Archive for the ‘Uncertainty’ category

Variety of Decision Making

July 20, 2022

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).

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.

Decision Making Under Deep Uncertainty

October 20, 2014

The above is a part of the title of a World Bank report.  The full title of that report is

Investment Decision Making Under Deep Uncertainty – Application to Climate Change

While that report focuses upon that one specific activity – Investing, and one area of deep uncertainty – Climate Change, there are some very interesting suggestions contained there that can be more broadly applied.

First, let’s look at the idea of Deep Uncertainty.  They define it as:

deep uncertainty is a situation in which analysts do not know or cannot agree on (1) models that relate key forces that shape the future, (2) probability distributions of key variables and parameters in these models, and/or (3) the value of alternative outcomes.

In 1973, Horst W.J. Rittel and Melvin M. Webber, two Berkeley professors, published an article in Policy Sciences introducing the notion of “wicked” social problems. The article, “Dilemmas in a General Theory of Planning,” named 10 properties that distinguished wicked problems from hard but ordinary problems.

1. There is no definitive formulation of a wicked problem. It’s not possible to write a well-defined statement of the problem, as can be done with an ordinary problem.

2. Wicked problems have no stopping rule. You can tell when you’ve reached a solution with an ordinary problem. With a wicked problem, the search for solutions never stops.

3. Solutions to wicked problems are not true or false, but good or bad. Ordinary problems have solutions that can be objectively evaluated as right or wrong. Choosing a solution to a wicked problem is largely a matter of judgment.

4. There is no immediate and no ultimate test of a solution to a wicked problem. It’s possible to determine right away if a solution to an ordinary problem is working. But solutions to wicked problems generate unexpected consequences over time, making it difficult to measure their effectiveness.

5. Every solution to a wicked problem is a “one-shot” operation; because there is no opportunity to learn by trial and error, every attempt counts significantly. Solutions to ordinary problems can be easily tried and abandoned. With wicked problems, every implemented solution has consequences that cannot be undone.

6. Wicked problems do not have an exhaustively describable set of potential solutions, nor is there a well-described set of permissible operations that may be incorporated into the plan. Ordinary problems come with a limited set of potential solutions, by contrast.

7. Every wicked problem is essentially unique. An ordinary problem belongs to a class of similar problems that are all solved in the same way. A wicked problem is substantially without precedent; experience does not help you address it.

8. Every wicked problem can be considered to be a symptom of another problem. While an ordinary problem is self-contained, a wicked problem is entwined with other problems. However, those problems don’t have one root cause.

9. The existence of a discrepancy representing a wicked problem can be explained in numerous ways. A wicked problem involves many stakeholders, who all will have different ideas about what the problem really is and what its causes are.

10. The planner has no right to be wrong. Problem solvers dealing with a wicked issue are held liable for the consequences of any actions they take, because those actions will have such a large impact and are hard to justify.

These Wicked Problems sound very similar to Deep Uncertainty.

The World Bank report suggests that “Accepting uncertainty mandates a focus on robustness”.

A robust decision process implies the selection of a project or plan which meets its intended goals – e.g., increase access to safe water, reduce floods, upgrade slums, or many others– across a variety of plausible futures. As such, we first look at the vulnerabilities of a plan (or set of possible plans) to a field of possible variables. We then identify a set of plausible futures, incorporating sets of the variables examined, and evaluate the performance of each plan under each future. Finally, we can identify which plans are robust to the futures deemed likely or otherwise important to consider.

That sounds a lot like a risk management approach.  Taking your plans and looking at how your plans work under a range of scenarios.

This is a different approach from what business managers are trained to take.  And it is a clear example of the fundamental conflict between risk management thinking and the predominant thinking of company management.

What business managers are taught to do is to predict the most likely future scenario and to make plans that will maximize the results under that scenario.

And that approach makes sense when faced with a reliably predictable world.  But in those situations when you are faced with Deep Uncertainty or Wicked Problems, the Robust Approach should be the preferred approach.

Risk managers need to understand that businesses mainly need to apply the Robust/risk management techniques to these Wicked Problems and Deep Uncertainty.  It is a major waste of time to seek to apply the Robust Approach when the situation is not that extreme.  Risk managers need to develop skills and processes to identify these situations.  Risk managers need to “sell” this approach to top management.  Risks need to be divided into two classes – “normal” and “Deep Uncertain/Wicked” and the Robust Approach used for planning what to do regarding the business activities subject to that risk.  The Deep Uncertainty may not exist now, but the risk manager needs to have the credibility with top management when they bring their reasoning for identifying a new situation of Deep Uncertainty.

The biggest Risk is that the rules keep changing

December 27, 2013

risk legacy

RISKVIEWS played the board game Risk Legacy with the family yesterday.  We were playing for the 8th time.  This game is a version of the board game Risk where the rules are changed by the players after each time playing the game.  Most often, the winner is the person who most quickly adapts to the new rules.  Once the other players see how the rules can be exploited, they can adapt to defend against that particular strategy, but at the same time, the rules have changed again, presenting a new way to win.

This game provides a brilliant metaphor for the real world and the problems faced by business and risk managers in constantly having to adapt both to avoid losing and to find the path to winning.  The biggest risk is that the rules keep changing.  But unlike the game, where the changes are public and happen only once per game, in the real world, the changes to the rules are often hidden and can happen at any time.

Regulators are forced to follow a path very much like the Risk Legacy game of making public changes on a clear timetable, but  competitors can change their prices or their products or their distribution strategy at any time.  Customers can change their behaviors, sometimes drastically, most often gradually without notice.  Even the weather seems to change, but we are not really sure how much.

Meanwhile, risk managers have been forced into a universe of their own design with the movement towards heavy metal complex risk models.  Those models are most often based upon the premise that when it comes to risk, things will not change.  That the future will be much like the past and in fact, that even inquiring about changes may be difficult and may therefore be discouraged due to limited resources.

But risk can be thought of as the tail of the cat.  The exact path of the cat is unpredictable.  The rules for what a cat is trying to accomplish at any point in time keep changing.  Not constantly changing, but changing nonetheless without warning.  So imagine trying to model the path of the cat.  Now shift to the tail of the cat representing the risk.  The tail has a much wider and more unpredictable path than the body of the cat.

That is not to suggest that the path of the tail (the risk) is wildly unpredictable.  But keeping up with the tail requires much more than simply extrapolating the path of the cat from the recent past.  It requires keeping up with the ever changing path of the cat.  And the tail movement will often represent the possibilities for changes in the future path.

Some risk models and risk management programs are created with recognition of the likelihood that the rules will change, sometimes even between the time that the model assumptions are set and when the model results are presented.  In those programs, the models are valued for their insights into the nature of risk, but of the risk as it was in the recent past.  And with recognition that the risk that will be will be somewhat different because the rules will change.

Ignoring a Risk

October 31, 2013

Ignoring is perhaps the most common approach to large but infrequent risks.

Most people think of a 1 in 100 year event as something so rare as it will never happen.

But just take a second and look at the mortality risk of a life insurer.  Each insured has on average around a 1 – 2 in 1000 likelihood of death in any one year.  However, life insurers do not plan for zero claims.  They plan for 1 -2 in 1000 of their policies to have a death claim in any one year.  No one thinks it odd that something with a 1-2 in 1000 likelihood happens hundreds of times in a year.  No one goes around scoffing at the validity of the model or likelihood estimate because such a rare event has happened.

But somehow, that seemingly totally simple minded logic escapes most people when dealing with other risks.  They scoff at how silly that it is that so many 1 in 100 events happen in a year.  Of course, they say, such estimated of likelihood MUST be wrong.

So they go forth ignoring the risk and ignoring the attempts at estimating the expected frequency of loss.  The cost of ignoring a low frequency risk is zero in most years.

And of course, any options for transferring such a risk will have both an expected frequency and an uncertainty charge built in.  Which make those options much too expensive.

The big difference is that a large life insurer takes on hundreds of thousands and in the largest cases, millions of exposures to the 1-2 in 1000 risks. Of course, the law of large numbers turns these individual ultra low frequency risks into a predictable claims pattern, in many cases one with a fairly tight distribution of possible claims.

But because they are ignored, no one tries to know how many of those 1 in 100 risks that we are exposed to.  But the statistics of 20 or 50 or 100 totally unrelated 1 in 100 risks is exactly the same as the life insurance math.

With 100 totally unrelated independent 1 in 100 risks, the chance of one or more turning into a loss in any one year is 63%!

And the most common reaction to the experience of a 1 in 100 event happening is to decide that the statistics are all wrong!

After Superstorm Sandy, NY Governor Cuomo told President Obama that NY “has a 100-year flood every two years now.”  Cuomo had been governor for less than two full years at that point.

The point is that organizations must go against the natural human impulse to separately decide to ignore each of their “rare” risks and realize that the likelihood of experiencing one of these rare events is not so rare, what is uncertain is which one.

Future Uncertainty

April 16, 2013

Often called emerging risks. Going back to Knight’s definitions of Risk and Uncertainty, there is very little risk contained in these potential situations.  Emerging risks are often pure uncertainty.  Humans are good at finding patterns.  Emerging risks are breaks in patterns.

What to Do about Emerging Risks…

Emerging risks are defined by AM Best as “new or evolving risks that are difficult to manage because their identification, likelihood of occurrence, potential impacts, timing of occurrence or impact, or correlation with other risks, are highly uncertain.” An example from the past is asbestos; other current examples could be problems deriving from nanotechnology, genetically modified food, climate change, etc. Lloyd’s, a major sufferer from the former emerging risk of asbestos, takes emerging risks very seriously. They think of emerging risks as “an issue that is perceived to be potentially significant but which may not be fully understood or allowed for in insurance terms and conditions, pricing, reserving or capital setting”.

What do the rating agencies expect?

AM Best says that insurers need “sound risk management practices relative to its risk profile and considering the risks inherent in the liabilities it writes, the assets it acquires and the market(s) in which it operates, and takes into consideration new and emerging risks.” In 2013, Best has added a question asking insurers to identify emerging risks to the ERM section of the SRQ. Emerging Risks Management has been one of the five major pillars of the Standard & Poor’s Insurance ERM ratings criteria since 2006.

How do you identify emerging risks?

A recent report from the World Economic Forum, The Global Risks 2012 report is based on a survey of 469 experts from industry, government, academia and civil society that examines 50 global risks. Those experts identified 8 of those 50 risks as having the most significance over the next 10 years:

  •   Chronic fiscal imbalances
  •   Cyber attacks
  •   Extreme volatility in energy and agriculture prices
  •   Food shortage crises
  •   Major systemic financial failure
  •   Rising greenhouse gas emissions
  •   Severe income disparity
  •   Water supply crises

This survey method for identifying or prioritizing risks is called the Delphi method and can be used by any insurer. Another popular method is called environmental scanning which includes simply reading and paying attention for unusual information about situations that could evolve into future major risks.

What can go wrong?

Many companies do not have any process to consider emerging risks.  At those firms, managers usually dismiss many possible emerging risks as impossible.  It may be the company culture to scoff at the sci fi thinking of the emerging risks process.  The process Taleb describes of finding ex post explanation for emerging Black Swan risks is often the undoing of careful plans to manage emerging risk.  In addition, lack of imagination causes some managers to conclude that the past worst case is the outer limit for future losses.

What can you do about emerging risks?

The objectives for emerging risks management are just the same as for other more well-known risks: to reduce the frequency and severity of future losses. The uncertain nature of emerging risks makes that much more difficult to do cost effectively. Insurers can use scenario testing to examine potential impact of emerging risks and to see what actions taken in advance of their emergence might lessen exposures to losses. This scenario testing can also help to identify what actions might lessen the impact of an unexpected loss event that comes from a very rapidly emerging risk. Finally, insurers seek to identify and track leading indicators of impending new risk emergence.

Reinsurance is one of the most effective ways to protect against emerging risks, second only to careful drafting of insurance contract terms and conditions

Many of the largest insurers and reinsurers have developed very robust practices to identify and to prepare for emerging risks.  Other companies can learn from the insurers who practice emerging risk management and adapt the same processes to their emerging risks.

Normal risk control processes focus on everyday risk management, including the management of identifiable risks and/or risks where uncertainty and unpredictability are mitigated by historical data that allow insurers to estimate loss distribution with reasonable confidence. Emerging risk management processes take over for risks that do not currently exist but that might emerge at some point due to changes in the environment. Emerging risks may appear abruptly or slowly and gradually, are difficult to identify, and may for some time represent an ill formed idea more than factual circumstances. They often result from changes in the political, legal, market, or physical environment, but the link between cause and effect is fully known in advance. An example from the past is asbestos; other examples could be problems deriving from nanotechnology, genetically modified food, climate change, etc. 
For these risks, normal risk identification and monitoring will not work because the likelihood is usually completely unknown. Nevertheless, past experience shows that when they materialize, they have a significant impact on the insurers and therefore cannot be excluded from a solid risk management 
program. So insurers have implemented unique specific strategies and approaches to cope with them properly.

Identifying emerging risks

Emerging risks have not yet materialized or are not yet clearly defined and can appear abruptly or very slowly. Therefore, having some sort of early warning system in place, methodically identified either through internal or external sources, is very important. To minimize the uncertainty surrounding these risks, insurers will consistently gather all existing relevant information to amass preliminary evidence of emerging risks, which would allow the insurer to reduce or limit growth of exposure as the evidence becomes more and more certain.  However, Insurers practicing this discipline will need to be aware of the cost of false alarms.

Assessing their significance

Assess the relevance (i.e. potential losses) of the emerging risks linked to a company’s commitment— which classes of business and existing policies would be affected by the materialization of the risk—and continue with the assessment of the potential financial impact, taking into account potential correlation with other risks already present in the firm. For an insurer, the degree of concentration and correlation of the risks that they have taken on from their customers are two important parameters to be considered; the risk in question could be subject to very low frequency/high intensity manifestations, but if exposure to that particular risk is limited, then the impact on the company may not be as important. On the other hand, unexpected risk correlations should not be underestimated; small individual exposures can coalesce into an extreme risk if underlying risks are highly interdependent. When developing extreme scenarios, some degree of imagination to think of unthinkable interdependencies could be beneficial.

A further practice of insurers is to sometimes work backwards from concentrations to risks. Insurers might envision risks that could apply to their concentrations and then track for signs of risk emergence in those areas. Some insurers set risk limits for insurance concentrations that are very similar to investment portfolio credit limits, with maximum concentrations in specific industries in geographic or political regions. In addition, just as investment limits might restrict an insurer’s debt or equity position as a percentage of a company’s total outstanding securities, some insurers limit the percentage of coverage they might offer in any of the sectors described above.

Define appropriate responses

Responses to emerging risks might be part of the normal risk control process, i.e., risk mitigation or transfer, either through reinsurance (or retrocession) in case of insurance risks, through the financial markets for financial risks, or through general limit reduction or hedging. When these options are not available or the insurer decides not to use them, it must be prepared to shoulder significant losses, which can strain a company’s liquidity.  Planning access to liquidity is a basic part of emerging risk management.  Asset-selling priorities, credit facilities with banks, and notes programs are possible ways of managing a liquidity crisis.

Apart from liquidity crisis management, other issues exist for which a contingency plan should be identified in advance. The company should be able to quickly estimate and identify total losses and the payments due. It should also have a clear plan for settling the claims in due time so as to avoid reputation issues. Availability of reinsurance is also an important consideration: if a reinsurer were exposed to the same risks, it would be a sound practice for the primary insurer to evaluate the risk that the reinsurer might delay payments.

Advance Warning Process

For the risks that have identified as most significant and where the insurer has developed coherent contingency plans, the next step is to create and install an advanced warning process.  To do that, the insurer identifies key risk indicators that provide an indication of increasing likelihood of a particular emerging risk.

Learn

Finally, sound practices for managing emerging risks include establishing procedures for learning from past events. The company will identify problems that appeared during the last extreme event and identify improvements to be added to the risk controls.  In addition, expect to get better at each step of the emerging risk process with time and experience.

But emerging risk management costs money.  And the costs that are most difficult to defend are the emerging risks that never emerge.  A good emerging risk process will have many more misses than hits.  Real emerged risks are rare.  A company that is really taking emerging risks seriously will be taking actions on occasion that cost money to perform and possibly include a reduction in the risks accepted and the attendant profits.  Management needs to have a tolerance for these costs.  But not too much tolerance.

 

This is one of the seven ERM Principles for Insurers

What Do Your Threats Look Like?

December 6, 2012

Severe and intense threats are usually associated with dramatic weather events, terrorist attacks, earthquakes, nuclear accidents and such like.  When one of these types of threats is thought to be immanent, people will often cooperate with a cooperative ERM scheme, if one is offered.  But when the threat actually happens, there are four possible responses:  cooperation with disaster plan, becoming immobilized and ignoring the disaster, panic and anti-social advantage taking.  Disaster planning sometimes goes no further than developing a path for people with the first response.  A full disaster plan would need to take into account all four reactions.  Plans would be made to deal with the labile and panicked people and to prevent the damage from the anti-social.  In businesses, a business continuity or disaster plan would fall into this category of activity.

When businesses do a first assessment, risks are often displayed in four quadrants: Low Likelihood/Low Severity; Low Likelihood/High Severity; High Likelihood/Low Severity; and High Likelihood/High Severity.  It is extremely difficult to survive if your risks are High Likelihood/High Severity, so few businesses find that they have risks in that quadrant.  So businesses usually only have risks in this category that are Low Likelihood.

Highly Cooperative mode of Risk Management means that everyone is involved in risk management because you need everyone to be looking out for the threats.  This falls apart quickly if your threats are not Severe and Intense because people will question the need for so much vigilance.

Highly Complex threats usually come from the breakdown of a complex system of some sort that you are counting upon.  For an insurer, this usually means that events that they thought had low interdependency end up with a high correlation.  Or else a new source of large losses emerges from an existing area of coverage.  Other complex threats that threaten the life insurance industry include the interplay of financial markets and competing products, such as happened in the 1980’s when money market funds threatened to suck all of the money out of insurers, or in the 1990’s the variable products that decimated the more traditional guaranteed minimum return products.

In addition, financial firms all create their own complex threat situations because they tend to be exposed to a number of different risks.  Keeping track of the magnitude of several different risk types and their interplay is itself a complex task.  Without very complex risk evaluation tools and the help of trained professionals, financial firms would be flying blind.  But these risk evaluation tools themselves create a complex threat.

Highly Organized mode of Risk Management means that there are many very different specialized roles within the risk management process.  May have different teams doing risk assessment, risk mitigation and assurance, for each separate threat.  This can only make sense when the rewards for taking these risks is large because this mode of risk management is very expensive.

Highly Unpredictable Threats are common during times of transition when a system is reorganizing itself.  “Uncertain” has been the word most often used in the past several years to describe the current environment.  We just are not sure what will be hitting us next.  Neither the type of threat, the timing, frequency or severity is known in advance of these unpredictable threats.

Businesses operating in less developed economies will usually see this as their situation.  Governments change, regulations change, the economy dips and weaves, access to resources changes abruptly, wars and terrorism are real threats.

Highly Adaptable mode of Risk Management means that you are ready to shift among the other three modes at any time and operate in a different mode for each threat.  The highly adaptable mode of risk management also allows for quick decisions to abandon the activity that creates the threat at any time.  But taking up new activities with other unique threats is less of a problem under this mode.  Firms operating under the highly adaptive mode usually make sure that their activities do not all lead to a single threat and that they are highly diversified.

Benign Threats are things that will never do more than partially reduce earnings.  Small stuff.  Not good news, but not bad enough to lose any sleep over.

Low Cooperation mode of Risk Management means that individuals within their firm can be separately authorized to undertake activities that expand the threats to the firm.  The individuals will all operate under some rules that put boundaries around their freedom, but most often these firms police these rules after the action, rather than with a process that prevents infractions.  At the extreme of low cooperation mode of risk management, enforcement will be very weak.

For example, many banks have been trying to get by with a low cooperation mode of ERM.  Risk Management is usually separate and adversarial.  The idea is to allow the risk takers the maximum degree of freedom.  After all, they make the profits of the bank.  The idea of VaR is purely to monitor earnings fluctuations.  The risk management systems of banks had not even been looking for any possible Severe and Intense Threats.  As their risk shifted from a simple “Credit” or “Market” to very complex instruments that had elements of both with highly intricate structures there was not enough movement to the highly organized mode of risk management within many banks.  Without the highly organized risk management, the banks were unable to see the shift of those structures from highly complex threats to severe and intense threats. (Or the risk staff saw the problem, but were not empowered to force action.)  The low cooperation mode of risk management was not able to handle those threats and the banks suffered large losses or simply collapsed.

Major Regime Change – The Debt Crisis

May 24, 2011

A regime change is a corner that you cannot see around until you get to it.  It is when many of the old assumptions no longer hold.  It is the start of a new set of patterns.  Regime changes are not necessarily bad, but they are disruptive.  Many of the things that made people and companies successful under the old regime will no longer work.  But there will be completely new things that will now work.

The current regime has lasted for over 50 years.  Over that time, debt went all in one direction – UP.  Most other financial variables went up and down over that time, but their variability was in the context of a money supply that was generally growing somewhat faster than the economy.

Increasing debt funds some of the growth that has fueled the world economies over that time.

But that was a ride that could not go on forever.  At some point in time the debt servicing gets to be too high in comparison to the capacity of the economy.  The economy has gone through the stage of hedge lending (see Financial Instability) where activities are able to afford payments on their debt as well as repayment of principal long ago.  The economy is in the stage of Speculative Finance where activities are able to afford payments on the debt, but not the repayment of principal.  The efforts to pay down debt will tell us whether it is possible to reverse course on that.  If one looks ahead to the massive pensions crisis that looms in the moderate term, then you would likely judge that the economy is in Ponzi Financing land where the economy can neither afford the debt servicing or the payment of principal.

All this seems to be pointing towards a regime change regarding the level of debt and other forward obligations in society.  With that regime change, the world economy may shift to a regime of long term contraction in the amount of debt or else a sudden contraction (default) followed by a long period of massive caution and reduced lending.

Riskviews does not have a prediction for when this will happen or what other things will change when that regime change takes place.  But risk managers are urged to take into account that any models that are calibrated to historical experience may well mislead the users.  And market consistent models may also mislead for long term decision making (or is that will continue to mislead for long term decision making – how else to characterize a spot calculation) until the markets come to incorporate the impact of a regime change.

This may be felt in terms of further extension of the uncertainty that has dogged some markets since the financial crisis or in some other manner.

However it materializes, we will be living in interesting times.

Dissappointment

April 12, 2011

Michael Thompson often describes the situation where a person or group does not get the experience that they expect as Surprise. I have also heard that called Disappointment.

Probably Surprise is a better term.

What is going on is that people expect one sort of experience and get another.

In a recent published article, Ingram and Thompson describe the expectations of various environments as:

  • Boom Environment – High Drift, Low Volatility
  • Moderate Environment – Moderate Drift, Moderate Volatility
  • Bust Environment – Negative Drift, Low Volatility
  • Uncertain Environment – Unpredictable Drift, Unpredictable Volatility

With those descriptions, Surprise/Disappointment is easier to describe.  If you believe that the environment is in a Boom and the experience you get is moderate drift and volatility, then you will be surprised and probably disappointed.  And similarly, if you expect a Bust environment and you experience high drift, then you will certainly be Surprised, but probably not Disappointed.  Unless you were really counting on complaining and  are disappointed about good fortune spoiling that.

Surprise is very different for those expecting an Uncertain environment.  For them, it is surprising that they are able to notice any pattern, whether it be high, low or moderate drift and volatility.  They are expecting unpredictable results, a high volatility as well as a high volatility of volatility.  For them, a surprise would be if the experiences did have a reliable volatility.

The Surprise that many of us have been experiencing started out as a Disappointment.  We thought that home prices had a large positive drift and low volatility.  So as many of us started to count upon that expectation, the system reached its carrying capacity for home real estate.  Which is hard to imagine, since with the loans that were over 100% of value, people were being paid by the financial sector to take new homes.

Suddenly, house prices stopped rising.  Most stories about the financial crisis do not even try to give any explanation for that happening.  But it is easy to picture that everyone who was willing to move had already done so recently.  Even in a pay to take, there is a high personal time cost to move.  So the hot market encouraged anyone who might be willing to move and move a year or two or three earlier than they would have otherwise.  But not enough people were willing to do that year after year.  And not enough people were crazy enough to take out mortgages that they had absolutely no chance to pay back.  So the turnover faltered.  Prices simply stopped rising.  And the Surprise hit everyone.

After an extended period of freefall, the market has settled into a much longer period of uncertainty.  No discernable pattern to drift or to volatility.  There is a large and uneven volume of foreclosed real estate in the system.  It comes to market and disrupts prices.  Because the real estate market had relied upon a rather primitive price discovery mechanism, the foreclosures are very disruptive to the pricing of non-foreclosed housing.  This is a major factor in the level of uncertainty of housing and it ripples through the entire financial system and the entire economy.

With this uncertainty, people who are expecting any of the three other patterns of risk are irregularly Surprised, and often Disappointed.  As there are more and more disappointments, more and more people shift their coping strategy to one that makes sense in an Uncertain economy, the strategy of Diversification.  That might sound to be a good thing, but in practice, it ends up meaning avoiding any large or lengthy commitments.  It means a slow down in basic investment and usually a deferral of any of the major investments that would start to fuel the next positive economic cycle.

This Uncertain cycle will end slowly because of the immense amount of extra home real estate that is still in the foreclosure pipeline.

Such cycles usually end when the flip side of the process described above that drove the stoppage in the real estate boom.  What stopped the boom was that people wore out of moving up in housing.  What will stop the Uncertain market will be that people will wear out of not changing houses.  The people who have had one more child will be fed up with the crowding in their smaller house and the people whose kids have moved away will get fed up with maintaining more house than they need.  The people who do well enough to afford a bigger and better house will be fed up with waiting for things to settle down.  And when that happens to enough people, the backlog of existing real estate will finally sell down and a new boom will start again.

And people who had adapted to uncertainty will be Surprised, but not disappointed that their house again finally starts to appreciate.

Modeling Uncertainty

March 31, 2011

The message that windows gives when you are copying a large number of files gives a good example of an uncertain environment.  That process recently took over 30 minutes and over the course of that time, the message box was constantly flashing completely different information about the time remaining.  Over the course of one minute in the middle of that process the readings were:

8 minutes remaining

53 minutes remaining

45 minutes remaining

3 minutes remaining

11 minutes remaining

It is not true that the answer is random.  But with the process that Microsoft has chosen to apply to the problem, the answer is certainly unknowable.  For an expected value to vary over a very short period of time by such a range – that is what I would think that a model reflecting uncertainty would  look like.

An uncertain situation could be one where you cannot tell the mean or the standard deviation because there does not seem to be any repeatable pattern to the experience.

Those uncertain times are when the regular model – the one with the steady mean and variance – does not seem to give any useful information.

The flip side of the uncertain times and the model with unsteady mean and variance that represents those times is the person who expects that things will be unpredictable.  That person will be surprised if there is an extended period of time when experience follows a stable pattern, either good or bad or even a stable pattern centered around zero with gains and losses.  In any of those situations, the competitors of that uncertain expecting person will be able to use their models to run their businesses and to reap profits from things that their models tell them about the world and their risks.

The uncertainty expecting person is not likely to trust a model to give them any advice about the world.  Their model would not have cycles of predictable length.  They would not expect the world to even conform to a model with the volatile mean and variance of their expectation, because they expect that they would probably get the volatility of the mean and variance wrong.

That is just the way that they expect it will happen.   A new Black Swan every morning.

Correction, not every morning, that would be regular.  Some mornings.

What’s Next?

March 25, 2011

Turbulent Times are Next.

At BusinessInsider.com, a feature from Guillermo Felices tells of 8 shocks that are about to slam the global economy.

#1 Higher Food Prices in Emerging Markets

#2 Higher Interest Rates and Tighter Money in Emerging Markets

#3 Political Crises in the Middle East

#4 Surging Oil Prices

#5 An Increase in Interest Rates in Developed Markets

#6 The End of QE2

#7 Fiscal Cuts and Sovereign Debt Crises

#8 The Japanese Disaster

How should ideas like these impact on ERM systems?  Is it at all reasonable to say that they should not? Definitely not.

These potential shocks illustrate the need for the ERM system to be reflexive.  The system needs to react to changes in the risk environment.  That would mean that it needs to reflect differences in the risk environment in three possible ways:

  1. In the calibration of the risk model.  Model assumptions can be adjusted to reflect the potential near term impact of the shocks.  Some of the shocks are certain and could be thought to impact on expected economic activity (Japanese disaster) but have a range of possible consequences (changing volatility).  Other shocks, which are much less certain (end of QE2 – because there could still be a QE3) may be difficult to work into model assumptions.
  2. With Stress and Scenario Tests – each of these shocks as well as combinations of the shocks could be stress or scenario tests.  Riskviews suggest that developing a handful of fully developed scenarios with 3 or more of these shocks in each would be the modst useful.
  3. In the choices of Risk Appetite.  The information and stress.scenario tests should lead to a serious reexamination of risk appetite.  There are several reasonable reactions – to simply reduce risk appetite in total, to selectively reduce risk appetite, to increase efforts to diversify risks, or to plan to aggressively take on more risk as some risks are found to have much higher reward.

The last strategy mentioned above (aggressively take on more risk) might not be thought of by most to be a risk management strategy.  But think of it this way, the strategy could be stated as an increase in the minimum target reward for risk.  Since things are expected to be riskier, the firm decides that it must get paid more for risk taking, staying away from lower paid risks.  This actually makes quite a bit MORE sense than taking the same risks, expecting the same reward for risks and just taking less risk, which might be the most common strategy selected.

The final consideration is compensation.  How should the firm be paying people for their performance in a riskier environment?  How should the increase in market risk premium be treated?

See Risk adjusted performance measures for starters.

More discussion on a future post.

Risk Manager Survey of Emerging Risks

March 21, 2011

“There is currently an upsurge in management’s willingness to listen to risk managers.”   But Risk Managers consistently show a disturbing tendency towards projecting the next crisis from the last.  Now in its fourth year, the Emerging Risks Survey from the Joint Risk Management Section and conducted by Max Rudolph.

Emerging risks are risks that are evolving in uncertain ways, have been forgotten in their dormancy, or are new.  Emerging risks typically do not have a known distribution, that is their frequency is unknown.

In 2007, a shock to oil prices was seen as the top “emerging risk” in the first survey of risk managers.  That year had seen a major spike in oil prices.  In 2008, a blow-up in asset prices was identified as the top “emerging risk” immediately following the melt down of the sub prime market and a major drop in stock prices.  In 2009, a fall in the value of the US dollar was identified as the top “emerging risk” at the end of a year when many major currencies had strengthened against the dollar.  The new 2010 survey, released this week, indicates again that a fall in the US dollar is the top “emerging risk”.

If in fact these risk managers are advising their employers in the same way that they answer surveys, firms will continue to be well prepared for the last crisis and unprepared for the next one.

However, when asked to identify the single top emerging risk concern, a Chinese economic hard landing was the top pick with 14% of the respondents selecting that choice.  That is certainly a scenario that has not just recently happened.  So at least 14% of the respondents are doing some forward thinking.

Download the entire survey report here.

Getting a Handle on Uncertainty

February 11, 2011

Frank Knight looked for the reason why firms are able to make a profit (in perfect competition situations that is) and he ultimately decided that firms were paid for UNCERTAINTY.  He then went on to distinguish uncertainty from risk.  Risk is the toss of the dice.  With risk, the frequency & severity distribution of possible outcomes is known.  Uncertainty differs fundamentally from risk because with uncertainty, the future likelihoods are unknown.

You are uncertain, to varying degrees, about everything in the future; much of the past is hidden from you; and there is a lot of the present about which you do not have full information. Uncertainty is everywhere and you cannot escape from it. Dennis Lindley

In risk management, we tend to treat everything as if it were a Knightian RISK and totally ignore UNCERTAINTY. We do our best job of estimating the frequency distribution of gains and losses and treat every best estimate the same.  See Sins of Risk Measurement.

But we can and should make an effort to identify the uncertainty that lurks, to vastly differing degrees within our risk measures.  A simple start to such an effort would be to develop a classification system for UNCERTAINTY.

  1. Almost Totally Certain – like a prediction of time of sunrise.  No experience contrary to predictions and good reason to believe that there will not be a regime change in the event.  Highly unlikely that any human activity will fall into this category.  Humans are just not this predictable.
  2. Highly certain – like a prediction of the Cubs not winning the World Series.  Never happened, but it is possible, but highly unlikely that there will be a regime change.  Things in this category will be things that there is a long amount of historical evidence.  The possibility of a fall in home prices were felt to fall into this category, but the historical evidence turned out to be from one single cycle.  To put something in this category, a firm should have direct experience with the activity in question so that there is insight within the firm about the reasons for the historical drivers of the seemingly highly certain event.
  3. Conditionally certain – Apple will stay successful as long as Jobs stays healthy (oops).  For these sorts of uncertain events, the firm should have a that clear idea of the drivers of a string of predictable experience and an understanding that the driver(s) are not themself highly certain events.
  4. Somewhat uncertain – “Bill says that it takes him 20 minutes to get to the airport” or “it usually takes me 20 minutes to get to the airport but sometimes it is an hour.” Here the firm either has only moderate amounts of experience to judge the actual uncertainty and the event seems to be fairly certain or else the firm has experience and knows that the event is somewhat uncertain.
  5. Unknown uncertainty – “this is the first time I am parachute jumping and I plan to land in my backyard lawn chair.”  Something new.  With only limited knowledge of other people’s experiences and not enough experience to know whether there are significant differences in the drivers.

The first time a firm does an economic capital model, they might classify the result as having Level 5 uncertainty.  Over time, some calculations might move up to Level 4 or Level 3.  In a few areas, the firm might have been doing risk calculations for a particular risk over much longer time and could move up to Level 2 uncertainty there.

But change the question from an estimation of a 1-in-200 risk to a “will this project make money or not” question and is is quite possible that many of the answers might have Level 2 or Level 3 uncertainty.

But firms should try assigning Uncertainty ratings to their efforts.  And track over time the degree to which the firm is devoting resources to projects with Level 5 Uncertainty.

Riskviews has worked for several firms that were over 100 years old at the time and those firms usually were very uncomfortable taking on any Level 5 Uncertainty.  Most often they kept those activities small until they gained experience.  When they went for long periods of time with no Level 5 Uncertainty, however, they tended to shrink relative to the rest of the industry.

On the other hand, the financial crisis was touched off by Banks and other institutions who committed to enough Level 4 and Level 5 uncertainty to send them over the edge.  Investors would certainly be interested to know how much Level 5 Uncertainty that a firm is taking at any point in time.

Using an Uncertainty scale like this and discussing the reasons for changes to the level of commitment to higher uncertainty projects will be a healthy and productive exercise for many firms.

Sins of Risk Measurement

February 5, 2011
.
Read The Seven Deadly Sins of Measurement by Jim Campy

Measuring risk means walking a thin line.  Balancing what is highly unlikely from what it totally impossible.  Financial institutions need to be prepared for the highly unlikely but must avoid getting sucked into wasting time worrying about the totally impossible.

Here are some sins that are sometimes committed by risk measurers:

1.  Downplaying uncertainty.  Risk measurement will always become more and more uncertain with increasing size of the potential loss numbers.  In other words, the larger the potential loss, the less certain you can be about how certain it might be.  Downplaying uncertainty is usually a sin of omission.  It is just not mentioned.  Risk managers are lured into this sin by the simple fact that the less that they mention uncertainty, the more credibility their work will be given.

2.  Comparing incomparables.  In many risk measurement efforts, values are developed for a wide variety of risks and then aggregated.  Eventually, they are disaggregated and compared.  Each of the risk measurements are implicitly treated as if they were all calculated totally consistently.  However,  in fact, we are usually adding together measurements that were done with totally different amounts of historical data, for markets that have totally different degrees of stability and using tools that have totally different degrees of certitude built into them.  In the end, this will encourage decisions to take on whatever risks that we underestimate the most through this process.

3.  Validate to Confirmation.  When we validate risk models, it is common to stop the validation process when we have evidence that our initial calculation is correct.  What that sometimes means is that one validation is attempted and if validation fails, the process is revised and tried again.  This is repeated until the tester is either exhausted or gets positive results.  We are biased to finding that our risk measurements are correct and are willing to settle for validations that confirm our bias.

4.  Selective Parameterization.  There are no general rules for parameterization.  Generally, someone must choose what set of data is used to develop the risk model parameters.  In most cases, this choice determines the answers of the risk measurement.  If data from a benign period is used, then the measures of risk will be low.  If data from an adverse period is used, then risk measures will be high.  Selective paramaterization means that the period is chosen because the experience was good or bad to deliberately influence the outcome.

5.  Hiding behind Math.  Measuring risk can only mean measuring a future unknown contingency.  No amount of fancy math can change that fact.  But many who are involved in risk measurement will avoid ever using plain language to talk about what they are doing, preferring to hide in a thicket of mathematical jargon.  Real understanding of what one is doing with a risk measurement process includes the ability to say what that entails to someone without an advanced quant degree.

6.  Ignoring consequences.  There is a stream of thinking that science can be disassociated from its consequences.  Whether or not that is true, risk measurement cannot.  The person doing the risk measurement must be aware of the consequences of their findings and anticipate what might happen if management truly believes the measurements and acts upon them.

7.  Crying Wolf.  Risk measurement requires a concentration on the negative side of potential outcomes.  Many in risk management keep trying to tie the idea of “risk” to both upsides and downsides.  They have it partly right.  Risk is a word that means what it means, and the common meaning associated risk with downside potential.  However, the risk manager who does not keep in mind that their risk calculations are also associated with potential gains will be thought to be a total Cassandra and will lose all attention.  This is one of the reasons why scenario and stress tests are difficult to use.  One set of people will prepare the downside story and another set the upside story.  Decisions become a tug of war between opposing points of view, when in fact both points of view are correct.

There are doubtless many more possible sins.  Feel free to add your favorites in the comments.

But one final thought.  Calling it MEASUREMENT might be the greatest sin.

Momentum Risk

January 31, 2011

How many times have you heard this

If it isn’t broken don’t fix it.

As a risk manager, momentum risk is one of the most difficult risk to overcome.  (I wonder how many times on these posts I have claimed this?)

But this is the aspect of the Horizon disaster that led to millions and millions of barrels of oil spilling into the Gulf.  Before that the oil companies claimed that there had never been a failure of an oil rig in the Gulf.  So that was the Momentum assumption.  It had never failed so it never would fail.

Standing against that is the seemly endlessly negative point of view of the risk manager:

If anything can go wrong, it will.

Murphy‘s Law is usually taken as the ultimate statement of negative pessimism.  But instead you the risk manager need to use Murphy’s law as he did.  As a mantra to keep repeating to yourself as you look for ways to stress test a system.

Looking to engineering (Murphy was an engineer you know) for some thinking about stress to failure, we find this post:

When a component is subject to increasing loads it eventually fails.   It is comparatively easy to determine the point of failure of a component subject to a single tensile force. The strength data on the material identifies this strength.   However when the material is subject to a number of loads in different directions some of which are tensile and some of which are shear, then the determination of the point of failure is more complicated…

Some of your stress to failure tests will have to be tensile, some compressive, some shear, in different directions and in different combinations.  You should do this sort of testing to know the weakest points of your system.

But there is no guarantee that the system will fail at the weakest points either.  In fact, you may put in place methods to reduce stresses to those weakest points.  Remember that now elevates other points to be the new stresses.

And do not let Momentum thinking define your approach to likelihood of these stresses.  In physical systems, the engineer knows how the system is supposed to be used and can plan for the stresses of those uses.  But in many cases, the systems designed and tested by engineers are not used in the conditions planned for or even for the exact uses that the engineer anticipated.

Sound familiar?

Human systems are not so fixed as physical systems.  Humans react to the system that they are experiencing and adjust their actions according to the feedback that they are receiving from the system.  So human systems will almost always change as they are used.

Human systems will almost always change as they are used.

That is what makes it so much more difficult to be a risk manager for a financial firm than for a firm that deals mainly with physical risks.  As noted above the humans that interface with the physical risks system do change and adapt, but there are usually a larger portion of possibilities that are fixed by the constraints of the physical systems.

With financial risks, the idea of adapting and using a type of transaction or financial structure for alternate purposes has become the occupation of a large number of folks who command a large amount of resources.

So if, for example, you are using a particular type of derivative to accomplish a fairly straightforward risk management purpose, it is quite possible that the market for that instrument will suddenly be taken over by folks with lots and lots of money, fast computers and turnover averages in the thousands per week.  Their entry into a market will change pricing and the speed of changes in pricing and then one day, suddenly, they will decide, perhaps little by little, but possibly all at once, to abandon that trade and the market will snap to being something different still.

The same sort of thing happens in insurance, but at a different speed.  Lawyers are always out there looking to “perfect” an argument to create a new class of claimants against different businesses and their insurers. THis results in a sudden jump in claims costs.

Interestingly, the strategies for those two examples might be the exact opposite.  It might be best to move on from the market that is suddenly overtaken by high speed hedge fund traders.  But the only way to recover extra losses from a newly discovered and “perfected” cause of tort is to stay with the coverage.

But in all cases, the risk manager is faced with the problem of overcoming Momentum Risk.  Convincing others that something that is not broken needs attention and possibly even fixing.


Intrinsic Risk

November 26, 2010

If you were told that someone had flipped a coin 60 times and had found that heads were the results 2/3 of the time, you might have several reactions.

  • You might doubt whether the coin was a real coin or whether it was altered.
  • You might suspect that the person who got that result was doing something other than a fair flip.
  • You might doubt whether they are able to count or whether they actually counted.
  • You doubt whether they are telling the truth.
  • You start to calculate the likelihood of that result with a fair coin.

Once you take that last step, you find that the story is highly unlikely, but definitely not impossible.  In fact, my computer tells me that if I lined up 225 people and had them all flip a coin 60 times, there is a fifty-fifty chance  that at least one person will get that many heads.

So how should you evaluate the risk of getting 40 heads out of 60 flips?  Should you do calculations based upon the expected likelihood of heads based upon an examination of the coin?  You look at it and see that there are two sides and a thin edge.  You assess whether it seems to be uniformly balanced.  Then you conclude that you are fairly certain of the inherent risk of the coin flipping process.

Your other choice to assess the risk is to base your evaluation on the observed outcomes of coin flips.  This will mean that the central limit theorem should help us to eventually get the right number.  But if your first observation is that person described above, then it will be quite a few additional observations before you find out what the Central Limit Theorem has to tell you.

The point being that a purely observation based approach will not always give you the best answer.   Good to make sure that you understand something about the intrinsic risk.

If you are still not convinced of this, ask the turkey.  Taleb uses that turkey story to explain a Black Swan.  But if you think about it, many Black Swans are nothing more than ignorance of intrinsic risk.

Why Successful Forecasts are not an indicator of good Risk Management

September 24, 2010
from Adventures in probability, market forecasting edition

Read the post at http://blogs.reuters.com/felix-salmon/2010/09/20/adventures-in-probability-market-forecasting-edition/

Thanks to Evan.

An Unusually Uncertain Economy

August 13, 2010

Economists sometimes admit that the economy has different phases.  I think that they are now up to three:  Boom, Bust and Normal.

Most of the Economics literature of the past 30 years relates solely to the Normal environment.

There may be economics literature relating to the Boom phase, but who would know.  No one ever listens to an economist during a boom.

Keynes provided the theories for the Bust phase.  His ideas had been discredited up until they were needed again.  Now many economists are again looking at the Bust phase.

But on July 22, Bernanke said that the recovery was “unusually uncertain”.

There just do not seem to be any economic theories about this “uncertain” environment.  Perhaps that is why no one seems to know what to do.  They have prescriptions that would work if the environment was still in a Bust.  So maybe a double dip recession is needed to take the economy back into a phase where there are economic theories.

What economics needs is a theory of the Uncertain Environment. There are definitely theories in the minds of consumers and business leaders.  Here is one:

In the face of massive uncertainty, hedging your bets and keeping your options open is almost always the right strategy.

Jim Manzi

And that is mostly what we see businesses and individuals doing right now.  Keeping their options open.  Hence the massive buildup of corporate cash and the paydown of individual debt.

I do not have a full economic theory for the Uncertain times, but I can suggest that economists need to start treating this as a true phase of the economy and developing a theory.

Regime Change

July 30, 2010

If something happens more or less the same way for any extended period of time, the normal reaction of humans is consider that phenomena as constant and to largely filter it out.  We do not then even try to capture new information about changes to that phenomena because our senses tell us that that input is “pure noise” with no signal.  Hence the famous story about boiling frogs.  Which may or may not be actually true about frogs, but it definitely reveals something about the way that humans take in information about the world.

But things can and do actually change.  Even things that are more or less the same for a very long time.

In the book, “This Time It’s Different”, the authors state that

“The median inflation rates before World War I were well below those of the more recent period: 0.5% per annum for 1500 – 1799 and 0.71% for 1800 – 1913, in contrast with 5% for 1914 – 2006.”

Imagine that.  Inflation averaged below 0.75% for about 300 years.  Since there is no history of extended periods of negative inflation, to get an average that low, there must be a very low standard deviation as well.  Inflation at a level of 3 or 4% is probably a one in a million situation.  Or so intelligent financial analysts before WWI must have thought that they could make plans without any concern for inflation.

But in the years following WWI, governments found a new way to default on their debts, especially their internal debts.  Reinhart and Rogoff point out that almost all of the discussion by economists regarding sovereign default is about external debt.  But they show that internal debt is very important to the situations of sovereign defaults.  Countries with high levels of internal debt and low external debt will usually not default, but countries with high levels of both internal and external debt will often default.

So as we contemplate the future of the aging western economies, we need to be careful that we do not exclude the regime changes that could occur.  And which regime changes that we should be concerned about becomes clearer when we look at all of the entitlements to retirees as debt (is there any effective difference between debt and these obligations?).  When we do that we see that there are quite a few western nations with very, very large internal debt.  And many of those countries have indexed much of that debt, taking the inflation option off of the table.

Reinhart and Rogoff also point out the sovereign default is usually not about ability to pay, it is about willingness to make the sacrifices that repayment of debt would entail.

So Risk Managers need to think about possible drastic regime changes, in addition to the seemingly highly unlikely scenario that the future will be more or less like the past.

Uncertain Decisions

June 7, 2010

There have been many definitions of ERM.  Most suffer from the “too many words” syndrome.  They are too long, making it likely that a casual reader will suffer reading fatigue before completing and therefore will decide that the topic is too complicated to be useful.

Here is a try at a very crisp definition:

ERM is a system for enhancing decision making under uncertainty that requires consideration of ALL of the risks of the enterprise.

And also for plain “Risk Management”

Risk Management is a system for enhancing decision making under uncertainty that focuses on risks as well as returns.

Fundamentally linking ERM and Risk Management to decision making is important, vitally important.  Otherwise funders of ERM programs will be quickly disenchanted with the expensive staffs and systems needed to support a Risk Management Entertainment System.

All ERM and Risk Management activities should be judged in terms of how well they support important decisions.

The important decisions that can be supported by ERM and Risk Management are many. Primary among them are:

  1. How much risk should the company take?
  2. How best to transition from the risk level that the company is taking to the risk level that the company should be taking?
  3. How to assure that the company takes no more risk than it should take?
  4. Which Risks should the company take?
  5. How best to transition from the risks that the company is taking to the risks that the company should be taking?
  6. How to manage the likelihood that the company will fall short of its earnings targets?

If a firm already has complete processes in place to make all of those decisions, then it already has ERM.  With the rising calls for ERM from regulators, rating agencies and boards, those firms will need to make sure that they can fully articulate the processes that they use to make those decisions.

If, on the other hand, a firm generally makes one or several of those decisions by default, as a fallout from other decisions or on a totally flexible basis as it happens in response to various market forces or on a purely momentum based process that ultimately relies upon some past decisions that may or may not have been made with any concern for risk; then future development of ERM could be vitally important.

The support that ERM provides to all of these decisions is of the nature of an eyes open approach to risk.  This general theme is perhaps the reason why ERM often seems to be a massive management information exercize.

But management information about risk is the means to supporting risk focused decision making, not the ends.

Stress to Failure

May 28, 2010

It is clear and obvious that BP and the US government regulators were not at all prepared for failure of a deep water oil rig in the Gulf.

What would have helped them is a procedure that I have heard Dave Sandberg describe many times that is used at his employer, Allianz.

Stress to Failure.

  1. Whenever something new is proposed, they require that a demonstration is prepared that shows the type of stress that will cause complete failure. That test provides them with several pieces of very valuable information: It helps to put a boundry around the situations under which it will NOT fail. This is the green (and yellow) zone for the new project. They can then evaluate the expected return and volatility of return in those scenarios.
  2. It allows an estimate of the likelihood of success vs. failure of the project.  This can be seen by looking at the type of situation that causes failure and the likelihood of that situation.  However, caution should be applied to not put too much weight on this likelihood estimate if the failure type of even has never before happened.  Human nature may well be biased towards underestimating adversity. 
  3. It allows for planning for the failure event.  This is where the BP folks and Transocean as well as the Minerals Management Service failed.  They clearly had no plan for the failure event.  It sounds like they were able to convince themselves that any failure event was so remote in likelihood that there was no need to plan for one. 
  4. Understanding the true weaknesses of the system.  If you do not know how to break it, then perhaps you do not understand the system. 

This is an idea our of engineering and probably we could learn much by studying how they have used the idea.

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

Comprehensive Actuarial Risk Evaluation

May 11, 2010

The new CARE report has been posted to the IAA website this week.

It raises a point that must be fairly obvious to everyone that you just cannot manage risks without looking at them from multiple angles.

Or at least it should now be obvious. Here are 8 different angles on risk that are discussed in the report and my quick take on each:

  1. MARKET CONSISTENT VALUE VS. FUNDAMENTAL VALUE   –  Well, maybe the market has it wrong.  Do your own homework in addition to looking at what the market thinks.  If the folks buying exposure to US mortgages had done fundamental evaluation, they might have noticed that there were a significant amount of sub prime mortgages where the Gross mortgage payments were higher than the Gross income of the mortgagee.
  2. ACCOUNTING BASIS VS. ECONOMIC BASIS  –  Some firms did all of their analysis on an economic basis and kept saying that they were fine as their reported financials showed them dying.  They should have known in advance of the risk of accounting that was different from their analysis.
  3. REGULATORY MEASURE OF RISK  –  vs. any of the above.  The same logic applies as with the accounting.  Even if you have done your analysis “right” you need to know how important others, including your regulator will be seeing things.  Better to have a discussion with the regulator long before a problem arises.  You are just not as credible in the middle of what seems to be a crisis to the regulator saying that the regulatory view is off target.
  4. SHORT TERM VS. LONG TERM RISKS  –  While it is really nice that everyone has agreed to focus in on a one year view of risks, for situations that may well extend beyond one year, it can be vitally important to know how the risk might impact the firm over a multi year period.
  5. KNOWN RISK AND EMERGING RISKS  –  the fact that your risk model did not include anything for volcano risk, is no help when the volcano messes up your business plans.
  6. EARNINGS VOLATILITY VS. RUIN  –  Again, an agreement on a 1 in 200 loss focus is convenient, it does not in any way exempt an organization from risks that could have a major impact at some other return period.
  7. VIEWED STAND-ALONE VS. FULL RISK PORTFOLIO  –  Remember, diversification does not reduce absolute risk.
  8. CASH VS. ACCRUAL  –  This is another way of saying to focus on the economic vs the accounting.

Read the report to get the more measured and complete view prepared by the 15 actuaries from US, UK, Australia and China who participated in the working group to prepare the report.

Comprehensive Actuarial Risk Evaluation

Much Worse than Anticipated

May 5, 2010

Arianna Huffington recently pointed out that time and time again, the crises that we face turn out to be Much Worse than We thought it would be.

And she has a good point there.  One that is important for risk managers to contemplate.  One that we are often asked after a major loss…

Why did your risk model get that wrong?

There is a correct answer, but it is one that we can never successfully use.

In situations where major risks are being underestimated widely in the market place, the risk managers who correctly size the worst risks can run into two responses:

  1. Their firm believes their evaluation of the risk and exits the exposure as rapidly as they can.
  2. Their firm does not believe their evaluation and will only believe a risk evaluation that gives a similar (under) estimation of the risk as the rest of the market.

It is a survival of the underestimators.

And this doesn’t just apply to risk managers and risk models.  Who do you think buys a house on a flood plain?  Someone who has a clear and realistic view of the risk or someone who vastly underestimates the risk?  The underestimator will out bid the realistic every time.

So after a flood, go around to those flooded out and ask if they expected this and most will tell you that this is “much worse that we thought it would be”.

Many “emerging risks” and “black swans” are such because most people had misunderestimated the size of the risk or the likelihood.

And one way to think of it is to go back to Knight and realize that all profits are simply rewards for the uncertainties.  So when we find ourselves getting profits where we cannot figure out the uncertainty that drives the profits, maybe we should go back and figure it out.

The solution is not to curl up in a ball, nor is it to just ignore all risks that pose these potential major threats.  The solution is to take our best shot at really evaluating the risks and make our decisions, eyes wide open, to the possibility that things might just be Much Worse than Anticipated.

Maybe we need to regularly add a column to our risk reports.  To the right of the column labeled Risk.  This one labeled “Worse Case”.

Many insurers with Cat risk exposures will report the 1/250 loss potential that is the focus of rating agencies, but along side of that show a 1/500 loss potential to remind management of just how much worse it might get.

Some people complain that risk managers are just too pessimistic.  But to me this sort of practice just seems to be acting as an adult and facing our risks honestly.  Not with the intention that we stop taking risks.  Instead hoping that we stop experiencing losses that are MUCH WORSE THAN ANTICIPATED.

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.

Volcano Risk

April 20, 2010

Remarks from Giovanni Bisignani (International Air Transport Association) at the Press Breakfast in Paris

The Volcano

There was one risk that we could not forecast. That is the volcanic eruption which has crippled the aviation sector.  First in Europe, but we saw increasing global implications.  The scale of this crisis is now greater than 9/11 when US air space was closed for three days.  In lost revenue alone, this is costing the industry at least $200 million a day.  On top of that, airlines face added costs of extra fuel for re-routing and passenger care – hotel, food and telephone calls.

For Europe’s carriers – the most seriously impacted – this could not have come at a worse time.  As just mentioned, we already expected the region to have the biggest losses this year.  For each day that planes don’t fly the losses get bigger.  We are now into our fifth day of closed skies.  Let me restate that safety is our number one priority. But it is critical that we place greater urgency and focus on how and when we can safely re-open Europe’s skies.

We are far enough into this crisis to express our dissatisfaction on how governments have managed the crisis:

  • With no risk assessment
  • No consultation
  • No coordination
  • And no leadership

In the face of a crisis that some have estimated has already cost the European economy billions of Euros, it is incredible that it has taken five days for Europe’s transport ministers to organize a conference call.

What must be done?

International guidance is weak. The International Civil Aviation Organization (ICAO) is the specialized UN agency for aviation. ICAO has guidance on information dissemination but no clear process for opening or closing airspace. Closing airspace should be the responsibility of the national regulator with the support of the air navigation service provider.  They rely on information from meteorological offices and Volcanic Ash Advisory Centers.

Europe has a unique system.  The region’s decisions are based on a theoretical model for how the ash spreads.  This means that governments have not taken their responsibility to make clear decisions based on fact.  Instead, it has been the air navigation service providers who announced that they would not provide service. These decisions have been taken without adequately consulting the operators—the airlines. This is not an acceptable system, particularly when the consequences for safety and the economy are so large.

I emphasize that safety is our top priority. But we must make decisions based on the real situation in the sky, not on theoretical models. The chaos, inconvenience and economic losses are not theoretical. They are enormous and growing. I have consulted our member airlines who normally operate in the affected airspace. They report missed opportunities to fly safely.  One of the problems with the European system is that the situation is seen as black or white. If there is the possibility of ash then the airspace is closed.  And it remains closed until the possibility disappears with no assessment of the risk.

We have seen volcanic activity in many parts of the world but rarely combined with airspace closures and never at this scale. When Mount St. Helens erupted in the US in 1980, we did not see large scale disruptions because the decisions to open or close airspace were risk managed with no compromise on safety.

Today I am calling for urgent action to safely prepare for re-opening airspace based on risk and fact.  I have personally asked ICAO President Kobeh and Secretary General Benjamin to convene an urgent extra-ordinary meeting of the ICAO Council later today. The first purpose would be to define government responsibility for the decisions to open or close airspace in a coordinated and effective way based on fact—not theory.

Airlines have run test flights to assess the situation.  The results have not shown any irregularities and the data is being passed to governments and air navigation service providers to help with their assessment. Governments must also do their own testing. European states must focus on ways to re-open the airspace based on this real data and on appropriate operational procedures to maintain safety.  Such procedures could include special climb and descent procedures, day time flying, restrictions to specific corridors, and more frequent boroscopic inspections of engines.

We must move away from blanket closures and find ways to flexibly open airspace. Risk assessments should be able to help us to re-open certain corridors if not entire airspaces.  I have also urged Eurocontrol to also take this up. I urge them to establish a volcano contingency center capable of making coordinated decisions.  There is a meeting scheduled for this afternoon that I hope will result in a concrete action plan.

Longer-term, I have also asked the ICAO Council to expedite procedures to certify at what levels of ash concentration aircraft can operate safely.  Today there are no standards for ash concentration or particle size that aircraft can safely fly through. The result is zero tolerance. Any forecast ash concentration results in airspace closure. We are calling on aircraft and engine manufacturers to certify levels of ash that are safe.

Summary

1. Safety is our number one priority
2. Governments must reopen airspace based on data that tell us it is safe. If not all airspace, at least some corridors
3. Governments must improve the decision-making process with facts—not theory
4. Governments must communicate better, consulting with airlines and coordinating among stakeholders
5. And longer-term, we must find a way to certify the tolerance of aircraft for flying in these conditions

You might wonder about your own Volcano Risk.  Check out an explanation of what is covered by State Farm.

Finally, I got a question from the press about companies that I knew that had prepared specifically for this event.  One more example of how the press misses the point.  ERM is not about guessing the future correctly.

For something that is as unique as this event, the best any company could have expected to do would have been to anticipated the broad class of events that would cause extended disruptions of flights, tested the impact of such a disruption on their business operations and made decisions about contingency plans that they might have put in place to prepare for such disruptions.

Chief Ignorance Officer

February 10, 2010

Great piece from HBR “Wanted: Chief Ignorance Officer“by David Gray.

The idea is that person would protect the ability of the firm to be open minded.  To consider both options and adverse possibilities.  The CIO would be the person who does not ever believe the claims on the outside of the box.  They would be the person who breaks the new toy immediately because they hold it the wrong way (hopefully while still in the store.) The CIO would be the person who is not so sure even when “everyone knows” that there is no risk in that new and growing area.

The CIO would also remind everyone that just because they have more information about one alternative it is not necessarily the best choice.  Sometimes, the best choice is to go ahead with something that is not necessarily known for sure to work.

The CIO would also provide the childlike ability to see old things in a new light and possibly see new solutions for old problems that utilize tools that are right there on the worktable but that we always thought were only to be used for something else.

The CIO will be willing to try lots and lots of different solutions because they will not know in advance which one will work.

The CRO definitely should have a lieutenant who is their CIO.  Someone who will actually see the road ahead because they have not been down it so many times that they no longer look.

The Dirty Dozen

February 4, 2010

Guest Post from David Merkel

The Aleph Blog

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

From David Merkel

The Aleph Blog

This post is produced by David Merkel CFA, a registered representative of Finacorp Securities as an outside business activity. As such, Finacorp Securities does not review or approve materials presented herein. By viewing or participating in discussion on this blog, you understand that the opinions expressed within do not reflect the opinions or recommendations of Finacorp Securities, but are the opinions of the author and individual participants. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security or other instrument. Before investing, consider your investment objectives, risks, charges and expenses. Any purchase or sale activity in any securities instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Finacorp Securities is a member FINRA and SIPC.

Crisis Pre-Nuptial

January 21, 2010

What is the reaction of your firm going to be in the event of a large loss or other crisis? 

If you are responsible for risk management, it is very much in your interest to enter into a Crisis Pre-Nuptial

The Crisis Pre-Nuptial has two important components. 

  1. A protocol for management actions in the event of the crisis.  There is likely a need for there to be a number of these protocols.   These protocols can be extremely valuable, their value will most likely far exceed the entire cost of a risk management function.  Their value comes because they eliminate two major problems that firms face in the event of a crisis or large loss.  First is the deer in the headlights problem – the delay when no one is sure what to do and who is to do it.  That delay can mean that corrective actions are much less effective or much more expensive or both.  Second is the opposite, that too many people take actions, but that the actions are conflicting.  This again increasses costs and decreases effectiveness.  Just as with severe medical emergencies, prompt corrective actions are almost always more likely to have the most favorable results. 
  2. Setting up an expectation that the crises and losses either are or are not an expected part of the risks that the firm is taking.  If the firm is taking high risks, but does not expect to ever experience losses, then there is a major disconnect between the two.  Just as a marital pre-nuptial agreement is a conscious acknowledgement that marriages sometimes end in divorce, a Crisis Pre-Nuptial is an acknowledgement that normal business activity sometimes involves losses and crises. 

Risk managers who have a Crisis Pre-Nuptial in place might, just might, have a better chance to survive with their job in tact after a crisis or large loss. 

And if someday, investors and/or boards come to the realization that firms that plan for rainy days are, in the long run, going to be more valuable, the information that is in the Crisis pre-nuptial could be very important information for them.

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.

New Decade Resolutions

January 1, 2010

Here are New Decade Resolutions for firms to adopt who are looking to be prepared for another decade

  1. Attention to risk management by top management and the board.  The past decade has been just one continuous lesson that losses can happen from any direction. This is about the survival of the firm.  Survival must not be delegated to a middle manager.  It must be a key concern for the CEO and board.
  2. Action oriented approach to risk.  Risk reports are made to point out where and what actions are needed.  Management expects to and does act upon the information from the risk reports.
  3. Learning from own losses and from the losses of others.  After a loss, the firm should learn not just what went wrong that resulted in the loss, but how they can learn from their experience to improve their responses to future situations both similar and dissimilar.  Two different areas of a firm shouldn’t have to separately experience a problem to learn the same lesson. Competitor losses should present the exact same opportunity to improve rather than a feeling of smug superiority.
  4. Forwardlooking risk assessment. Painstaking calibration of risk models to past experience is only valuable for firms that own time machines.  Risk assessment needs to be calibrated to the future. 
  5. Skeptical of common knowledge. The future will NOT be a repeat of the past.  Any risk assessment that is properly calibrated to the future is only one one of many possible results.  Look back on the past decade’s experience and remember how many times risk models needed to be recalibrated.  That recalibration experience should form the basis for healthy skepticism of any and all future risk assessments.

  6. Drivers of risks will be highlighted and monitored.  Key risk indicators is not just an idea for Operational risks that are difficult to measure directly.  Key risk indicators should be identified and monitored for all important risks.  Key risk indicators need to include leading and lagging indicators as well as indicators from information that is internal to the firm as well as external. 
  7. Adaptable. Both risk measurement and risk management will not be designed after the famously fixed Ligne Maginot that spectacularly failed the French in 1940.  The ability needs to be developed and maintained to change focus of risk assessment and to change risk treatment methods on short notice without major cost or disruption. 
  8. Scope will be clear for risk management.  I have personally favored a split between risk of failure of the firm strategy and risk of losses within the form strategy, with only the later within the scope of risk management.  That means that anything that is potentially loss making except failure of sales would be in the scope of risk management. 
  9. Focus on  the largest exposures.  All of the details of execution of risk treatment will come to naught if the firm is too concentrated in any risk that starts making losses at a rate higher than expected.  That means that the largest exposures need to be examined and re-examined with a “no complacency” attitude.  There should never be a large exposure that is too safe to need attention.   Big transactions will also get the same kind of focus on risk. 

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.

Risk Intelligence

December 20, 2009

Nick sent out a link to a test that you can take that measures Risk Intelligence

http://www.projectionpoint.com/

Try it…  I believe that it does give some insight to a different aspect of intelligence that is needed for good risk management.

I would not say that it suggests anything new.  In fact, it seems to link Risk Intelligence back to the ancient inscription at the Oracle of Delphi,

KNOW THYSELF

To be able to understand RISK, that is a good first step, to be able to distinguish between things that you know and things that you do not know are true. I would suggest that is pretty basic for success in any endeavor, including risk management.

However, I would suggest a slightly different standard as the most important kind of intelligence needed for risk management. That would be the ability to

Distinguish between Future Events that are Certainties and Future Events that are Uncertain.

Distinguish between RISK and UNCERTAINTY in a Knightian sense for the Uncertain events.

Remember after the fact that at some past time, when a decision had to be made, the future events that we now all know to be certain because they have happened, were uncertain.

But those conditions seem like boundary conditions – there is no Risk Intelligence if those conditions are not met.

Real Risk Intelligence would then be the ability to make reliable estimates of the likelihood of Uncertain Events.

Real Risk Intelligence would need to be scored as the Projection Point test is scored, that is against a scale that incorporates the idea that answers are not right or wrong, but that acknowledges that probabilistic answers should be scored on a curve (actually they use a diagonal) that reflects the likelihood as well as the outcome.

I would suggest that taking the Projection Point Risk Intelligence Test is worth the 10 minutes that it takes.  But it is the beginning rather than the end of investigation into the idea of Risk Intelligence.

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.

From Innovation to Exploitation

November 23, 2009

An interesting aspect of the recent financial market chaos is how innovation plays into the facts. While arguably simply bad lending behavior was at the core of the problem, increasingly complex (i.e innovative) financial instruments such as credit default swaps played a key role as well.

By Christopher E. Mandel

What intrigues me is what some view as the cycle of innovation that produces these bad effects.

I recently heard Mark Cuban say: first there’s innovation, then come the imitators then come the idiots. While there are many examples of this cycle of creativity ending in disaster, few to date are of such magnitude as the current credit crisis. Oftentimes it’s not bad behaviors as much as the way in which initial creativity and its success produces laziness.

Today’s good idea is tomorrow’s exploited idea. New products and services often have short lives. In fact most things have their “season” but creative capitalism drives imitation and as more and more imitators pile in for quick profits, it is all destined to be short lived, absent continuous innovation and improvement.

One of the keys to this cycle is the constant drumbeat for better, faster, cheaper and more. Author Richard Swenson in a book titled “Hurtling Toward Oblivion” makes a compelling case for this phenomenon. First his observations: that we are subject to profusion or the phenomenon of always requiring more of everything, forcing progress.

Continued on Risk & Insurance

Reflexivity of Risk

November 19, 2009

George Soros says that financial markets are reflexive.  He means that the participants in the system influence the system. Market prices reflect not just fundamentals, but investors expectations.

The same thing is true of risk systems.  This can be illustrated by a point that is frequently made by John Adams.  Seat belts are widely thought to be good safety devices.  However, Adams points out that aggregate statistics of traffic fatalities do not indicate any improvement whatsoever in safety.  He suggests that because of the real added safety from the seat belts, people drive more recklessly, counteracting the added safety with added risky behavior.

That is one of the problems that firms who adopted and were very strong believers in their sophisticated ERM systems.  Some of those firms used their ERM systems to enable them to take more and more risk.  In effect, they were using the ERM system to tell them where the edge of the cliff was and they then proceeded to drive along the extreme edge at a very fast speed.

What they did not realize was that the cliff was undercut in some places – it was not such a steady place to put all of your weight.

Stated more directly, the risk system caused a feeling of safety that encouraged more risk taking.

What was lost was the understanding of uncertainty.  Those firms were perfectly safe from risks that had happened before and perhaps from risks that were anticipated by the markets.  The highly sophisticated systems were pretty accurate at measuring those risks.  However, they were totally unprepared for the risks that were new.  Mark Twain once said that history does not repeat itself, but it rhymes.  Risk is the same only worse.

The Future of Risk Management – Conference at NYU November 2009

November 14, 2009

Some good and not so good parts to this conference.  Hosted by Courant Institute of Mathematical Sciences, it was surprisingly non-quant.  In fact several of the speakers, obviously with no idea of what the other speakers were doing said that they were going to give some relief from the quant stuff.

Sad to say, the only suggestion that anyone had to do anything “different” was to do more stress testing.  Not exactly, or even slightly, a new idea.  So if this is the future of risk management, no one should expect any significant future contributions from the field.

There was much good discussion, but almost all of it was about the past of risk management, primarily the very recent past.

Here are some comments from the presenters:

  • Banks need regulator to require Stress tests so that they will be taken seriously.
  • Most banks did stress tests that were far from extreme risk scenarios, extreme risk scenarios would not have been given any credibility by bank management.
  • VAR calculations for illiquid securities are meaningless
  • Very large positions can be illiquid because of their size, even though the underlying security is traded in a liquid market.
  • Counterparty risk should be stress tested
  • Securities that are too illiquid to be exchange traded should have higher capital charges
  • Internal risk disclosure by traders should be a key to bonus treatment.  Losses that were disclosed and that are within tolerances should be treated one way and losses from risks that were not disclosed and/or that fall outside of tolerances should be treated much more harshly for bonus calculation purposes.
  • Banks did not accurately respond to the Spring 2009 stress tests
  • Banks did not accurately self assess their own risk management practices for the SSG report.  Usually gave themselves full credit for things that they had just started or were doing in a formalistic, non-committed manner.
  • Most banks are unable or unwilling to state a risk appetite and ADHERE to it.
  • Not all risks taken are disclosed to boards.
  • For the most part, losses of banks were < Economic Capital
  • Banks made no plans for what they would do to recapitalize after a large loss.  Assumed that fresh capital would be readily available if they thought of it at all.  Did not consider that in an extreme situation that results in the losses of magnitude similar to Economic Capital, that capital might not be available at all.
  • Prior to Basel reliance on VAR for capital requirements, banks had a multitude of methods and often used more than one to assess risks.  With the advent of Basel specifications of methodology, most banks stopped doing anything other than the required calculation.
  • Stress tests were usually at 1 or at most 2 standard deviation scenarios.
  • Risk appetites need to be adjusted as markets change and need to reflect the input of various stakeholders.
  • Risk management is seen as not needed in good times and gets some of the first budget cuts in tough times.
  • After doing Stress tests need to establish a matrix of actions that are things that will be DONE if this stress happens, things to sell, changes in capital, changes in business activities, etc.
  • Market consists of three types of risk takers, Innovators, Me Too Followers and Risk Avoiders.  Innovators find good businesses through real trial and error and make good gains from new businesses, Me Too follow innovators, getting less of gains because of slower, gradual adoption of innovations, and risk avoiders are usually into these businesses too late.  All experience losses eventually.  Innovators losses are a small fraction of gains, Me Too losses are a sizable fraction and Risk Avoiders often lose money.  Innovators have all left the banks.  Banks are just the Me Too and Avoiders.
  • T-Shirt – In my models, the markets work
  • Most of the reform suggestions will have the effect of eliminating alternatives, concentrating risk and risk oversight.  Would be much safer to diversify and allow multiple options.  Two exchanges are better than one, getting rid of all the largest banks will lead to lack of diversity of size.
  • Problem with compensation is that (a) pays for trades that have not closed as if they had closed and (b) pay for luck without adjustment for possibility of failure (risk).
  • Counter-cyclical capital rules will mean that banks will have much more capital going into the next crisis, so will be able to afford to lose much more.  Why is that good?
  • Systemic risk is when market reaches equilibrium at below full production capacity.  (Isn’t that a Depression – Funny how the words change)
  • Need to pay attention to who has cash when the crisis happens.  They are the potential white knights.
  • Correlations are caused by cross holdings of market participants – Hunts held cattle and silver in 1908’s causing correlations in those otherwise unrelated markets.  Such correlations are totally unpredictable in advance.
  • National Institute of Financa proposal for a new body to capture and analyze ALL financial market data to identify interconnectedness and future systemic risks.
  • If there is better information about systemic risk, then firms will manage their own systemic risk (Wanna Bet?)
  • Proposal to tax firms based on their contribution to gross systemic risk.
  • Stress testing should focus on changes to correlations
  • Treatment of the GSE Preferred stock holders was the actual start of the panic.  Leahman a week later was actually the second shoe to drop.
  • Banks need to include variability of Vol in their VAR models.  Models that allowed Vol to vary were faster to pick up on problems of the financial markets.  (So the stampede starts a few weeks earlier.)
  • Models turn on, Brains turn off.

Black Swan Free World (7)

October 17, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

Hyman Minsky’s Financial Instability Hypothesis talks about the financial markets working in three regimes, Hedge, Speculative and Ponzi.   Under Hedge financing, investments generally have sufficient cashflow to pay both principle and interest.  Under Speculative financing, investments generally have cashflows sufficient to pay interest, but depend upon rolling over financing to continue.  Ponzi financing does not have sufficient cashflows to pay either interest or principle.  Ponzi financing requires that values will increase enough to pay both principle and interest to repay financing.

Speculative financing requires a belief that the value of the collateral will be stable to justify future refinancing or rolling over of the financing.  That belief could be called confidence.

Ponzi financing requires a belief that the value of collateral will grow faster than the interest rate charged.  That belief requires a significantly higher amount of confidence.

There are several other levels that a financial business could operate.  For example, the value of the collateral could be viewed in terms, not of its current value, but of its value in an adverse scenario.  A very conservative lender could then make sure that each investment used that adverse value as the actual amount of collateral granted.  In that situation, the investor does not want to rely upon the belief that the asset value will be stable.  A significantly more aggressive investor will want to make sure that their portfolio in total adjusts the value of collateral for the possible loss in an adverse situation, allowing for the effects of diversification in the portfolio.

Credit practices in the US have drifted against the path of having the borrower put up cash for that difference between adverse value and current value.  Instead, practice has changed so that the lender will hold capital against that adverse scenario and charge the borrowed the cost of holding that capital.

What has changed with that drift, is who will bare the losses in the adverse scenario.  That has shifted from the borrower to the lender.  So the loan transaction has changed from a simple credit transaction to a combined credit and asset value insurance transaction.  (Which makes me wonder if the geniuses who thought of this thought to charge appropriately for the insurance or if they just believed that if the market bought it when they securitized it, then the price must be right.)

This will look different from the former loan business where the borrowed bore the asset value risk because the lender will have fluctuations in their balance sheet when the adverse scenarios hit and the collateral value falls below the loan value.  And that is exactly what we are seeing right now.

In addition, as we are seeing now, when there is a extremely severe drop in the value of collateral, having the banks hold the risk of the decline in collateral value, then a drop in the collateral will have a significant impact on bank capital.  The impact on bank capital may have a major impact on the bank’s ability to lend which will impact on all of the rest of the economy that had no connection to the impaired asset class.

So to Taleb’s point about confidence,  it seems that he is stating that lending practices should revert to their prior level where collateral was valued under an adverse scenario.  Then there will be little if any confidence involved in the lending business.  And less chance that a steep drop in any one asset class will spill over to the rest of the economy.

So the dividing line would be that the financial firms that could be subject to future government bailouts would need to value collateral pessimistically and to avoid loans that are not fully collateralized.

Sounds SAFE.

But here is the problem with that proposal…

If any other firms, outside of that restriction are permitted to lend in the same markets, business will ultimately shift to those institutions.  They will be able to offer better loan terms and larger loans for the same collateral AND in most years, they will show much higher profits.

Bad risk management will drive out good.  The institutions that take the most optimistic view of risk, those who have the most confidence, will drive the firms with the more pessimistic view (whether that is their own view or the view imposed by the regulators) out of the market.

And then when the next crisis hits, regulators will find that the business has shifted to the non-regulated firms and they they will instead need to bail them out, unless they make it illegal for non-regulated firms to do any of the kinds of finance that is related to a government’s need to bailout.

Then the bank would almost always have real collateral and any drop in confidence could be resolved by assigning that collateral over to someone with cash and settling any needs for cash that the lack of confidence creates.

Taleb is not clear however whether he is referring to banks or the financial system in general or to the government with his statement.  The discussion above is about banks.

Trying to think about this idea in the context of the entire financial system, I wonder if he was suggesting a return to the gold standard.  When there was a gold standard, there was no need for confidence in the currency.  If you stay with the current currency regime, then the confidence idea, I suppose, relates to the question of inflating the currency.  If the government does seem to consistently hold the money supply at a reasonable level in proportion to the economy, then there will not be a problem.  However, I cannot think of any way of looking at the floating currency system that does not REQUIRE confidence that the government will hold inflation in check.

Applying the idea to the government, I would also say that confidence is required there as well.  A government that could be counted on to fund fully for spending programs would instill confidence, but there could be no surity, especially under the US system where the next congress could immediately trample on the good record of a all preceding governments.

Black Swan Free World (10)

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Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Black Swan Free World (6)

October 13, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

It is my opinion that many bubbles come about after a completely incorrect valuation model or approach becomes widely adopted.  Today, we have the advantage over observers from prior decades.  In this decade we have experienced two bubbles.  In the case of the internet bubble, the valuation model was attributing value to clicks or eyeballs.  It had drifted away from there being any connection between free cashflow and value.  As valuations soared, people who had internet investments had more to invest in the next sensation driving that part of the bubble. The internet stocks became more and more like Ponzi schemes.  In fact, Hyman Minsky described bubbles as Ponzi finance.

In the home real estate bubble, valuation again drifted away from traditional metrics, the archaic and boring loan to value and coverage ratio pair.  It was much more sophisticated and modern to use copulas and instead of evaluating the quality of the credit to use credit ratings of a structured securities of loans.

Goerge Soros has said that the current financial crisis might just be the final end of a fifty year mega credit bubble.  If he is right, then we will have quite a long slow ride out of the crisis.

There are two aspects of derivatives that I think were ignored in the run up to the crisis.  The first is the leverage aspect of derivatives.  A CDS is equivalent to a long position in a corporate bond and a short position in a risk free bond.  But few observers and even fewer principals considered CDS as containing additional leverage equal to the full notional amount of the bond covered.  And leverage magnifies risk.  Worse than that.

Leverage takes the cashflows and divides them between reliable cashflows and unreliably cashflows and sells the reliable cashflows to someone else so that more unreliable cashflows can be obtained.

The second misunderstood aspect of the derivatives is the amount of money that can be lost and the speed at which it can be lost.  This misunderstanding has caused many including most market participants to believe that posting collateral is a sufficient risk provision.  In fact, 999 days out of 1000 the collateral will be sufficient.  However, that other day, the collateral is only a small fraction of the money needed.  For the institutions that hold large derivative positions, there needs to be a large reserve against that odd really bad day.

So when you look at the two really big, really bad things about derivatives that were ignored by the users, Taleb’s description of children with dynamite seems apt.

But how should we be dealing with the dynamite?  Taleb suggests keeping the public away from derivatives.  I am not sure I understand how or where the public was exposed directly to derivatives, even in the current crisis.

Indirectly the exposure was through the banks.  And I strongly believe that we should be making drastic changes in what different banks are allowed to do and what different capital must be held against derivatives.  The capital should reflect the real leverage as well as the real risk.  The myth that has been built up that the notional amount of a derivative is not an important statistic and that the market value and movements in market value is the dangerous story that must be eliminated.  Derivatives that can be replicated by very large positions in securities must carry the exact same capital as the direct security holdings.  Risks that can change overnight to large losses must carry reserves against those losses that are a function of the loss potential, not just a function of benign changes in market values and collateral.

In insurance regulatory accounting, there is a concept called a non-admitted asset.  That is something that accountants might call an asset but that is not permitted to be counted by the regulators.  Dealings that banks have with unregulated financial operations should be considered non-admitted assets.  Transferring something off to the books to an unregulated entity just will not count.

So i would make it extremely expensive for banks to get anywhere near the dynamite.  Or to deal with anyone who has any dynamite.

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What is RISK?

October 12, 2009

I have started to get bothered by the way that the word RISK is used to mean almost anything – noun verb adjective.

It makes it almost impossible to understand what someone is trying to say about a risk or risk management topic.  I am probably even more guilty than most.  I was once told by an editor that I used the word over 100 times in an article.

One way that people misuse the word is in place of the word loss.  For the most part, people are interested in minimizing losses, not risks.  For some reason, risk seems to be a more professional word to use than loss.  But we should be honest with ourselves and be clear about when we really mean losses.  Looking forward, something can be a risk.  Looking backwards, something can no longer be a risk, it is a loss or not a loss.

In addition, many folks want to define risk to have both upside and downside.

I think that they are  being sloppy with words.

I think that they may trying to say that the concerns of risk managers are related to both the upside and downside.

Or they are trying to say that the upside part of Risk is the risk of foregone opportunities?  That at least makes a little sense to me.

But if you really mean upside and downside, then that definition of Risk seems to me to be Orwellian.  Like defining “hot” to include the temperature of ice. And your heating system to include your air conditioner.

It also seems that if you follow that line of reasoning to its logical conclusion, the only possible candidate for the CRO job is the CEO.

It seems that risk management is unhappy with only dealing with preventing bad things (losses) – it is so hard to get headlines if you are a defensive player on a sports team.  The things that do not happen do not lead to bonuses.

But making sure that bad things do not happen (with greater frequency or severity than the risk appetite) IS the job of the risk manager.

So I would define risk as “exposure to the potential for a future uncertain adverse event”.

This definition does not follow Knight, who separates Risk and Uncertainty.  Knight divides the two terms based upon the degree to which we know the distribution of outcomes.  I combine them because I do not believe that there is a set of future events with known distributions and another set with unknown distributions (putting aside dice).  I believe that there is a continuum of degrees to which we suspect that we know distributions of outcomes of future events.

So with this definition, I would suggest that there is no risk in an unknown future event where there are only positive outcomes possible.

I say this because there is more than enough to worry about on the downside regarding the management of potential losses.

Risk Limits always mean a limit in the amount of potential losses.  I have never heard of any organization anywhere ever that has put a limit on favorable deviations.

Black Swan Free World (5)

October 9, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

Complexity gets away from us very, very quickly.  And at the same time, we may spend so much time worrying about the complexity, building very complex models to deal with the complexity, that we lose sight of the basics.  So Complexity can hurt us both coming and going.

So why do we insist on Complexity?  That at least is simple.  Most complexity exists to provide differentiation between financial products that otherwise would be pure commodities.  The excuse is that the Complex products are needed to match up with the risks of a complex world.  Another, even less admirable reason for the complexity is to create something that sounds like a simple risk relief product but that costs the seller much less to provide, by carving out the parts of the risk relief that are more expensive but less desirable or less well understood by the customer.

Generally, customers who are buying risk relief products like insurance or hedges have a simple objective.  If they have a loss they want something that will make a payment that will offset the loss.  Complexity comes in when the risk relief products are customized to potentially better meet customer needs. (according to the sales literature).

Taleb suggests that complexity also hides leverage.  That is ver definitely the case.  For example, a CDS can be replicated by a long position in a credit and a short position in a treasury.  A short position in a treasury is finance speak for a loan at a better rate than you can actually get.  And a loan is leverage.  THe amount of the leverage is the full notional amount of the CDS.  Fans of derivatives will scoff at the idea that the notional amount if of any interest to anyone, but in this case at least, anyone who wants to know how much leverage the buyer of a CDS has, needs to add in the full notional amount of all of the CDS.

Debt bubbles are vicious because of the feedback loop in debt.  If one borrows money to purchase an asset and the asset increases in value, then you can use that increased value as collateral to increase the debt and purchase more of the asset.  The increase in demand for the asset causes prices to rise and so it goes.

But ultimately the reason that may economists have a hard time identifying bubbles (other than they do not believe that bubbles really ever exist) is that they do not know the capacity of any asset market to absorb additional investment.  Clearly in the example above, if there is a fixed amount of the asset that becomes subject to a debt bubble, it will very, very quickly run into a bubble situation.  But if the asset is a business or more likely a sector, it is not so easy to know exactly when the capacity of that sector to efficiently use additional capital is reached.

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Black Swan Free World (4)

October 3, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

For many years, money managers were paid out of the revenue from a small management fee charged on assets.  The good performing funds attracted more funds and therefore had more gross revenue.  Retail mutual funds usually charged a flat rate.  Institutional funds charged a sliding scale that went down as a percentage of assets as the amount of assets went up.  Since mutual fund expenses were relatively flat, that meant that the larger funds could generate quite substantial profits.

Then hedge funds came along fifty years ago and established the pattern of incentive compensation of 20% of profits fairly early.  In addition, the idea of the fund using leverage was an early innovation of hedge funds.

Another innovation was the custom that the hedge fund manager’s gains would stay in the fund so that the incentives were aligned.  But think about how that works.  The investor puts up $1 million.  The fund gains 20%, the manager gets $400k and the investor gets $160k.  Then the fund drops 50%, the investor’s account is now worth $580k – he is down $420k.  The manager is down to $80k, but still up by that $80k.  The investor is creamed but the manager is well ahead.  Seems like that incentives need realignment.

Taleb may be thinking of a major issue with hedge funds – valuation of illiquid investments.  Hedge funds often make purchases of totally illiquid investments.  Each quarter, the manager makes an estimate of what they are worth.  The manager gets paid based upon those estimates.  However, with the recent downturn, even in funds that have not shown significant losses have had significant redemptions.  When these funds have redemptions, the liquid assets are sold to pay off the departing investors.  Their shares are determined using the estimated values of the illiquid assets and the remaining fund becomes more and more concentrated in illiquid assets.

If the fund manager had been optimistic about the value of the illiquid assets or simply did not anticipate the shift in demand that has ocurred with the financial crisis, there may well be a major problem brewing for the last investors out the door.  The double whammy of depressed prices for the illiquid assets as well as the distribution based upon values for those assets that are now known to be optimistic.

And over payment of the one sided performance bonuses to the manager were supported by the optimistic valuations.

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

UNRISK (Part 1)

September 16, 2009

Post from Jawwad Farid

I have now been doing this “risk” business for more than a decade. Eleven years ago, right about this time, I was rudely introduced to my first risk application. Fresh from my actuarial exams, I was stumped on an interview question dealing with moments of a distribution. I have read the material, struggled with it, taken an exam on it and passed it. But in the room overlooking Fleet Street in London, in the month Russia defaulted on its domestic debt, I couldn’t explain it.

A question dealing with the moment generating function has an exact and mathematical answer. These days, across three continents, clients ask more difficult questions. “Does risk really works? Or is it smoke and mirrors” and/or “what is the one thing I can do to better manage my exposures?” While risk managers are generally stereotyped as the quite sort with short snappy answers (or little to say as some uncharitable critics suggest), it has been difficult to come up with a catchy symbolic one word answer to the above two questions.

Sometime last year while reviewing a list of competitors I came across an interesting name “Unrisk”. Same concept as insured, uninsured. Risk, unrisk. Just the word I had been looking for. Catchy, symbolic and with far more cool/mystique factor than just plain simple risk management. A bright new term for an age old profession. When I saw it for the first time, I instantly knew that Unrisk would represent a state of institutional nirvana that we would achieve when we have done all that we could possibly do to manage risk on our platforms.

Next time a client would ask for a guide to a risk based paradise; you would simply give him the road map to the Unrisk state. The real question would be what you would put on that road map? And would it really protect you from all that an evil generating function could throw at you.

Second question first. No the unrisk state won’t really guarantee immunity from the evil eye. Neither will we stop booking risk. We will keep on carrying exposures on our balance sheet and will load as much risk as we can carry, sometimes even more.

And yes it won’t stop us from falling, stumbling or faltering.

Just that the frequency and severity of our nightmares would reduce a bit; we would still degrade but we would do it far more gracefully.

My personal recipe for the state is a short one. It only has one item on it.

  1. Understanding the distribution

To be continued

Are You Sure About That?

September 6, 2009

Most risk models consist of a series of best guesses for the size of each risk. Some of the risks are very well known. The risk models here have relatively little uncertainty. They are mostly models of volatility, where there is a long history of past volatility and good reason to expect future volatility to be similar. Others of the risks have little or no track record. The volatility assumptions in these models are based on extensions of information from other situations. There may be very high degrees of uncertainty in the parameters for these models. However, many of the folks who build the models believe for various reasons that reflecting parameter uncertainty is too cautious an approach to the risk model and adds so much to the risk evaluation that it makes the risk model unusable. The numbers from both types of risk are usually just added together or presented on the same page with no distinction between their credibility. So it seems that the users of risk models are faced with two choices – to have risk models that reflect high potential risk for new and untested risks and therefore stifle participation in new business opportunities and risk models that sometimes drastically understate the risks.

The alternate is to keep track of many different aspects of risk and pay attention to all of them.  See Multidimensional risk.

Then everyone can know that the economic capital or any other comprehensive risk measurement does NOT reflect the degree of uncertainty, but that another report gives information about uncertainty.

The report on uncertainty might look at each of the risks and give an indication of the level of uncertainty of each of the values in the economic capital.  So it might say that 75% of economic capital comes from risks with low uncertainty, 20% moderate and 5% high uncertainty.

Even more revealing, profits could be analyzed in the same manner.  That might help to show how much of profits are coming from activities with higher uncertainty – a dangerous situation that should trigger a high degree of concern among management.


Models & Manifesto

September 1, 2009

Have you ever heard anyone say that their car got lost? Or that they got into a massive pile-up because it was a 1-in-200-year event that someone drove on the wrong side of a highway? Probably not.

But statements similar to these have been made many times since mid-2007 by CEOs and risk managers whose firms have lost great sums of money in the financial crisis. And instead of blaming their cars, they blame their risk models. In the 8 February 2009 Financial Times, Goldman Sachs’ CEO Lloyd Blankfein said “many risk models incorrectly assumed that positions could be fully hedged . . . risk models failed to capture the risk inherent in off-balance sheet activities,” clearly placing the blame on the models.

But in reality, it was, for the most part, the modellers, not the models, that failed. A car goes where the driver steers it and a model evaluates the risks it is designed to evaluate and uses the data the model operator feeds into the model. In fact, isn’t it the leadership of these enterprises that are really responsible for not clearly assessing the limitations of these models prior to mass usage for billion-dollar decisions?

But humans, who to varying degrees all have a limit to their capacity to juggle multiple inter-connected streams of information, need models to assist with decision-making at all but the smallest and least complex firms.

These points are all captured in the Financial Modeler’s Manifesto from Paul Wilmott and Emanuel Derman.

But before you use any model you did not build yourself, I suggest that you ask the model builder if they have read the manifesto.

If you do build models, I suggest that you read it before and after each model building project.

Random Numbers

August 30, 2009

Just a quick thought on random numbers.

Perhaps we have the wrong model for a random number generator with the regular statistical probability distributions.
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I am wondering if it wouldn’t be better to think of random numbers as coming from a toss of several dice where the dice are drawn from a barrel where some number of the dice in the barrel are non-standard dice. We do not know how many dots are on those dice or how many of the non-standard dice are in the barrel.

We might go for dozens of tosses without hitting one of the non-standard dice, and then one day we get two of them.

Somehow we need to figure out how to play the game well when we get the regular dice but be ready when the non-standard dice are drawn without warning.

Multi dimensional Risk Management

August 28, 2009

Many ERM programs are one dimensional. They look at VaR or they look at Economic Capital. The Multi-dimensional Risk manager consider volatility, ruin, and everything in between. They consider not only types of risk that are readily quantifiable, but also those that may be extremely difficult to measure. The following is a partial listing of the risks that a multidimensional risk manager might examine:
o Type A Risk – Short-term volatility of cash flows in one year
o Type B Risk – Short-term tail risk of cash flows in one year
o Type C Risk – Uncertainty risk (also known as parameter risk)
o Type D Risk – Inexperience risk relative to full multiple market cycles
o Type E Risk – Correlation to a top 10
o Type F Risk – Market value volatility in one year
o Type G Risk – Execution risk regarding difficulty of controlling operational losses
o Type H Risk – Long-term volatility of cash flows over five or more years
o Type J Risk – Long-term tail risk of cash flows over 5 five years or more
o Type K Risk – Pricing risk (cycle risk)
o Type L Risk – Market liquidity risk
o Type M Risk – Instability risk regarding the degree that the risk parameters are stable

Many of these types of risk can be measured using a comprehensive risk model, but several are not necessarily directly measurable. But the muilti dimensional risk manager realizes that you can get hurt by a risk even if you cannot measure it.

ERM only has value to those who know that the future is uncertain.

August 26, 2009

Businesses have three key needs.

First they need to have a product or service that people will buy. They need revenues.

Second they need to have the ability to provide that product or service at a cost less than what their customers will pay. They need profits.

Once they have revenues and profits, their business is a valuable asset. So third, they need to have a system to avoid losing that asset because of unforeseen adverse experience. They need risk management.

So Risk Management is the third most important need of a firm.

And there is often a conflict between risk management and the other two goals. Risk management will sometimes say that a business activity that produces revenue is too risky and must be curtailed or modified in such a way that it produces less revenues. Risk Management often costs money or otherwise depresses profits. For example, an insurance policy covering fire of a building owned by the firm will cost money and depress profits.

So Risk Management needs to defend its value to the firm. Many risk management proponents have been asked to tell the value added of their activities. This is difficult to explain. Not because risk management does not have a value, but because the cost of risk management in terms of reduced revenues or increased costs are usually tangible and definite, while the benefits are probabilistic. Often the person asking the question is looking for a traditional spreadsheet answer that shows two columns adding up and perhaps the difference between the two is the benefit of risk management.

It does not work that way. For Risk Management to have value, one must understand that the future is uncertain. The value of risk management comes from the way that it shapes that uncertainty.

The next time you are asked about the value of risk management, ask the questioner what value they would put on the airbags and seat belts in their car. If they have no uncertainty about their ability to avoid accidents, then they will put a zero value on the safety devices – the personal risk management systems. If they resist answering, ask them if they will agree to have them removed for $20? Or for $2000? What value do they place on that risk management?

Most people will agree that the demise of a company is less serious than the demise of a person, but it is not difficult to see that there is some value to activities that increase the chance that a company will not expire in the next business cycle or windstorm.

So risk management decreases the uncertainty about the survival of the firm. There is a way to quantitatively value that reduction in uncertainty and compare it to the reduced revenues or increased costs of the risk management activities.


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