Posted tagged ‘Regulation’

ORSA ==> AC – ST > RCS

June 30, 2014

The Own Risk and Solvency Assessment (or Forward Looking Assessment of Own Risks based on ORSA principles) initially seems daunting.  But the simple formula in the title of this post provides a guide to what is really going on.

  1. To preform an ORSA, an insurer must first decide upon its own Risk Capital Standard.
  2. The insurer needs to develop the capacity to project the financial and risk exposure statistics forward for several years under a range of specified conditions.
  3. Included in the projection capacity is the ability to determine (a) the amount of capital required under their own risk capital standard and (b) the projected amount of capital available.
  4. The insurer needs to select a range of Stress Tests that will be used for the projections.
  5. If, under a projection based upon a Stress Test, the available capital exceeds the Risk Capital Standard, then that Stress Test is a pass.                   AC – ST >RCS
  6. If, under a projection based upon a Stress Test, the available capital is less than the Risk Capital Standard, then that Stress Test is a fail and requires an explanation of intended management actions.                            AC – ST < RCS  ==> MA

RISKVIEWS suggests that Stress Tests should be chosen so that the company can demonstrate that they can pass (AC – ST >RCS) the tests under a wide range of scenarios AND in addition, that one or several of the Stress Tests are severe enough to produce a fail (AC – ST < RCS  ==> MA) condition so that they can demonstrate that management has conceptualized the actions that would be needed in extreme loss situations.

RISKVIEWS also guesses that an insurer that picks a low Risk Capital Standard and Normal Volatility Stress Tests will get push back from the regulators reviewing the ORSA.

RISKVIEWS also guesses that an insurer that picks a high Risk Capital Standard will fail some or all of the more severe Stress Tests.

Furthermore, RISKVIEWS predicts that many insurers will fail the real Future Worst Case Stress Tests.  Only firms that hold themselves to a Robust Risk Capital Standard are likely to have sufficient capital to potentially maintain solvency.  In RISKVIEWS opinion, these Future Worst Case Stress Tests are useful mainly as the starting point for a Reverse Stress Test process.  In financial markets, we have experienced a real life worst case stress with the 2008 Financial Crisis and the following events.  Imaging insurance worst case scenarios that are as adverse as those events seems useful to promoting insurer survival.  Imagining events that are much worse than those – which is what is meant by the Future Worst Case Scenario idea – seems to be overkill.  But, in fact,  the history of adverse events in the recent past seems to indicate that each new major loss is at least twice the previous record.

A Reverse Stress Test is a process under which an insurer would determine the adverse scenario that drives the insurer to insolvency.  Under the NAIC ORSA, Reverse Stress Tests are required, but it is not specified whether those tests should be based upon a condition of failing to meet the insurer’s own Risk Capital Standard or the regulators solvency standard.  RISKVIEWS would recommend both types of tests be performed.

This discussion is the heart of the ORSA.  The full ORSA requires many other elements.  See the recent post INSTRUCTIONS FOR A 17 STEP ORSA PROCESS for the full discussion.

Risk Culture doesn’t come from a memo

December 16, 2013

Nor from a policy, nor from a speech, nor from a mission statement nor a value statement.

Like all of corporate culture, Risk Culture comes from experiences.  Risk Culture comes from experiences with risk.  Corporate Culture is fundamentally the embedded, unspoken assumptions that underlie behaviors and decisions of the management and staff of the firm.  Risk Culture is fundamentally the embedded, unspoken assumptions and beliefs about risk that underlie behaviors and decisions of the management and staff of the firm.

Corporate culture is formed initially when a company is first started.  The new company tries an approach to risk, usually based upon the prior experiences of the first leaders of the firm.  If those approaches are successful, then they become the Risk Culture.  If they are unsuccessful, then the new company often just fails.

In his book, Fooled by Randomness, Nassim Taleb points out that there is a survivor bias involved here.  Some of the companies that survive the early years are managing their risk correctly and some are simply lucky.  Taleb tells the story of mutual fund managers who either beat the market or not each year.  Looking back over 5 years, a fund manager who was one of 30 out of 1000 who beat the market every one of those five years might believe that their performance and therefore their ability was far above average.  However, Taleb points out that if whether a manager beat the market or not each year was determined by a coin toss, statistics tells us to expect 31 to beat the market.

That was for a situation where we assume that the good results were likely 50% of the time.  For risk management, the event that is being managed is often a 1/100 likelihood.  There is a 95% chance of avoiding a 1/100 loss in any five year period, just by showing up with average risk management.  That makes it fairly likely that poor risk management can be easily overcome by just a little bit of luck.

So by the natural process of experience, Risk Culture is formed based upon what worked in the past.

In banks and hedge funds and other financial firms where risk taking is a fundamental part of the business, the Risk Culture often supports those who take risks and win.  Regardless of whether the amount of risk is within limits or tolerances or risk appetite.

You see, all of those ideas (limits, tolerances, appetites) are based upon an opinion about the future.  And the winner just has a different opinion about the future of his/her risk.  The fact that the winner’s opinion proves itself as experience shows that the bad outcome that those worrying risk people said was the future is not the case.  When the winner suddenly makes a bad call (see London Whale), that shows that their ability to see the future better than the risk department’s models may be done.  You see, there are very very few people who can keep the perspective needed to consistently beat the market.  (RISKVIEWS thinks that the fall off might well follow an exponential decay pattern as predicted by statistics!)

The current ideas of a proper Risk Culture (see FSB consultation paper) are doubtless not what most firms set up as their initial response to risk. That paper focuses on four specific aspects of Risk Culture.

  • Tone from the top: The board of directors11 and senior management are the starting point for setting the financial institution’s core values and risk culture, and their behaviour must reflect the values being espoused. As such, the leadership of the institution should systematically develop, monitor, and assess the culture of the financial institution.
  • Accountability: Successful risk management requires employees at all levels to understand the core values of the institutions’ risk culture and its approach to risk, be capable of performing their prescribed roles, and be aware that they are held accountable for their actions in relation to the institution’s risk-taking behaviour. Staff acceptance of risk-related goals and related values is essential.
  • Effective challenge: A sound risk culture promotes an environment of effective challenge in which decision-making processes promote a range of views, allow for testing of current practices, and stimulate a positive, critical attitude among employees and an environment of open and constructive engagement.
  • Incentives: Performance and talent management should encourage and reinforce maintenance of the financial institution’s desired risk management behaviour. Financial and non-financial incentives should support the core values and risk culture at all levels of the financial institution.

(These descriptions are quotes from the paper)

These practices are supported by the Risk Culture for a few very new firms.  As well as a very few other firms (and we will mention why that is in a few paragraphs).  But for at least 80 percent of financial firms, these items, if they are happening, are not at all supported by the Risk Culture.  The true Risk Culture of a successful firm has evolved based upon the original choices of the firm and the decisions and actions taken by the firm that have been successful over the life of the firm.

These aspects of Risk Culture are a part of one of the three layers of culture (see Edgar Schein, The Corporate Culture Survival Guide).  He calls those layers:

  • Artifacts
  • Espoused Values
  • Shared Assumptions

The four aspects of Risk Culture featured by the FSB can all be considered to be “artifacts”.  Those are the outward signs of the culture, but not the whole thing.  Espoused Values are the Memos, policies, speeches, mission and value statements.

Coercion from outside the organization, such as through regulator edict, can force management to change the Espoused Values.  But the real culture will ignore those values.  Those outside edicts can force behaviors, just as prison guards can force prisoners to certain behaviors.  But as soon as the guards are not looking, the existing behavioral standards based upon the shared assumptions will re-emerge.

When the insiders, including top management of an organization, want to change the culture, they are faced with a difficult and arduous task.

That will be the topic of the next post.

The Most Successful Financial System the World has Ever Known

June 2, 2010

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

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

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

There are two issues that I have with that conclusion. 

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

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

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

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

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

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

The Elephant in the Room


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