Archive for the ‘Risk’ category

Real World Risks

December 16, 2015

There are many flavors of Risk Management.  Each flavor of risk manager believes that they are addressing the Real World.

  • Bank risk managers believe that the world consists of exactly three sorts of risk:  Market, Credit and Operational.  They believe that because that is the way that banks are organized.  At one time, if you hired a person who was a banking risk manager to manage your risks, their first step would be to organize the into those three buckets.
  • Insurance Risk Managers believe that a company’s insurable risks – liability, E&O, D&O, Workers Comp, Property, Auto Liability – are the real risks of a firm.  As insurance risk managers have expanded into ERM, they have adapted their approach, but not in a way that could, for instance, help at all with the Credit and Market risk of a bank.
  • Auditor Risk Managers believe that there are hundreds of risks worth attention in any significant organization. Their approach to risk is often to start at the bottom and ask the lowest level supervisors.  Their risk management is an extension of their audit work.  Consistent with the famous Guilliani broken windows approach to crime.  However, this approach to risk often leads to confusion about priorities and they sometimes find it difficult to take their massive risk registers to top management and the board.
  • Insurer Risk Managers are focused on statistical models of risk and have a hard time imagining dealing with risks that are not easily modeled such as operational and strategic risks.  The new statistical risk managers often clash with the traditional risk managers (aka the underwriters) whose risk management takes the form of judgment based selection and pricing processes.
  • Trading Desk Risk Managers are focused on the degree to which any traders exceed their limits.  These risk managers have evolved into the ultimate risk takers of their organizations because they are called upon to sometime approve breaches when they can be talked into agreeing with the trader about the likelihood of a risk paying off.  Their effectiveness is viewed by comparing the number of days that the firm’s losses exceed the frequency predicted by the risk models.

So what is Real World Risk?

Start with this…

Top Causes of death

  • Heart disease
  • stroke
  • lower respiratory infections
  • chronic obstructive lung disease
  • HIV
  • Diarrhea
  • Lung cancers
  • diabetes

Earthquakes, floods and Hurricanes are featured as the largest insured losses. (Source III)

Cat LossesNote that these are the insured portion of the losses.  the total loss from the Fukishima disaster is estimated to be around $105B.  Katrina total loss $81B. (Source Wikipedia)

Financial Market risk seems much smaller.  When viewed in terms of losses from trading, the largest trading loss is significantly smaller than the 10th largest natural disaster. (Source Wikipedia)

Trading LossesBut the financial markets sometimes create large losses for everyone who is exposed at the same time.

The largest financial market loss is the Global Financial Crisis of 2008 – 2009.  One observer estimates the total losses to be in the range of $750B to $2000B.  During the Great Depression, the stock market dropped by 89% over several years, far outstripping the 50% drop in 2009.  But some argue that every large drop in the stock market is preceded by an unrealistic run up in the value of stocks, so that some of the “value” lost was actually not value at all.

If your neighbor offers you $100M for your house but withdraws the offer before you can sell it to him and then you subsequently sell the house for $250k, did you lose $99.75M?  Of course not.  But if you are the stock market and for one day you trade at 25 time earnings and six months later you trade at 12 times earnings, was that a real loss for any investors who neither bought or sold at those two instants?

So what are Real World Risks?

 

Comments welcomed…

 

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Top 10 RISKVIEWS Posts of 2014 – ORSA Heavily Featured

December 29, 2014

RISKVIEWS believes that this may be the best top 10 list of posts in the history of this blog.  Thanks to our readers whose clicks resulted in their selection.

  • Instructions for a 17 Step ORSA Process – Own Risk and Solvency Assessment is here for Canadian insurers, coming in 2015 for US and required in Europe for 2016. At least 10 other countries have also adopted ORSA and are moving towards full implementation. This post leads you to 17 other posts that give a detailed view of the various parts to a full ORSA process and report.
  • Full Limits Stress Test – Where Solvency and ERM Meet – This post suggests a link between your ERM program and your stress tests for ORSA that is highly logical, but not generally practiced.
  • What kind of Stress Test? – Risk managers need to do a better job communicating what they are doing. Much communications about risk models and stress tests is fairly mechanical and technical. This post suggests some plain English terminology to describe the stress tests to non-technical audiences such as boards and top management.
  • How to Build and Use a Risk Register – A first RISKVIEWS post from a new regular contributor, Harry Hall. Watch for more posts along these lines from Harry in the coming months. And catch Harry on his blog, http://www.pmsouth.com
  • ORSA ==> AC – ST > RCS – You will notice a recurring theme in 2014 – ORSA. That topic has taken up much of RISKVIEWS time in 2014 and will likely take up even more in 2015 and after as more and more companies undertake their first ORSA process and report. This post is a simple explanation of the question that ORSA is trying to answer that RISKVIEWS has used when explaining ORSA to a board of directors.
  • The History of Risk Management – Someone asked RISKVIEWS to do a speech on the history of ERM. This post and the associated new permanent page are the notes from writing that speech. Much more here than could fit into a 15 minute talk.
  • Hierarchy Principle of Risk Management – There are thousands of risks faced by an insurer that do not belong in their ERM program. That is because of the Hierarchy Principle. Many insurers who have followed someone’s urging that ALL risk need to be included in ERM belatedly find out that no one in top management wants to hear from them or to let them talk to the board. A good dose of the Hierarchy Principle will fix that, though it will take time. Bad first impressions are difficult to fix.
  • Risk Culture, Neoclassical Economics, and Enterprise Risk Management – A discussion of the different beliefs about how business and risk work. A difference in the beliefs that are taught in MBA and Finance programs from the beliefs about risk that underpin ERM make it difficult to reconcile spending time and money on risk management.
  • What CEO’s Think about Risk – A discussion of three different aspects of decision-making as practiced by top management of companies and the decision making processes that are taught to quants can make quants less effective when trying to explain their work and conclusions.
  • Decision Making Under Deep Uncertainty – Explores the concepts of Deep Uncertainty and Wicked Problems. Of interest if you have any risks that you find yourself unable to clearly understand or if you have any problems where all of the apparent solutions are strongly opposed by one group of stakeholders or another.

Cavalcade of Risk – Aristotle and Risk

April 30, 2014

The WC Roundup is  hosting the 207th Cavalcade of Risk.  This bi-weekly blog is a collection of risk-related posts covering topics from finance, to insurance, to health.

http://blog.reduceyourworkerscomp.com/2014/04/cavalcade-risk-207-collection-top-risk-posts-blogosphere/
Topics this time include Workers Comp, Health, ACA, Life Insurance, Venture Capital and Aristotle.
Check it out.

What is the definition of RISK?

July 8, 2013

The word risk is a common English word with a definition that has been well established for hundreds of years.  There is no need for risk managers to redefine the word to mean something else.  In fact, redefining a word so that its meaning would incorporate the exact opposite of the common definition is a precess that George Orwell called DOUBLETHINK.

Imagine what you would think if you hired someone to paint your house and when they showed up they told you that in their minds the word “paint” meant repaving your driveway in addition to applying a colored covering to your house?  Sounds crazy doesn’t it.  But there are many, many risk managers who will heatedly argue about this point.  For example, see The ISO 31000 group discussion here.

The Definition of risk

noun

a situation involving exposure to danger:flouting the law was too much of a risk all outdoor activities carry an element of risk

[in singular] the possibility that something unpleasant or unwelcome will happen:reduce the risk of heart disease [as modifier]:a high consumption of caffeine was suggested as a risk factor for loss of bone mass

[usually in singular with adjective] a person or thing regarded as likely to turn out well or badly, as specified, in a particular context or respect:Western banks regarded Romania as a good risk

[with adjective] a person or thing regarded as a threat or likely source of danger:she’s a security risk gloss paint can burn strongly and pose a fire risk

(usually risks) a possibility of harm or damage against which something is insured.

the possibility of financial loss: [as modifier]:project finance is essentially an exercise in risk management

verb

[with object]

expose (someone or something valued) to danger, harm, or loss:he risked his life to save his dog

act or fail to act in such a way as to bring about the possibility of (an unpleasant or unwelcome event):unless you’re dealing with pure alcohol you’re risking contamination from benzene

incur the chance of unfortunate consequences by engaging in (an action):he was far too intelligent to risk attempting to deceive her

Phrases

at risk

exposed to harm or danger:23 million people in Africa are at risk from starvation

at one’s (own) risk

used to indicate that if harm befalls a person or their possessions through their actions, it is their own responsibility:they undertook the adventure at their own risk

at the risk of doing something

although there is the possibility of something unpleasant resulting:at the risk of boring people to tears, I repeat the most important rule in painting

at risk to oneself (or something)

with the possibility of endangering oneself or something:he visited prisons at considerable risk to his health

risk one’s neck

put one’s life in danger.

run the risk (or run risks)

expose oneself to the possibility of something unpleasant occurring:she preferred not to run the risk of encountering his sister

Origin:

mid 17th century: from French risque (noun), risquer (verb), from Italian risco ‘danger’ and rischiare ‘run into danger’

from Oxford dictionary of American English

Redefining the word risk to include its opposite (i.e. gain) is a perfect example of what Orwell called DOUBLETHINK.

DOUBLETHINK:  The power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both of them… To tell deliberate lies while genuinely believing in them, to forget any fact that has become inconvenient, and then, when it becomes necessary again, to draw it back from oblivion for just as long as it is needed, to deny the existence of objective reality and all the while to take account of the reality which one denies – all this is indispensably necessary. Even in using the word doublethink it is necessary to exercise doublethink. For by using the word one admits that one is tampering with reality; by a fresh act of doublethink one erases this knowledge; and so on indefinitely, with the lie always one leap ahead of the truth.  From 1984 George Orwell (1949)

Delusions about Success and Failure

April 8, 2013

In his book, The Halo Effect: … and the Eight Other Business Delusions That Deceive Managers, author Phil Rosenzweig discusses the following 8 delusions about success:

1. Halo Effect: Tendency to look at a company’s overall performance and make attributions about its culture, leadership, values, and more.

2. Correlation and Causality: Two things may be correlated, but we may not know which one causes which.

3. Single Explanations: Many studies show that a particular factor leads to improved performance. But since many of these factors are highly correlated, the effect of each one is usually less than suggested.

4. Connecting the Winning Dots: If we pick a number of successful companies and search for what they have in common, we’ll never isolate the reasons for their success, because we have no way of comparing them with less successful companies.

5. Rigorous Research: If the data aren’t of good quality, the data size and research methodology don’t matter.

6. Lasting Success: Almost all high-performing companies regress over time. The promise of a blueprint for lasting success is attractive but unrealistic.

7. Absolute Performance: Company performance is relative, not absolute. A company can improve and fall further behind its rivals at the same time.

8. The Wrong End of the Stick: It may be true that successful companies often pursued highly focused strategies, but highly focused strategies do not necessarily lead to success.

9. Organizational Physics: Company performance doesn’t obey immutable laws of nature and can’t be predicted with the accuracy of science – despite our desire for certainty and order.

By Julian Voss-Andreae (Own work) [CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)%5D, via Wikimedia Commons

A good risk manager will notice that all 8 of these delusions have a flip side that applies to risk analysis and risk management.

a.  Bad results <> Bad Culture – there are may possible reasons for poor results.  Culture is one possible reason for bad results, but by far not the only one.

b.  Causation and Correlation – actually this one need not be flipped.  Correlation is the most misunderstood statistic.  Risk managers would do well to study and understand what valuable and reliable uses that there are for correlation calculations.  They are very likely to find few.

c.  Single explanations  – are sometimes completely wrong (see c. above), they can be the most important of several causes, they can be the correct and only reason for a loss, or a correct but secondary reason.  Scapegoating is a process of identifying a single explanation and quickly moving on.  Often without much effort to determine which of the four possibilities above applies to the scapegoat.  Scapegoats are sometimes chosen that make the loss event appear to be non-repeatable, therefore requiring no further remedial action.

d.  Barn door solutions – looking backwards and finding the activities that seemed to lead to the worst losses at the companies that failed can provide valuable insights or it can lead to barn door solutions that fix past problems but have no impact on future situations.

e.  Data Quality – same exact issue applies to loss analysis.  GIGO

f.  Regression to the mean – may be how you describe what happens to great performing companies, but for most firms, entropy is the force that they need to be worried about.  A firm does not need to sport excellent performance to experience deteriorating results.

g.  Concentration risk – should be what a risk manager sees when strategy is too highly concentrated.

h.  Uncertainty prevails – precision does not automatically come from expensive and complicated models.

Unintended Consequences – Distortion of Decisions

October 7, 2012

Central bankers have tools to help the economy, but for the most part, those tools all have the effect of lowering interest rates.

But there are consequences of overriding the market to change the price of something.  The consequences are that every decision that uses the information from the affected market prices will be distorted.

Interest rates are a price for deferral of receiving cash.  Low interest rates signal that there is very little risk to deferral of receiving cash.  So one only has to pay a little extra to pay later rather than now.

This is helpful in stimulating consumption.  People without the money right now can promise to pay later with low penalty for the deferral.

But is the risk from the deferral really lower?  The interest rates are very low because the central bank is overwhelming the market demand.  Not because anyone really believes that deferral of receipt of cash is low risk.

But anyone who simply uses the market interest rates is having their decision distorted.  They are open to taking deferral risk without expecting to be reasonably compensated for that risk.

To purists who believe that the only usable value is the market price, this is the only real information.

But if you want to make good decisions about transactions that stretch out over a long time, you might want to consider making your own adjustment for the risk of deferral.

What is Risk?

January 12, 2012

from Max Rudolph

As I deal with a variety of industries, professionals, investors and even risk managers, it has become obvious that the first issue that needs to be addressed from a risk management context is to define the term “risk”. I generally get pushback on this, but what I find is that everyone has a strong definition in their own mind that varies from person to person. How you define risk drives both risk appetite and risk culture. One of the keys in many of the management classes I have attended over the years has been to recognize that others tend to not think like I do. This is important here too. Before reading further, how do you define risk? Let me know if you don’t see your personal high level definition below.

Knightian Risk

Probably the most interesting risk definition I have seen, and the one I had never considered in its extreme, was put forth by Frank Knight in his 1921 book Risk, Uncertainty and Profit. Risk is defined as uncertainty. It is best explained by an example. If you were to launch yourself into space with no protection against the cold and lack of oxygen that defines space, you know you would die. By this definition there is no risk. If there is no uncertainty, in any direction, there is no risk. Sure to fail, no risk. Sure to win, no risk. Most people consider this definition in moderation when managing risk, although most would override it with one of the definitions we will consider next.

Downside Risk

When managing a business or portfolio, many managers consider risk only with respect to something bad that could happen. Outcomes can be defined numerically as more of something is either good or bad, and less of something is the opposite. An additional nuance is needed, and it has been mentioned by others. I like to look at “good” outcomes and “bad” outcomes. To follow an example earlier in this thread, higher sales might initially be called a good outcome, but often it eventually becomes a bad outcome as it outstrips capital availability or flags a pricing issue. Keep in mind that what is important is the overall impact on the entity, so a good overall outcome should be encouraged even if some lines of business would call it a bad outcome for their silo. High mortality is an example of this, with a life insurance line saying it is a bad outcome and a payout annuity considering it a good outcome. This is an example of a natural hedge, provided by two lines with offsetting risks in their portfolio.

Most companies today are looking at risk from a one sided perspective to meet their regulatory compliance needs. Risk management is viewed as a fixed cost under this paradigm. This approach is useful and helps the company avoid bankruptcy. It also provides a base from which you can leverage your ERM efforts.

Volatility Risk

I often think of traders when considering a volatility driven definition of risk. Opportunities abound if prices move, no matter which direction. Those who look at risk from a two sided perspective, and are good at it, can provide an organization with a competitive advantage as enterprise risk management becomes a major part of the strategic planning process. Everything is on the table. This helps an organization grow and prosper, in addition to lowering the probability of ruin. Incorporating risk into decision making provides a competitive advantage in all environments. The downside of this approach is that many who think of volatility as risk also believe that risk can be modeled accurately. They are more prone to model risk.

Not everyone is capable of the two sided risk approach. Risk culture can get in the way, but you also need the right people in place to drive risk management opportunities to senior team members. A risk manager should try to nudge their firm in this direction, but trying to leap there all at once is not likely to work.

Which risk definition is the best one?

It will depend on firm culture and risk appetite to know which definition is most consistent within an entity, and employing people with each definition can help a firm avoid overfocusing on one of the definitions. This will allow the firm to make better decisions. Risk is Opportunity!

©2011 Rudolph Financial Consulting, LLC

Warning: The information provided in this post 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!


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