Archive for the ‘Operational Risk’ category

Imminent Risk – Employee Turnover

May 16, 2011

Many risks go in cycles.  And While it makes some sense to keep an eye on them during the part of the cycle when they are low, it makes much more sense to concentrate on them when they are imminent.

A recent report from Metlife “Study of Employee Benefits Trends” diverts from its primary topic to spend an entire chapter on The Erosion of Employee Loyalty.  One startling statistic that they report is that over one third of employees say that if they have the choice, they will change employers in 2011!

Risk managers often think of risks like employee turnover as being “soft” risks that are difficult to measure and model.  But that may be mostly due to lack of familiarity.  In this case, people have measured the costs.  The Society of Human Resources Management (SHRM) has estimated that turnover costs vary by the level of employee.  For minimum wage employees, the costs are 30% to 50% and goes up for more skilled employees – up as high as 400% of salary for the most skilled employees.

And that does not take into account that the people who are most able to leave are the most competent and productive of your employees.

So your firm has an imminent risk that will emerge when the job market in your industry opens up.  You will know exactly when that risk is going to hit.  You will know because your firm will start to hire more after several years of low or zero hiring.  Once you notice the actual turnover, it will be too late. So monitoring hiring by your own firm and in your part of the economy is your key risk leading indicator.

The risk treatment steps to take would be those that might impact either the frequency or severity of the losses from this risk.  (duh)

Metlife includes this discussion in their report on employee benefits so that they can make the case that more employee benefits would be an effective preventative.

But before setting out to define risk treatment plans, the risk manager will want to look at the loss estimates.  That SHRM study points to costs from the hiring process, from training costs as well as productivity losses.  Each firm should examine their practices and experience to refine the general estimate to their situation.  Some firms will always choose to hire highly experienced employees to minimize the training and lost productivity costs.  Other firms will go to the other extreme, hiring mostly at the entry level and expecting to promote from within to replace any higher level losses.

Salary costs are a large percentage of financial businesses costs.  The management of this cost could probably benefit from some good quantitative analysis, if that is not already the practice.

If the SHRM costs are correct and even half the people identified by Metlife are able to change jobs, then firms on the average are facing extra costs of as much as 20% of payroll.

Do the math, where does this put employee turnover risk in terms of your top ten risks list?

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Infrastructure Risk – Too High

March 23, 2011

The American Society of Civil Engineers has produced a reportcard on the state of the infrastructure in the US.

The good news is that the richest country in the world did not flunk.

The bad news is that the overall average grade is a D.

Now Warren Buffet reminds us that you shouldn’t expect an unbiased answer if you ask a barber whether you need a haircut.  And in this case, the civil engineers would benefit significantly from an increase of attention to infrastructure.

But let’s look at the sorts of suggestions that they make.  Many of them can be generalized to other areas of risk. (Paraphrased by Riskviews)

  • Encourage risk reduction/management programs
  • Use the best of current science rather than continuing to follow science from many years ago
  • Develop emergency action plans
  • Develop maintenance standards
  • Establish plan to fund needed improvements in risk management
  • Evaluate specific impact of failure to improve risk management
  • Educate stakeholders regarding above
  • Establish a regular review process

In the case of infrastructure, there is a recognized lifespan of the systems and a continual deterioration expected.

Risk systems in general are not thought of as wasting assets, but perhaps that is simply because risk management is so new.

Perhaps even the firms that have achieved the point of a full and integrated set of risk management systems should think of the useful life of those systems.

“The principal reason we have train crashes is a lack of investment in rail infrastructure – and the reason we have systemic crises is a lack of investment in financial infrastructure.”  Hugo Bänziger, in the FT

The money will always be there to keep funding innovations in the way that risk is added to a firm.

ERM Questions for US Insurers

March 10, 2011

By Max Rudolph

A.M. Best added a Supplemental Rating Questionnaire (SRQ) for insurers at the end of 2010. While it will provide interesting information that will aid the analyst develop questions for a face-to-face meeting, the mainly checklist format will limit its value. A better option would be for a company to utilize this SRQ to develop an internal risk management report that could be presented to the board and external stakeholders much as insurers generate an investment management report. The A.M. Best checklist could be a by-product of this process. A.M. Best’s statement that “each company’s need for ERM is different” is absolutely correct. Organizations with complex and varied product mixes should spend their time understanding both the silo risks and the interactions between those silos. Going into 2006 insurers (and rating agencies) did not have leading indicators in place to monitor housing prices, yet that proved to be the driver leading to the financial crisis. There is little in this questionnaire that is forward looking toward new and emerging risks.

Concentration

The questionnaire does not do enough to focus on concentration of exposures. No credit is awarded for a diversified group of independent risks. There is also no mention of counterparty risk with reinsurers. The financial crisis left reinsurers ever more entangled, and if one ever experiences financial difficulties a contagion effect could drag quite a few down with them. If that happens there is no reason to think that insurers would not batten down the hatches as banks did with their loan portfolios. Insurers should have a contingency plan for this possibility, along with performing other stress tests and board discussions.

Key Risk Indicators

The questionnaire refers to reporting risk metrics. This should be more specific. Financial statements do a pretty good job of reporting lagging indicators such as revenue and net income. What would be more useful when managing risk are leading indicators. What metric can I look at today to anticipate future revenue? Keeping track of metrics such as agent retention, applications received, or unemployment will allow the line manager to better understand the business line and the risk manager to better identify potential risks. Today, many insurers are developing this process but it is still evolving.

Risk Culture

In the risk culture section of the questionnaire, terms such as risk/return measures and reporting risk jump out at me. Not all risks can be measured, and many can’t be measured accurately. That does not mean they can’t, and certainly does not mean they should not, be managed. Examples would include the likelihood and severity of civil unrest around the world. It is not important to judge precisely how likely these events might be, but it is important to think about how you might react if such an event does occur. Options are generally limited after an event occurs, and time is often the critical factor. Reporting risk means many things to many people. It would be preferred to have a dialogue about risks, using a written report as a starting point.

Identifying Risks

In the Risk Identification/Measurement/Monitoring section of the questionnaire, A.M. Best asks “Who is the most responsible for identifying material risks to the company’s financial position?” This seems to be a no-win question, as no matter who is listed shortcomings will be associated with it. If you list the CEO, then the CRO is short-changed. If you list the CRO, the line managers wonder what their role is. Perhaps a better question would be to ask who is responsible for consolidating risks and looking at them holistically, scanning for emerging risks as well. It will be interesting to see what A.M. Best does with the table considering the largest potential threats to financial strength. There is no consistent approach to estimated potential impact. Two companies with the exact same exposure to a risk might report vastly different dollar figures. The higher number might be generated by the organization that better understands the risk.

Economic Capital

The most interesting question to me would be to ask how independent of results are the modelers? Who do they report to? How is their bonus determined? My perception is that there is subtle pressure put on modelers to hit certain results and that they should understand their models well enough to know which levers to pull that won’t raise a warning flag. At this point there is no audit requirement for an economic capital model.

Forward Looking

Missing in this questionnaire, as well as the NAIC’s Risk Focused Examinations, is a view of the future. In my opinion, if there is not an immediate solvency issue then the most interesting question is what could impair this organization in the future. For many insurance firms this will be related to selling profitable products and being flexible. It is hard to find distribution without giving away either options or returns. Consolidation in the insurance industry is likely. How many companies have considered their competitive position is their competitors merge? For distressed firms it is rarely a previously managed risk that takes them down. What environmental scanning is being done? What Risks are you Worried about Today? Risks that could be included in this type of analysis would be considered stress tests by many, but how many organizations would share more than they think their competitors are sharing? Here are some risks to ponder, along with their unintended consequences, in no order.

  • Low interest rate environment is replaced by an inflationary shock
  • A new competitor enters the insurance market with a known and trusted brand and new distribution channel (WalMart comes to mind)
  • A reinsurer becomes insolvent due to investment losses, stressing other reinsurers.
  • The insurance industry experiences higher trending mortality, with a flurry of 30-50 deaths due to obesity
  • Climate change results in changing weather patterns, with more volatile weather and crop patterns
  • A consolidator enters the industry, generating economies of scale that reduce potential returns by 2%.
  • Infrastructure around the world ends its useful lifetime and is not replaced.
  • Water wells are drilled in developed countries by farmers and local communities to access an aquifer.
Warning: The information provided in this newsletter is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Good luck! Warning: The information provided in this newsletter is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Good luck!

Outsourcing Risk

February 16, 2011

Last week the Seattle Times had an incredible story about the ultimate costs of a failed outsourcing strategy at Boeing.

The story quotes Wall Street sources to say that ultimately the failure of outsourcing partners created $12 Billion of extra costs on a project initially planned to cost $5 Billion.

“We spent a lot more money in trying to recover than we ever would have spent if we’d tried to keep the key technologies closer to home,” said Boeing Commercial Airplanes Chief Jim Albaugh.

The story is probably one extreme of bad outsourcing.  In many cases it works out well.  But it is quite likely that firms often make the mistake of ignoring or downplaying risk and uncertainty and only look at cost savings when they make outsourcing decisions.

One simple way to look at the uncertainty is with the 5 point scale from “Getting a Handle on Uncertainty“.  But perhaps because of the “one off” nature of outsourcing, one point should be added to the uncertainty score.

But doubtless, firms who get “comfortable” with outsourcing, get comfortable with a higher degree of uncertainty.

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

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: 

Murphy was a Risk Manager!

July 6, 2010

Perhaps you have heard the saying…

If anything can go wrong, it will.

Widely known as Murphy’s Law.  Well, you may not know it but Murphy was actually a risk manager.

The originator of Murphy’s Law was an engineer named Captain Ed Murphy.  He was responsible for safety testing for the Air Force and later for several private engineering firms.

He was a reliability engineer.  And in his mind, the statement that became known as Murphy’s Law was just his way of describing how you had to think to design stress tests.

He had just experienced the failure of a device that he had designed because of incorrect wiring.  At the time, he may have blamed the problem on the people who installed his device, but later, he came to realize that he should have anticipated the possibility of confusion over which lead to connect to what and made provision for the wiring error in his design.

His original design required that the installer would have perfect knowledge of his intentions with the design.  Instead he should have assumed that the installer would have been completely ignorant of what was in his head.

Does that sound like a word of caution for the designers of risk models?

Will future operators of your risk model need to fully understand what you had intended?  Or do you anticipate that they will doubtless not.

I had that experience.  Fifteen years after I had completed a risk model for a company and in the process taken some shortcuts that made perfect sense to me, I was told that the firm was still using my model, but they suddenly noticed that it was giving very troubling signals, signals that turned out to be almost completely incorrect.

Those shortcuts had moved further and further away from the truth.  I had some realization that the model needed regular recalibration, but I had failed to make that completely clear to the people who inherited the model from me and they certainly had not thought it important to pass along my verbal instructions to the people who inherited it from them.

So remember Murphy’s Law and this little story about how Murphy came to originally say what became known as his law.  It could happen to you.


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