of robust risk management.

After all, expending all of your limited resources on identification and assessment really doesn’t buy you much but awareness. In fact awareness, from a legal perspective, creates another element of risk, one that can be quite costly if reasonable action is not taken in a timely manner. Not every exposure will result in this incremental risk, but a surprising number do.

Right now, there’s a substantial number of actors in the financial services sector who wish they’d understood risk velocity and taken some form of prudent action that could have perhaps altered the course of loss events as they came home to roost; if only.

More at Risk and Insurance

Radical Collaboration

June 8, 2010

There are situations that require collaboration if they are going to be resolved in a manner that produces the largest combined benefit or the smallest combined loss.  This is not the “greatest good for the greatest number” objective of socialism – it is simple efficiency.  Collaborative results can be greater than competitive results.  It is the reason that a sports team where everyone is playing the same strategy does better than the team where each individual seeks to do their personal best regardless of what everyone else is doing.

There are also situations where the application of individual and separate and uncoordinated actions will result in a sub optimal conclusion and where the famous Invisible Hand points in the wrong direction.

You see, the reason why the Invisible Hand ever works is because by the creative destruction of wrong turns, the individual actions find a good way to proceed and eventually all resources are marshaled in following that optimal way of proceeding.  But for the Invisible Hand to be efficient, the destruction part of creative destruction needs to be small relative to the creative part.  For the Collaborative effort to be efficient, the collaboration needs to result in selection of an efficient approach without the need for destruction through a collaborative decision making process.  For the Collaborative effort to be necessary, the total cost of the risk management effort needs to exceed the amount that single firms could afford.

Remember the story of the Iliad. It is the story of armies that worked entirely on the Invisible Hand principle. Each warrior decided on his own what he would do, how and when he would fight.  It was the age of Heroes.

The stories of the success of Alexander and later the Roman armies was the success of an army that was collaborative.  The age of Heroes was over.   The efficiencies of the individual Heroes each finding their own best strategy and tactics was found to be inferior to the collaborative efforts of a group of soldiers who were all using the same strategy and tactics in coordination.

There are many situations in risk management were some sort of collaboration needs to be considered.

The Gulf Oil leak situation seems like it might be one of those.  BP is now admitting that it did not have the resources available or even the expertise to do what needs to be done.  And perhaps, this leak is a situation where the collective cost of their failure is much higher than society’s tolerance for this sort of loss.  But the frequency of this sort of problem has to date been so very low that having BP provide those capabilities may not have made economic sense.

However, there are hundreds of wells in the Gulf.  With clear hindsight, the cost of developing and maintaining the capacity to deal with this sort of emergency could have been borne jointly by all of the drillers in the Gulf.

There are many situations in risk management where collaboration would produce much better results than separate actions.  Mostly in cases where a common threat faces many where to overcome the threat would take more resources than any one could muster.

Remember the situation with LTCM?  No one bank could have helped LTCM alone, they would have gone down with LTCM.  But by the forced collaborative action, a large group of banks were able to keep the situation from generating large losses.  Now this action rankles many free marketeers, but it is exactly the sort of Radical Collaboration that I am talking about.  It did not involve any direct government funding.  It used the balance sheets of the group of banks to stabilize the situation and allow for an orderly disposition of LTCMs positions.  In the end, I beleive that it was reported that the banks did not end up taking a loss either.  (That was mostly an artifact of depressed market prices at the time of the rescue, I would guess.)

The exact same sort of thinking does NOT seem to have been tried with Lehman.  If Paulson could not find a single firm to rescue Lehman, he was not going to do anything.  But looking back and remembering LTCM, Paulson could have arranged an LTCM style rescue for Lehman.  In hindsight, that, even with government guarantees to sweeten the pot would have been better then the financial carnage that ensued.

Perhaps Paulson was one of the free marketeers that hated the LTCM “bailout”.  But in the end, he trampled the free market much worse than his predecessors did with LTCM when he bailed out AIG without even giving any thought to terms of the bailout.

Collaboration might have seemed radical to Paulson.  But it is sometimes needed for risk management.

The Most Successful Financial System the World has Ever Known

June 2, 2010

Chris Whalen in his June 1 Commentary for RiskCenter reproduces an excerpt from a piece by Peter Wallison.  In that, Peter makes the statement that

“the United States is well on its way to taking down the most innovative and successful financial system the world has ever known.”

And I want to react to the conclusion that he starts with that the financial system is “the most successful”. 

There are two issues that I have with that conclusion. 

  1. The main evidence of success of the financial system is that it has been successful in collecting a major share of the US economy’s profits.  In 1980, the share of the financial sector of total US corporate profits was under 10%.  In the 30 years before that time, the sector had averaged about 12% of profits.  From 1980 to 2006, the financial sector was extremely succesful.  Its share of total US profits grew to over 40%.  A more than four fold leap in share. 
  2. The destruction of value in 2008 in both the financial sector and in the “real economy” was enormous.  In the financial sector, that destruction amounted to over 10 years of profits. 

So first I would question whether the “success” of the financial sector is first of all real?  Shouldn’t we take into account both the losses and the gains when determining success? 

And second, I would question whether even just looking at the “up side” experiences prior to the financial crisis, whether the financial sector success was of any benefit to the economy as a whole, or just to the bankers.  (and many have commented that the bankers did much better than the owners of banks, since the owners had both upside and downside exposures, while the bankers had mostly upside exposures.)

When we decide what sort of regulations that should be applied to the banks, we have concentrated upon the second item above.  The bankers have been concentrating on the first item.  They want to make sure that a system is maintained where their ability to take profits is not constrained by our attempts to limit the possibilities of the second situation reoccurring. 

But I would suggest that in the regulatory discussion, we ought to be thinking about the first situation as well.  Is it possible to run a healthy economy while the bankers are taking over 40% of the profits?  Unless we know the answer to that, we do not know whether we ought to be encouraging the bankers to shoot for 60% of profits or limiting them somehow to under 20% (the pre-1990 maximum level). 

This question is the elephant in the room that is motivating the bankers and that is funding their enormous contributions to politicians.  And the recent Supreme Court decision that allows unlimited political contributions from corporations makes that a much more important question to the politicians than ever before.

The Elephant in the Room

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 jpberliet@att.net

Holding Sufficient Capital

May 23, 2010

From Jean-Pierre Berliet

The companies that withstood the crisis and are now poised for continuing success have been disciplined about holding sufficient capital. However, the issue of how much capital an insurance company should hold beyond requirements set by regulators or rating agencies is contentious.

Many insurance executives hold the view that a company with a reputation for using capital productively on behalf of shareholders would be able to raise additional capital rapidly and efficiently, as needed to execute its business strategy. According to this view, a company would be able to hold just as much “solvency” capital as it needs to protect itself over a one year horizon from risks associated with the run off of in-force policies plus one year of new business. In this framework, the capital need is calculated to enable a company to pay off all its liabilities, at a specified confidence level, at the end of the one year period of stress, under the assumption that assets and liabilities are sold into the market at then prevailing “good prices”. If more capital were needed than is held, the company would raise it in the capital market.

Executives with a “going concern” perspective do not agree. They observe first that solvency capital requirements increase with the length of the planning horizon. Then, they correctly point out that, during a crisis, prices at which assets and liabilities can be sold will not be “good times” prices upon which the “solvency” approach is predicated. Asset prices are likely to be lower, perhaps substantially, while liability prices will be higher. As a result, they believe that the “solvency” approach, such as the Solvency II framework adopted by European regulators, understates both the need for and the cost of capital. In addition, these executives remember that, during crises, capital can become too onerous or unavailable in the capital market. They conclude that, under a going concern assumption, a company should hold more capital, as an insurance policy against many risks to its survival that are ignored under a solvency framework.

The recent meltdown of debt markets made it impossible for many banks and insurance companies to shore up their capital positions. It prompted federal authorities to rescue AIG, Fannie Mae and Freddie Mac. The “going concern” view appears to have been vindicated.

Directors and CEOs have a fiduciary obligation to ensure that their companies hold an amount of capital that is appropriate in relation to risks assumed and to their business plan. Determining just how much capital to hold, however, is fraught with difficulties because changes in capital held have complex impacts about which reasonable people can disagree. For example, increasing capital reduces solvency concerns and the strength of a company’s ratings while also reducing financial leverage and the rate of return on capital that is being earned; and conversely.

Since Directors and CEOs have an obligation to act prudently, they need to review the process and analyses used to make capital strategy decisions, including:

  • Economic capital projections, in relation to risks assumed under a going concern assumption, with consideration of strategic risks and potential systemic shocks, to ensure company survival through a collapse of financial markets during which capital cannot be raised or becomes exceedingly onerous
  • Management of relationships with leading investors and financial analysts
  • Development of reinsurance capacity, as a source of “off balance sheet” capital
  • Management of relationships with leading rating agencies and regulators
  • Development of “contingent” capital capacity.

The integration of risk, capital and business strategy is very important to success. Directors and CEOs cannot let actuaries and finance professionals dictate how this is to happen, because they and the risk models they use have been shown to have important blind spots. In their deliberations, Directors and CEOs need to remember that models cannot reflect credibly the impact of strategic risks. Models are bound to “miss the point” because they cannot reflect surprises that occur outside the boundaries of the closed business systems to which they apply.

©Jean-Pierre Berliet   Berliet Associates, LLC (203) 972-0256  jpberliet@att.net

Managing Strategic Risks

May 19, 2010

Contributed by Jean-Pierre Berliet

It is not enough for insurance companies to understand and manage the financial risks of their business that can cause insolvency. They need also to manage external “strategic” risks to their business. Strategic risks result from events that can undermine the viability of their business models and strategies or reduce their growth prospects and damage their market value. Strategic risks include changes in competitive dynamics, regulations, taxation, technology and other innovations that disrupt market equilibrium. They also include events and changes in other industries that can impact adversely the going concern viability and financial performance of insurance companies.

Until the present crisis, many insurers did not think much about their dependence on the efficient functioning of credit and other financial markets or the overall safety and soundness of the banking system. Now they do. Although the sub-prime mortgage crisis and resulting credit market meltdown can be viewed simply as market risk events, they should be seen as the combined, unexpected but theoretically predictable result of design weaknesses in institutional and regulatory arrangements and changes in financial technology.

From this vantage point, the near collapse of the financial system resulted from:

  • Pro-cyclical effects of capital regulations under fair value accounting standards,
  • Explosive growth of outstanding derivative contracts, especially credit default swaps
  • The redistribution of housing finance risks (especially sub-prime) across financial institutions on a global basis, facilitated by securitization.

Together, these factors combined to create a time bomb. That it exploded is no market risk event, but rather a failure of risk management.

The explosion could have been anticipated. Had CROs not abdicated their responsibilities to rating agencies and conducted appropriate due diligence, toxic securities would not have found their way to their balance sheets. Similarly, fundamental changes in the characteristics of mortgage products and the creditworthiness of the customer base should have been examined closely. Such examination would have diminished the attractiveness of CDOs as investments, have reduced their spread throughout the financial system and have prevented or reduced the losses of capital that caused confidence to collapse and market liquidity to vanish.

Insurers, however, did not understand that risks to the financial system were elements of their strategic risk. Strategic risk elements embedded in the financial system are difficult to mitigate. They create dependencies among businesses that undermine diversification benefits achieved through underwriting of a multiplicity of risks and exposures. They have a tendency to hit all activities at the same time.

In this area, prudence is the source of wisdom. Companies that have had the discipline not to underwrite exposures that they did not understand, or invest in financial instruments or asset classes that they could not assess to their satisfaction (e.g., tranches of securitization backed by sub-prime mortgages), have withstood the crisis comparatively well. Some of these companies are benefiting from the weakness of their less thoughtful and less disciplined competitors. For example, Warren Buffett’s decision to create a financial guaranty insurer recently and to resume investing in U.S. companies appears perfectly timed to capitalize on opportunities created by the weakness of established competitors and the steep fall in the market value of many companies.

Methodologies for identifying, measuring and managing strategic risks are in their infancy. Since there are no established conceptual frameworks to guide analysis and decision making, building resilient portfolios of insurance businesses and protecting them from strategic risks is a challenge. In their oversight roles, directors and CEOs can help company executives by re-examining the appropriateness of traditions, conventions and modes of thought that influence risk assumption decisions.

They should demand that company management:

  • Conduct periodic defensibility analyses of their companies’ business models and strategy, including consideration of weaknesses in institutional arrangements of the financial system. Such strategy review must also focus on the identification and monitoring of emerging trends with adverse effects on competitive advantage and pricing flexibility (loss of business to competitors, emergence of new risk transfer technologies or product innovations, regulatory developments, etc.) that can reduce company valuations sharply and rapidly.
  • Reassess periodically the company’s strategy for controlling performance volatility and achieving a balance between risk and return through specialization in risk assumption, diversification (e.g., across lines, industries, regions or countries), ceded reinsurance or structural risk sharing and financing vehicles such as captives or side-cars.
  • Assess the possibility for disruption of business plans caused by events that reduce capital availability or flexibility in capital deployment.
  • Develop appropriate responses through adjustment in capabilities, redeployment of capacity across lines of activity, change in limits offered, exclusions, terms and conditions, ancillary services provided, lobbying of lawmakers and regulators and participation in industry associations.
  • Hold executives accountable for discipline in under writing and investment decisions.

Because the insurance industry has been highly regulated, many insurance companies have not developed a deep strategic risk assessment capability. They need one urgently.

©Jean-Pierre Berliet   Berliet Associates, LLC (203) 972-0256  jpberliet@att.net

Your Mother Should Know

April 29, 2010

Something as massive as the current financial crisis is much too large to have one or two or even three simple drivers.  There were many, many mistakes made by many different people.

My mother, who was never employed in the financial world,  would have cautioned against many of those mistakes.

When I was 16, I had some fine arguments with my mother about the girls that I was dating. My mother did not want me dating any girls that she did not want me to marry.

That was absolutely silly, I argued. I was years and years away from getting married. That was a concern for another time. My mother knew that in those days, “shotgun marriages” were common, a sudden unexpected change that triggered a long-term commitment. Well, as it happened, even without getting a shotgun involved, five years later I got married to a girl that I started dating when I was 16.

There are two different approaches to risk that firms in the risk-taking business use. One approach is to assume that they can and will always be able to trade away risks at will. The other approach is to assume that any risks will be held by the firm to maturity. If the risk managers of the firms with the risk-trading approach would have listened to their mothers, they would have treated those traded risks as if they might one day hold those risks until maturity. In most cases, the risk traders can easily offload their risks at
will. Using that approach, they can exploit little bits of risk insight to trade ahead of market drops. But when the news reveals a sudden unexpected adverse turn, the trading away option often disappears. In fact, using the trading option will often result in locking in more severe losses than what might eventually occur. And in the most extreme situations, trading just freezes up and there is not even the option to get out with an excessive loss.

So the conclusion here is that, at some level, every entity that handles risks should be assessing what would happen if they ended up owning the risk that they thought they would only have temporarily. This would have a number of consequences. First of all, it could well stop the idea of high speed trading of very, very complex risks. If these risks are too complex to evaluate fully during the intended holding period, then perhaps it would be better for all if the trading just did not happen so very quickly. In the case of the recent subprime-related issues, banks often had very different risk analysis requirements for trading books of risks vs. their banking book of risks. The banking (credit mostly) risks required intense due diligence or underwriting.  The trading book only had to be run through models, where the assignment of assumptions was not required to be based upon internal analysis.

From 2008 . . .

Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications

Lots more great stuff there.  Check it out.

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.

Making Better Decisions using ERM

April 21, 2010

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

Key Points:

ERM’s Role in Strategic Planning

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

ERM is Not:

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

Have You ever heard of the Financial Crisis?

And Much more…

Max Rudolph

LIVE from the ERM Symposium

April 17, 2010

(Well not quite LIVE, but almost)

The ERM Symposium is now 8 years old.  Here are some ideas from the 2010 ERM Symposium…

  • Survivor Bias creates support for bad risk models.  If a model underestimates risk there are two possible outcomes – good and bad.  If bad, then you fix the model or stop doing the activity.  If the outcome is good, then you do more and more of the activity until the result is bad.  This suggests that model validation is much more important than just a simple minded tick the box exercize.  It is a life and death matter.
  • BIG is BAD!  Well maybe.  Big means large political power.  Big will mean that the political power will fight for parochial interests of the Big entity over the interests of the entire firm or system.  Safer to not have your firm dominated by a single business, distributor, product, region.  Safer to not have your financial system dominated by a handful of banks.
  • The world is not linear.  You cannot project the macro effects directly from the micro effects.
  • Due Diligence for mergers is often left until the very last minute and given an extremely tight time frame.  That will not change, so more due diligence needs to be a part of the target pre-selection process.
  • For merger of mature businesses, cultural fit is most important.
  • For newer businesses, retention of key employees is key
  • Modelitis = running the model until you get the desired answer
  • Most people when asked about future emerging risks, respond with the most recent problem – prior knowledge blindness
  • Regulators are sitting and waiting for a housing market recovery to resolve problems that are hidden by accounting in hundreds of banks.
  • Why do we think that any bank will do a good job of creating a living will?  What is their motivation?
  • We will always have some regulatory arbitrage.
  • Left to their own devices, banks have proven that they do not have a survival instinct.  (I have to admit that I have never, ever believed for a minute that any bank CEO has ever thought for even one second about the idea that their bank might be bailed out by the government.  They simply do not believe that they will fail. )
  • Economics has been dominated by a religious belief in the mantra “markets good – government bad”
  • Non-financial businesses are opposed to putting OTC derivatives on exchanges because exchanges will only accept cash collateral.  If they are hedging physical asset prices, why shouldn’t those same physical assets be good collateral?  Or are they really arguing to be allowed to do speculative trading without posting collateral? Probably more of the latter.
  • it was said that systemic problems come from risk concentrations.  Not always.  They can come from losses and lack of proper disclosure.  When folks see some losses and do not know who is hiding more losses, they stop doing business with everyone.  None do enough disclosure and that confirms the suspicion that everyone is impaired.
  • Systemic risk management plans needs to recognize that this is like forest fires.  If they prevent the small fires then the fires that eventually do happen will be much larger and more dangerous.  And someday, there will be another fire.
  • Sometimes a small change in the input to a complex system will unpredictably result in a large change in the output.  The financial markets are complex systems.  The idea that the market participants will ever correctly anticipate such discontinuities is complete nonsense.  So markets will always be efficient, except when they are drastically wrong.
  • Conflicting interests for risk managers who also wear other hats is a major issue for risk management in smaller companies.
  • People with bad risk models will drive people with good risk models out of the market.
  • Inelastic supply and inelastic demand for oil is the reason why prices are so volatile.
  • It was easy to sell the idea of starting an ERM system in 2008 & 2009.  But will firms who need that much evidence of the need for risk management forget why they approved it when things get better?
  • If risk function is constantly finding large unmanaged risks, then something is seriously wrong with the firm.
  • You do not want to ever have to say that you were aware of a risk that later became a large loss but never told the board about it.  Whether or not you have a risk management program.

The Evidence is all Around

March 24, 2010

In October 2008, Alan Greenspan had the following exchange during testimony before a Congressional committee:

Representative HENRY WAXMAN (Committee Chairman, Democrat, 30th District of California): You found a flaw in the reality…

Mr. GREENSPAN: Flaw in the model that I perceived is a critical functioning structure that defines how the world works, so to speak.

Rep. WAXMAN: In other words, you found that your view of the world, your ideology was not right. It was not working.

Mr. GREENSPAN: How it – precisely. That’s precisely the reason I was shocked, because I’ve been going for 40 years or more with very considerable evidence that it was working exceptionally well.

One of the things in that model was an assumption that the self interest of the bankers was a more important factor in containing their risks than regulations.

But the evidence that self interest is insufficient to control excessive risk taking is all around us and has been for many, many years.  It takes a massive amount of selective blindness to ignore it.

All it takes it to take your car out of the driveway and drive on the roads.  Driving involves risk management decision making.  For one thing, almost everyone drives a car that is capable of traveling much faster than the speed limit.  And the speed limits are only very occasionally enforced.  So it is an individual risk management decision of how fast to drive a car.

Now, I happen to live in an area of the New York City suburbs where many of the folks who work on Wall Street firms live.  And the evidence is all around.  Many drivers do not put long term safety self interest above short term time advantage of speeding.  In many cases, they are deliberately trying to take advantage of the folks who are trying to be safe and driving extra recklessly under the assumption that they will not run into someone who is driving as recklessly as they are.

Now it is quite possible that none of the reckless drivers are Wall Street executives.  But the reckless drivers are all people.  And the readily available evidence with 50 years or more of accident statistics to back up shows that self interest is NOT sufficient motivation for safety.

Perhaps economists and especially central bankers do not own cars.

To the rest of us who do, the theory seems to be from another planet.  The people that are risk takers and the people who drive safely are two different sets of people.

Burn out, Fade Away …or Adapt

February 27, 2010

When I was a kid in the 1960′s, I was sick and tired of how much time on TV and movies was taken up with stories of WWII.  Didn’t my parent’s generation get it?  WWII was ancient history.  It was done.  Move on.  Join the real world that was happening now.

From that statement, you can tell that I am a Boomer.  But I am already sick and tired of how much ink and TV and movies and Web time is devoted to the passing of the world as the Boomers remember the golden age of our youth.  Gag me.  Am I going to have to hear this the entire rest of my life?  Get over it.  Move on.  Live in the current world.

Risk managers need to carefully convey that message to the folks who run their companies as well.  What ever way the world was in the “Glory Days” of the CEO or Business Unit manager’s career, things are different.  Business is different.  Risks are different.  Strategies and companies must adapt.  Adapt, Burn Out or Fade Away are the choices.  Better to Adapt.

I saw this happen once before in my career.  Interest rates steadily rose from the late 1940′s through the early 1980′s.  A business strategy that emphasized amassing cash, locking in a return promise and investing it in interest bearing instruments could show a steady growth in profits almost every single year without too much difficulty.  Then suddenly in the mid-1980′s that didn’t work anymore.  Interest rates went down more than up for a decade and have since stayed low.  Firms either adapted, burned out or faded away.

We have just concluded a (thankfully) brief period of massive financial destruction and are in an uncertain period.  When we come out of this uncertainty, some of the long held strategies of firms will not work.  Risks will be different.

The risk manager needs to be one of the voices that helps to make sure that this is recognized.

In addition, the risk manager needs to recognize that one or many of the risk models that were used to assess risk in past periods will no longer work well.  The risk manager needs to stand ready to adapt or fade away.

And the models need to be calibrated to the new world, not the old.  Calibrating to include the worst of the recent past might seem like prudent risk management, but it may well not be realistic.  If the world reverts to a reasonable growth pattern, the next such event may well not happen for 75 years.  Does your firm really need to avoid exposures to the sorts of things that lost money in 2008 for 75 years?  Or would that mean forgoing most of the business opportunities of that period?

Getting the correct answers to those questions will mean the different between Growth, burn out or fading away for your firm.

Visions from the Blind

February 11, 2010

On the same theme as Chief Ignorance Officer I was inspired by a review I just read of the book Invisible by Hughes de Montalembert.  That book tells the autobiography of an artist who is blinded 30 years earlier.  I was struck by the repeated references to things that the blind man was able to learn or notice that might not have been noticed by the sighted. 

So take that idea to risk management and you end up with a very simple but potentially highly powerful exercize.  The idea would be to see what you could learn about one of your risks if you totally exclude the information and anaylysis that you usually use – your eyesight. 

If you rely totally on rating agency opinions for credit analysis, try to see whether you could reach similar information by a process that does not refer in any way to the ratings. 

If you use a one year market consistent economic capital calculation to determine your capital adequacy, could you come to a similar conclusion about your security totally independently from the information and calculations of that model? 

If you develop your underwriting risk view based upon your firm’s experience over the past 15 years, what sort of assumptions would you need to apply to industry history to get to your opinion about your firm’s risk? 

Goldman Sachs famously decided to start hedging their sub prime exposures because an alternate analysis of their experience was just not as consistent with their primary information as it had been in the past.  Notice that they started out with a track record of previous such exercizes and an expectation for the degree of deviation from their different sources.  It is often the case with this alternate analysis that the absolute outcome might not be significant , but divergence in trend might be the key information that can lead to an avoidance of major loss. 

So think about how to put the blinders on to your usual way of looking at your risks.

The Risk of Market Value

January 28, 2010

In 1984, Warren Buffet gave a speech about value investing at Columbia University.  Here is a quote from that speech:

“it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem to be able to grasp the concept, simple as it is.” Warren Buffett

Not about risk management but, if you can get your head around Buffett’s comment about upside, there is a logical counterparty about downside.

“Either the idea of buying dollar bills at $2 seems risky to someone immediately or it never will. If the response is, ‘if that is what the market rate is’ then just dig into your pocket and look for some dollars to sell.” Dave Ingram

In the book “The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History”, Greg Zuckerman tells just how difficult it was to be among the few investors who saw that the US mortgage market was overheated – that the market value of the houses and the securities written on the mortgages on those houses were all dollar bills being traded over and over again at $2.

But that was aggressive trading.  The risk management response with that knowledge would been to stay away.  And many, many financial institutions did stay away.  All of the press went to the firms that played that game to their and all of our detriment.

So the Paulson story of good to read because it tells about the other side of some of the trades.  And there always in another side, no matter how poorly the press chooses to cover it.

And the other side of the risk mismanagement by the largest banks and AIG is the risk management of the firms who were not exposed to overpriced mortgage securities.  But it is hard to make a story about the exposures that those firms did not have.

Which is one of the puzzles of risk management.  Sometimes the greatest successes are when nothing happens.

All Things Being Equal

January 26, 2010

is a phrase that is left out more often than left in when it is actually a key and seldom true assumption behind an argument.

If you are talking about risk and risk models, that phrase should be a red flag.  If the phrase is actually stated, the risk manager should immediately challenge it.  Because when a major risk becomes a loss or threatens to become a loss, very rarely are all things equal.

Most, and possibly all, major loss situations have ripple effects.  These ripple effects may be direct or they may be because they affect people who then in turn take actions that cause other unusual things to happen.

Here is a map of how the World Economic Forum thinks that the major risks of the world are interconnected:

Another example of a problem with the “All things Being Equal” assumption is the discussion of inflation.  Few people remember to say it but when they worry that addional money in the system due to direct Fed actions or Stimulus spending will cause inflation – that would be true – ALL THINGS BEING EQUAL.  But in fact, they are not equal, or even close to equal.

What is different is the amount of money that was in the system prior to the crisis other than the money from the Fed and the Stimulus.  The losses suffered by the banks and the shrinkage of loans and the inability of consumers and businesses to get loans – each of those things REDUCES the amount of money in the economy.  So in no stretch of the imagination are all things equal.

So the old rule about government spending being inflationary is only true ALL THINGS BEING EQUAL.

That does not, however, mean that there is not a difficult task ahead for the Fed to try to discern how fast the total money supply catches up with the economy so that they can reel back the money that they have put in.  But the problem with that idea is that because of the amount of economic activity that has been totally privatized, the Fed does not necessarily have the information to do that directly.

So ALL THINGS BEING EQUAL, they will have to try anyway by looking at the pick up in activity from the parts of the economy that they do have information about.

Meanwhile, folks like the NIF are looking to help to improve the information flow so that proper management of the money supply is possible from direct information.

Moral Hazard

January 13, 2010

Kevin Dowd has written a fine article titled “Moral Hazard and the Financial Crisis” for the Cato Journal.  Some of his very well articulated points include:

  • Moral Hazard comes from the ability for individuals to benefit from gains without having an equal share in losses.  (I would add that that has almost nothing to do with government bailouts.  It exists fully in the compensation of most executives of most firms in most economies. )
  • Bad risk model (Gaussian).  That ignore abnormal market conditions. 
  • Ignoring the fact that others in the market all have the same risk management strategy and that that strategy does not work for the entire market at once. 
  • Mark to Model where model is extremely sensitive to assumptions. 
  • Using models that were not designed for that purpose. 
  • Assumption of continuously liquid markets. 
  • Risk management system too rigid, resulting in easy gaming by traders. 
  • “the more sophisticated the [risk management] system, the more unreliable it might be.”
  • Senior management was out of control.  (and all CEOs are paid as if they were above average!)
  • Fundamental flaw in Limited Liability system.  No one has incentive to put a stop to this.  Moral Hazard is baked into the system.

Unfortunately, there are two flaws that I see in his paper. 

First, he misses the elephant in the room.  The actual exposure of the financial system to mortage loan losses in the end was over 400% of the amount of mortgages.  So without the multiplication of risk that happened under the guise of risk spreading had not happened, the global financial crisis would have simply been a large loss for the banking sector and other investors.  However, with the secret amplification of risk that happened with the CDO/CDS over the counter trades, the mortgage crisis became a depression sized loss, exceeding the capital of many large banks. 

So putting all of the transactions out in the open may have gone a long way towards allowing the someone to react intelligently to the situation.  Figuring out a way to limit the amount of the synthetic securities would probably be a good idea as well.  Moral Hazard is a term from insurance that is important to this situation.  Insurable interest in one as well. 

The second flaw of the paper is the standard Cato line that regulation should be eliminated.  In this case, it is totally outrageous to suggest that the market would have applied any discipline.  The market created the situation, operating largely outside of regulations. 

So while I liked most of the movie, I hated the ending. 

We really do need a Systemic Risk Regulator.  And somehow, we need to create a system so that 50 years from now when that person is sitting on a 50 year track record of no market meltdowns, they will still have enough credibility to act against the mega bubble of those days.

Best Risk Management Quotes

January 12, 2010

The Risk Management Quotes page of Riskviews has consistently been the most popular part of the site.  Since its inception, the page has received almost 2300 hits, more than twice the next most popular part of the site.

The quotes are sometimes actually about risk management, but more often they are statements or questions that risk managers should keep in mind.

They have been gathered from a wide range of sources, and most of the authors of the quotes were not talking about risk management, at least they were not intending to talk about risk management.

The list of quotes has recently hit its 100th posting (with something more than 100 quotes, since a number of the posts have multiple quotes.)  So on that auspicous occasion, here are my favotites:

  1. Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.  Douglas Adams
  2. “when the map and the territory don’t agree, always believe the territory” Gause and Weinberg – describing Swedish Army Training
  3. When you find yourself in a hole, stop digging.-Will Rogers
  4. “The major difference between a thing that might go wrong and a thing that cannot possibly go wrong is that when a thing that cannot possibly go wrong goes wrong it usually turns out to be impossible to get at or repair” Douglas Adams
  5. “A foreign policy aimed at the achievement of total security is the one thing I can think of that is entirely capable of bringing this country to a point where it will have no security at all.”– George F. Kennan, (1954)
  6. “THERE ARE IDIOTS. Look around.” Larry Summers
  7. the only virtue of being an aging risk manager is that you have a large collection of your own mistakes that you know not to repeat  Donald Van Deventer
  8. Philip K. Dick “Reality is that which, when you stop believing in it, doesn’t go away.”
  9. Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.  Albert Einstein
  10. “Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”  Sherlock Holmes (A. Conan Doyle)
  11. The fact that people are full of greed, fear, or folly is predictable. The sequence is not predictable. Warren Buffett
  12. “A good rule of thumb is to assume that “everything matters.” Richard Thaler
  13. “The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.”  Avinash Persaud
  14. There are more things in heaven and earth, Horatio,
    Than are dreamt of in your philosophy.
    W Shakespeare Hamlet, scene v
  15. When Models turn on, Brains turn off  Til Schuermann

You might have other favorites.  Please let us know about them.

Lessons for Insurers (1)

January 11, 2010

In late 2009,  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…

1. The success of ERM hinges on a strong risk management culture which starts at the top of
a company.

This seems like a very simple statement that is made over and over again by most observers.  But why is it important and why is it very often lacking?

First, what does it mean that there is a “strong risk management culture”?

A strong risk management culture is one where risk considerations make a difference when important decisions are made PERIOD

When a firm first adopts a strong risk management culture, managers will find that there will be clearly identifiable decisions that are being made differently than previously.  After some time, it will become more and more difficult for management to notice such distinctions because as risk management becomes more and more embedded, the specific impact of risk considerations will become a natural inseparable part of corporate life.

Next, why is it important for this to come from the top?  Well, we are tying effective risk management culture to actual changes in DECISIONS and the most important decisions are made by top management.  So if risk management culture is not there at the top, then the most important decisions will not change.  If the risk management culture had started to grow in the firm,

when middle managers see that top management does not let risk considerations get in their way, then fewer and fewer decisions will be made with real consideration risk.

Finally, why is this so difficult?  The answer to that is straight forward, though not simple.  The cost of risk management is usually a real and tangible reduction of income.  The benefit of risk management is probabilistic and intangible.  Firms are compared each quarter to their peers.

If peer firms are not doing risk management, then their earnings will appear higher in most periods.

Banks that suffered in the current financial crisis gave up 10 years of earnings!  But the banks that in fact correctly shied away from the risks that led to the worst losses were seen as poor performers in the years leading up to the crisis.

So what will change this?  Only investors will ultimately change this.  Investors who recognize that in many situations, they have been paying un-risk adjusted multiples for earnings that have a large component of risk premiums for low frequency, high severity risks.

They are paying multiples, in many cases where they should be taking discounts!

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Risk Management in 2009 – Reflections

December 26, 2009

Perhaps we will look back at 2009 and recall that it is the turning point year for Risk Management.  The year that boards ans management and regulators all at once embraced ERM and really took it to heart.  The year that many, many firms appointed their first ever Chief Risk Officer.  They year when they finally committed the resources to build the risk capital model of the entire firm.

On the other hand, it might be recalled as the false spring of ERM before its eventual relegation to the scrapyard of those incessant series of new business management fads like Management by Objective, Managerial Grid, TQM, Process Re-engineering and Six Sigma.

The Financial Crisis was in part due to risk management.  Put a helmet on a kid on a bicycle and they go faster down that hill.  And if the kid really doesn’t believe in helmets and they fail to buckle to chin strap and the helmet blows off in the wind, so much the better.  The wind in the hair feels exhilarating.

The true test of whether the top management is ready to actually DO risk management is whether they are expecting to have to vhange some of their decisions based upon what their risk assessment process tells them.

The dashboard metaphor is really a good way of thinking about risk management.  A reasonable person driving a car will look at their dashboard periodically to check on their speed and on the amount of gas that they have in the car.  That information will occasionally cause them to do something different than what they might have otherwise done.

Regulatory concentration on Risk Management is. on the whole, likely to be bad for firms.  While most banks were doing enough risk management to satisfy regulators, that risk management was not relevant to stopping or even slowing down the financial crisis.

Firms will tend to load up on risks that are not featured by their risk assessment system.  A regulatory driven risk management system tends to be fixed, while a real risk management system needs to be nimble.

Compliance based risk management makes as much sense for firms as driving at the speed limit regardless of the weather, road conditions or the conditions of the car’s breaks and steering.

Many have urged that risk management is as much about opportunities as it is about losses.  However, that is then usually followed by focusing on the opportunities and downplaying the importance of loss controlling.

Preventing a dollar of loss is just as valuable to the firm as adding a dollar of revenue.  A risk management loss controlling system provides management with a methodology to make that loss prevention a reliable and repeatable event.  Excess revenue has much more value if it is reliable and repeatable.  Loss control that is reliable and repeatable can have the same value.

Getting the price right for risks is key.  I like to think of the right price as having three components.  Expected losses.  Risk Margin.  Margin for expenses and profits.  The first thing that you have to decide about participating in a market for a particular type of risk is whether the market in sane.  That means that the market is realistically including some positive margin for expenses and profits above a realistic value for the expected losses and risk margin.

Most aspects of the home real estate and mortgage markets were not sane in 2006 and 2007.  Various insurance markets go through periods of low sanity as well.

Risk management needs to be sure to have the tools to identify the insane markets and the access to tell the story to the real decision makers.

Finally, individual risks or trades need to be assessed and priced properly.  That means that the insurance premium needs to provide a positive margin for expenses and profits above the realistic provision for expected losses and a reasonable margin for risk.

There were two big hits to insurers in 2009.  One was the continuing problems to AIG from its financial products unit.  The main lesson from their troubles ought to be TANSTAAFL.  There ain’t no such thing as a free lunch.  Selling far out of the money puts and recording the entire premium as a profit is a business model that will ALWAYS end up in disaster.

The other hit was to the variable annuity writers.  In their case, they were guilty of only pretending to do risk management.  Their risk limits were strange historical artifacts that had very little to do with the actual risk exposures of the firm.  The typical risk limits for a VA writer were very low risk retained from equities if the potential loss was due to an embedded guarantee and no limit whatsoever for equity risk that resulted in drops in basic M&E revenue.  A typical VA hedging program was like a homeowner who insured every item of his possessions from fire risk, but who failed to insure the house!

So insurers should end the year of 2009 thinking about whether they have either of those two problems lurking somewhere in their book of business.

Are there any “far out of the money” risks where no one is appropriately aware of the large loss potential ?

Are there parts of the business where risk limits are based on tradition rather than on risk?

Have a Happy New Year!

Enduring Fundamentals in a ‘Relocated World’ (Recovering From This Dislocation)

December 22, 2009

From Mike Cohen

“Where do we go from here, and what have we learned to help us arrive there safely and prosperously?” What risk management lessons have been learned?

Dislocations have occurred many times in history, and have occurred in many societal areas, changing many aspects of life profoundly:

- Economy: Agrarian, manufacturing, technology, service

- Military history: Strategies/tactics, weaponry

- Social/family mores: Many, many variations with intensely personal and emotional elements

- Political systems: Capitalism vs. socialism, big vs. small government, government leadership vs. self-determination

Dislocations will, without question, continue to occur in the future, and just as surely manifest themselves in unpredictable ways. Survivors, and ideally ‘thrivers’, will understand when dislocations occur and make the changes necessary to operate well in their new environments.

There are a number of business and societal behaviors that have been culpable in contributing to the interim demise of our socio-economic system:

- Greed

- Poor analysis

- Nonchalance

They are not effective, and have eerie parallels to the seven deadly sins.

While many aspects of our personal and business lives have changed, certain themes remain the same. Righting the ship will be driven by adherence to a number of fundamentals that have driven our success over history and will drive our success in the future.

1) Responsibility and trust: Our actions … what we say and what we do … are our legacy. Do we stand behind them in terms of honesty and wisdom?

Kahlil Gibran, in his epic work ‘The Prophet’, said that “You are the bows from which your children as living arrows are sent forth.” Quite so, but we need to make sure our aim is straight and sure. Our children are our most sacred trust, the most important manifestations of our legacy. Our actions are right along side in terms of importance.

2) Be ‘students’ of what we do:

- What is the purpose of our actions? What are we trying to accomplish?

- Are people or institutions going to be hurt by what we are doing?

- What risks are we taking?

- Functions of all kinds … how do they need to be performed?

3) How do our products work? What needs and wants do they satisfy? In life insurance, for example, those needs and wants to be satisfied are:

- Protection

- Asset accumulation

- Transactions

- Advice:

* Our financial world has never been more complicated and uncertain, and customers (both individuals and corporations) have never had a greater need for guidance

* ‘Caveat emptor’ (let the buyer beware) – Is this too difficult a burden for the consumer of the 21st century?

4) What do corporations need to do to succeed?

- Satisfy their customers’ needs and wants, more effectively and efficiently than their competitors can

- Manage the profit characteristics, for themselves and their customers, well

- Understand the risks in their enterprise, and ensure that they don’t interfere with the interests of their stakeholders

- Operate with integrity and transparency

We have recovered from dislocations in the past; we’re here, aren’t we? Understanding change, that it will always be occurring and how changes have manifested themselves, is critical to our evolution. Not recovery, but evolution. If we forget history, then we are doomed to repeat it. The same is true for understanding history, although the understanding of history is affected by the authors who report it. “How was your vacation?” “I don’t know. I have to wait to see the pictures”

We will solve the major issues confronting our financial system, but we will in all likelihood come out the other end in a very different place.

ReCapitalization Fantasy

December 17, 2009

Guest Post from Larry Rubin

I question whether sufficient attention is being paid to the definition of risk in most risk measures and in solvency II. In this case the use of 1-year VAR. Insurance companies makes long term promises as compared to other financial institutions. Yet we have seen the inadequacies of this risk measure for these other institutions. 1-year VAR is based on the assumption that if a company can survive a year it can re-capitalize. The credit crisis has shown that in a period of economic distress when it is most likely that many companies will be “in the tail” the ability to re-capitalize is suspect if non-existent. Companies such as, Lehman Brothers, Northern Rock, AIG and INDYMac could not re-capitalize. Bear Stearns, Merrill Lynch and WaMU required government support to facilitate the sale of their liabilities.
I believe one of the lessons of the credit crisis is that is that either the 1-year VAR analysis needs to reflect the potential drying up of capital during a tail event or insurance companies need to re-think the 1-year VAR measure. US Risk Based Capital, while an imperfect measure, has had ruin theory as its fundamental premise. This measure has held up well as most US life insurance operating companies maintained sufficient capital to survive to the point where it was possible to re-capitalize

Larry H. Rubin

Risk Management Changed the Landscape of Risk

December 9, 2009

The use of derivatives and risk management processes to control risk was very successful in changing the risk management Landscape.

But that change has been in the same vein as the changes to forest management practices that saw us eliminating the small forest fires only to find that the only fires that we then had were the fires that were too big to control.  Those giant forest fires were out of control from the start and did more damage than 10 years of small fires.

The geography of the world from a risk management view is represented by this picture:

The ball represents the state of the world.  Taking a risk is represented by moving the ball one direction or the other.  If the ball goes over the top and falls down the sides, then that is a disaster.

So risk managers spend lots of time trying to measure the size of the valley and setting up processes and procedures so that the firm does not get up to the top of the valley onto one of the peaks, where a good stiff wind might blow the firm into the abyss.

The tools for risk management, things like derivatives with careful hedging programs now allowed firms to take almost any risk imaginable and to “fully” offset that risk.  The landscape was changed to look like this:

Managers believed that the added risk management bars could be built as high as needed so that any imagined risk could be taken.  In fact, they started to believe that the possibility of failure was not even real.  They started to think of the topology of risk looking like this:

Notice that in this map, there is almost no way to take a big enough risk to fall off the map into disaster.  So with this map of risk in mind, company managers loaded up on more and more risk.

But then we all learned that the hedges were never really perfect.  (There is no profit possible with a perfect hedge.)  And in addition, some of the hedge counterparties were firms who jumped right to the last map without bothering to build up the hedging walls.

And we also learned that there was actually a limit to how high the walls could be built.  Our skill in building walls had limits.  So it was important to have kept track of the gross amount of risk before the hedging.  Not just the small net amount of risk after the hedging.

Now we need to build a new view of risk and risk management.  A new map.  Some people have drawn their new map like this:

They are afraid to do anything.  Any move, any risk taken might just lead to disaster.

Others have given up.  They saw the old map fail and do not know if they are ever again going to trust those maps.

They have no idea where the ball will go if they take any risks.

So we risk managers need to go back to the top map again and revalidate our map of risk and start to convince others that we do know where the peaks are and how to avoid them.  We need to understand the limitations to the wall building version of risk management and help to direct our firms to stay away from the disasters.

Commentary on Timeline of the Global Financial Crisis

December 2, 2009

Link to Detailed Timeline

The events of the past three years are unprecedented in almost all of our lifetimes.  One needs to go back and look at how much was happening in such a short time to get an appreciation of how difficult it must have been to be in the hot seats of government, central banks and regulators, especially during the fall of 2008.

On the other hand, it is pretty easy, with 20-20 hindsight, to point to events that should have made it clear that something bad was on its way.

The timeline that is posted here on Riskviews is an amalgam from 5 or 6 different sources, including the BBC, Federal Reserve and Wikipedia.  None of them seemed to be very complete.  Not that this one is.  My personal biases left out some items from all of the sources.

Let us know what was left out that is important.  This timeline was created over a one year period and there was little effort to go back and pick up items that did not seem important at the time, but that later were found to be early signals of later big problems.

The reaction that I have had when I used this timeline to make a presentation about the Financial Crisis is that it is pretty unfair to go pointing fingers about actions taken during the fall of 2008.  When you look at the daily earth shaking events that were happening, it is really totally overwhelming, even a year later.  If the events that occured daily were spread out one per month, then perhaps a case could be made that “they” should ahve done better.

Going back much further, I am not willing to be quite so kind.  This crisis was manufactured by collision of two deliberate government policies – home-ownership for all and deregulation of financial markets.  That collision was preventable.  Neither policy had to be taken to the extreme that it was taken – to what looks now like an absurd extreme in both cases.

And in addition, the financial firms themselves are far from blameless.  Greenspan’s belief that the bankers were capable of looking out for their shareholder’s best interest was correct.  They were capable.

Read the history.  See what happened.  Decide for yourself.  Let me know what I missed.

Link to Detailed Timeline


The Worst Decade

November 30, 2009

Time magazine is calling the 00′s, the Decade From Hell.  At least from an American point of view (admitting that things in China, India or Brazil have been very different in the past 10 years).

Here is a partial list of the problems:

  1. Y2K – one of the highlights actually
  2. 2000 Presidential Election
  3. Tech Bubble bursting
  4. 9/11 WTC
  5. Hurricane Katrina
  6. War in Afghanistan
  7. War in Iraq
  8. Enron & Worldcom & Madoff
  9. 2004 Tsunami
  10. Housing Bubble bursting
  11. Banking Crisis

Time reminds us of Ronald Regan’s famous question “Are you better off than 10 years ago?”

This is also the decade that saw the emergence of Risk Management as a serious discipline.  We should ask ourselves “Was Risk Management a response to these crisis or was it a contributor?”

John Adams calls it the Risk Thermometer effect.  Just like our body seeks to keep the same internal temperature no matter what the temperature outside, our risk thermometer seeks to keep the same level of risk.  That means that when we add risk management for additional safety, we automatically add more risk to bring things back to the same level of risk.

The other claim is that risk management failed.  At the very least, it was heavily over sold.

And finally, there is the argument made by the Senior Supervisors Group that risk management was actually under-bought, that few firms were actually doing risk management in the last decade.

So we have a month left in the decade.  Most were touched by the adverse events of the past decade in some way.  Risk Managers should be able to offer something for the future that is better than the 00′s.


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