Variety of Decision Making

Over the past several years, an anthropologist (Thompson), a control engineer (Beck) and an actuary (Ingram) have formed an unlikely collaboration that has resulted in countless discussions among the three of us along with several published (and posted) documents.

Our work was first planned in 2018. One further part of what was planned is still under development — the application of these ideas to economic thinking. This is previewed in document (2) below, where it is presented as Institutional Evolutionary Economics.

Here are abstracts and links to the existing documents:

1. Model Governance and Rational Adaptability in Enterprise Risk Management, January 2020, AFIR-ERM section of the International Actuarial Association. The problem context here is what has been called the “Insurance Cycle”. In this cycle we recognize four qualitatively different risk environments, or seasons of risk. We address the use of models for supporting an insurer’s decision making for enterprise risk management (ERM) across all four seasons of the cycle. In particular, the report focuses expressly on: first, the matter of governance for dealing with model risk; and, second, model support for Rational Adaptability (RA) at the transitions among the seasons of risk. This latter examines what may happen around the turning points in the insurance cycle (any cycle, for that matter), when the risk of a model generating flawed foresight will generally be at its highest.
2. Modeling the Variety of Decision Making, August 2021, Joint Risk Management Section. The four qualitatively different seasons of risk call for four distinctly different risk-coping decision rules. And if exercising those strategies is to be supported and informed by a model, four qualitatively different parameterizations of the model are also required. This is the variety of decision making that is being modeled. Except that we propose and develop in this work a first blueprint for a fifth decision-making strategy, to which we refer as the adaptor. It is a strategy for assisting the process of RA in ERM and navigating adaptively through all the seasons of risk, insurance cycle after insurance cycle. What is more, the variety of everyday risk-coping decision rules and supporting models can be substituted by a single corresponding rule and model whose parameters vary (slowly) with time, as the model tracks the seasonal business and risk transitions.
3. The Adaptor Emerges, December 2021, The Actuary Magazine, Society of Actuaries. The adaptor strategy focuses on strategic change: on the chops and changes among the seasons of risk over the longer term. The attention of actuaries coping with everyday risk is necessarily focused on the short term. When the facts change qualitatively, as indeed they did during the pandemic, mindsets, models, and customary everyday rules must be changed. Our adaptor indeed emerged during the pandemic, albeit coincidentally, since such was already implied in RA for ERM.
4. An Adaptor Strategy for Enterprise Risk Management, April 2022, Risk Management Newsletter, Joint Risk Management Section. In our earlier work (2009-13), something called the “Surprise Game” was introduced and experimented with. In it, simulated businesses are obliged to be surprised and shaken into eventually switching their risk-coping decision strategies as the seasons of risk undergo qualitative seasonal shifts and transitions. That “eventually” can be much delayed, with poor business performance accumulating all the while. In control engineering, the logic of the Surprise Game is closely similar to something called cascade control. We show how the adaptor strategy is akin to switching the “autopilot” in the company driving seat of risk-coping, but ideally much more promptly than waiting (and waiting) for any eventual surprise to dawn on the occupant of the driving seat.
5. An Adaptor Strategy for Enterprise Risk Management (Part 2), July 2022, Risk Management Newsletter, Joint Risk Management Section. Rather than its switching function, the priority of the adaptor strategy should really be that of nurturing the human and financial resources in the makeup of a business — so that the business can perform with resilience, season in, season out, economic cycle after economic cycle. The nurturing function can be informed and supported by an adaptor “dashboard”. For example, the dashboard can be designed to alert the adaptor to the impending loss or surfeit of personnel skilled in implementing any one of the four risk-coping strategies of RA for ERM. We cite evidence of such a dashboard from both the insurance industry and an innovation ecosystem in Linz, Austria.
6. Adaptor Exceptionalism:Structural Change & Systems Thinking, March 2022, RISKVIEWS, Here we link Parts 1 and 2 of the Risk Management Newsletter article ((4) and (5) above). When we talk of “when the facts change, we change our mindsets”, we are essentially talking about structural change in a system, most familiarly, the economy. One way of grasping the essence of this, hence the essence of the invaluable (but elusive) systemic property of resilience, is through the control engineering device of a much simplified model of the system with a parameterization that changes relatively slowly over time — the adaptor model of document (2) above, in fact. This work begins to show how the nurturing function of the adaptor strategy is so important for the achievement of resilient business performance.
7. Adaptor Strategy: Foresight, May 2022, RISKVIEWS. This is a postscript to the two-part Newsletter article and, indeed, its linking technical support material of document (6). It identifies a third possible component of an adaptor strategy: that of deliberately probing the uncertainties in business behaviour and its surrounding risk environment. This probing function derives directly from the principle of “dual adaptive control” — something associated with systems such as guided missiles. Heaven forbid: that such should be the outcome of a discussion between the control engineer, the actuary, and the anthropologist!

Still to be completed is the full exposition of Institutional Evolutionary Economics that is previewed in Section 1 of Modeling the Variety of Decision Making (Item 2 above).

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Risk Trajectory – Do you know which way your risk is headed?

Which direction are you planning on taking?

• Are you expecting your risk to grow faster than your capacity to bare risk?
• Are you expecting your risk capacity to grow faster than your risk?
• Or are you planning to keep growth of your risk and your capacity in balance?

If risk is your business, then the answer to this question is one of just a few statements that make up a basic risk strategy.

RISKVIEWS calls this the Risk Trajectory.  Risk Trajectory is not a permanent aspect of a businesses risk strategy.  Trajectory will change unpredictably and usually not each year.

There are four factors that have the most influence on Risk Trajectory:

1. Your Risk Profile – often stated in terms of the potential losses from all risks at a particular likelihood (i.e. 1 in 200 years)
2. Your capacity to bear risk – often stated in terms of capital
3. Your preferred level of security (may be factored directly into the return period used for Risk Profile or stated as a buffer above Risk Profile)
4. The likely rewards for accepting the risks in your Risk Profile

If you have a comfortable margin between your Risk Profile and your preferred level of security, then you might accept a risk trajectory of Risk Growing Faster than Capacity.

Or if the Likely Rewards seem very good, you might be willing to accept a little less security for the higher reward.

All four of the factors that influence Risk Trajectory are constantly moving.  Over time, anything other than carefully coordinated movements will result in occasional need to change trajectory.  In some cases, the need to change trajectory comes from an unexpected large loss that results in an abrupt change in your capacity.

For the balanced risk and capacity trajectory, you would need to maintain a level of profit as a percentage of the Risk Profile that is on the average over time equal to the growth in Risk Profile.

For Capacity to grow faster than Risk, the profit as a percentage of the Risk Profile would be greater than the growth in Risk Profile.

For Risk to grow faster than Capacity, Risk profile growth rate would be greater than the profit as a percentage of the Risk Profile.

RISKVIEWS would guess that all this is just as easy to do as juggling four balls that are a different and somewhat unpredictably different size, shape and weight when they come down compared to when you tossed them up.

Reviewing the Risk Environment

The new US Actuarial Standards of Practice 46 and 47 suggest that the actuary needs to assess the risk environment as a part of risk evaluation and risk treatment professional services. The result of that evaluation should be considered in that work.

And assessment of the risk environment would probably be a good idea, even if the risk manager is not a US actuary.
But what does it mean to assess the risk environment?  One example of a risk environment assessment can be found on the OCC website.  They prepare a report titled “Semi Annual Risk Perspective“.

This report could be a major source of information, especially for Life Insurers, about the risk environment.  And for Non-Life carriers, the outline can be a good road map of the sorts of things to review regarding their risk environment.

Part I: Operating Environment

• Slow U.S. Economic Growth Weighs on Labor Market
• Sluggish European Growth Also Likely to Weigh on U.S. Economic Growth in Near Term
• Treasury Yields Remain Historically Low
• Housing Metrics Improved
• Commercial Real Estate Vacancy Recovery Uneven Across Property Types

Part II: Condition and Performance of Banks.

A. Profitability and Revenues: Improving Slowly..

• Profitability Increasing .
• Return on Equity Improving, Led by Larger Banks .
• Fewer Banks Report Losses
• Noninterest Income Improving for Large and Small Banks.
• Trading Revenues Return to Pre-Crisis Levels
• Counterparty Credit Exposure on Derivatives Continues to Decline ………….
• Low Market Volatility May Understate Risk
• Net Interest Margin Compression Continues..

B. Loan Growth Challenges

• Total Loan Growth: C&I Driven at Large Banks; Regionally Uneven for Small Banks….

• Commercial Loan Growth Led by Finance and Insurance, Real Estate, and Energy …

• Residential Mortgage Runoff Continues, Offsetting Rising Demand for Auto and Student Loans………….

C. Credit Quality: Continued Improvement, Although Residential Real Estate Lags

• Charge-Off Rates for Most Loan Types Drop Below Long-Term Averages
• Shared National Credit Review: Adversely Rated Credits Still Above Average Levels .
• Significant Leveraged Loan Issuance Accompanied by Weaker Underwriting.
• New Issuance Covenant-Lite Leveraged Loan Volume Surges .
• Commercial Loan Underwriting Standards Easing .
• Mortgage Delinquencies Declining, but Remain Elevated.
• Auto Lending Terms Extending ..

Part III: Funding, Liquidity, and Interest Rate Risk

• Retention Rate of Post-Crisis Core Deposit Growth Remains Uncertain
• Small Banks’ Investment Portfolios Concentrated in Mortgage Securities
• Commercial Banks Increasing Economic Value of Equity Risk

Part IV: Elevated Risk Metrics

• VIX Index Signals Low Volatility…
• Bond Volatility Rising but Near Long-Term Average
• Financials’ Share of the S&P 500 Rising but Remains Below Average
• Home Prices Rising .
• Commercial Loan Delinquencies and Losses Decline to Near or Below Average ..
• Credit Card Delinquencies and Losses Near Cyclical Lows .

Part V: Regulatory Actions

• Banks Rated 4 or 5 Continue to Decline
• Matters Requiring Attention Gradually Decline
• Enforcement Actions Against Banks Slow in 2013

For those who need a broader perspective, the IMF regularly publishes a report called World Economic Output.  That report is much longer but more specifically focused on the general level of economic activity.  Here are the main chapter headings:

Chapter 1. Global Prospects and Policies

Chapter 2. Country and Regional Perspectives

Chapter 3. Dancing Together? Spillovers, Common Shocks, and the Role of Financial and Trade Linkages

Chapter 4. The Yin and Yang of Capital Flow Management: Balancing Capital Inflows with Capital outflows

The IMF report also includes forecasts, such as the following: