Posted tagged ‘Risk Management’

Comparing Eagles and Clocks

August 11, 2015

Original Title: Replacing Disparate Frequency Severity Pairs.  Quite catchy, eh?

But this message is important.  Several times, RISKVIEWS has railed against the use of Frequency Severity estimates as a basis for risk management.  Most recently

Just Stop IT! Right Now. And Don’t Do IT again.

But finally, someone asked…

What would you do instead to fix this?

And RISKVIEWS had to put up or shut up.

But the fix was not long in coming to mind.  And not even slightly complicated or difficult.

Standard practice is to identify a HML for Frequency and Severity for each risk.  But RISKVIEWS does not know any way to compare a low frequency, high impact risk with a medium frequency, medium impact risk.  Some people do compare the risks by rating the frequency and severity on a numerical scale and then adding or multiplying the values for frequency and severity for each risk to get a “consistent” factor.  However, this process is frankly meaningless.  Like multiplying the number of carrots times the number of cheese slices in your refrigerator.

But to fix it is very easy.

The fix is this…

For each risk, develop two values.  First is the loss expected over a 5 year period under normal volatility.  The second is the loss that is possible under extreme but not impossible conditions – what Lloyd’s calls a Realistic Disaster.

These two values then each represent a different aspect of each risk.  They can each be compared across all of the risks.  That is you can rank the risks according to how large a loss is possible under Normal Volatility and how large a loss is possible under a realistic disaster.

Now, if you are concerned that we are only looking at financial risks with this approach, you can go right ahead and compare the impact of each risk on some other non-financial factor, under both normal volatility and under a realistic disaster.  The same sort of utility is there for any other factor that you like.

If you do this carefully enough, you are likely to find that some risks are more of a problem under normal volatility and others under realistic disasters.  You will also find that some risks that you have spent lots of time on under the Disparate Frequency/Severity Pairs method are just not at all significant when you look at the consistently with other risks.

So you need to compare risk estimates where one aspect is held the same.  Like comparing two bikes:

Helsinki_city_bikes

Or two birds:

ISU_mute_swans

But you cannot compare a bird and a Clock:

Adalberti_1

Bahnsteiguhr[1]

And once you have those insights, you can more effectively allocate your risk management efforts!

“Adalberti 1” by Juan lacruz – Own work. Licensed under CC BY-SA 3.0 via Wikimedia Commons – https://commons.wikimedia.org/wiki/File:Adalberti_1.jpg#/media/File:Adalberti_1.jpg

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The CRO is making a list and checking it twice

February 2, 2015

“You never said that you wanted me to do that”  is an answer that managers often get when they point out a shortfall in performance.  And in many cases it is actually true.  As a rule, some of us tend to avoid too much writing things down.  And that is also true when it comes to risk management

That is where ERM policies come in.  The ERM policy is a written agreement between various managers in a company and the board documenting expectations regarding risk management.

policy

But too many people mistake a detailed procedure manual for a policy statement.  Often a policy statement can be just a page or two.

For Risk Management there are several places where firms tend to “write it down”:

  • ERM Policy – documents that the firm is committed to an enterprise wide risk management system and that there are broad roles for the board and for management.  This policy is usually approved by the board.  The ERM Policy should be reviewed annually, but may not be changed but every three to five years.
  • ERM Framework – this is a working document that lists many of the details of how the company plans to “do” ERM.  When an ERM program is new, this document many list many new things that are being done.  Once a program is well established, it will need no more or no less documentation than other company activities.  RISKVIEWS usually recommends that the ERM Framework would include a short section relating to each of the risk management practices that make up a Risk Management System.
  • Risk Appetite & Tolerance Statement – may be separate from the above to highlight its importance and the fact that it is likely to be more variable than the Policy statement, but not as detailed as the Framework.
  • Separate Risk Policies for major risk categories – almost all insurers have an investment policy.  Most insurers should consider writing policies for insurance risk.  Some firms decide to write operational risk policies as well.  Very few have strategic risk policies.
  • Policies for Hedging, Insurance and/or Reinsurance – the most powerful risk management tools need to have clear uses as well as clear lines of decision-making and authority.
  • Charter for Risk Committees – Some firms have three or more risk committees.  On is a board committee, one is at the executive level and the third is for more operational level people with some risk management responsibilities.  It is common at some firms for board committees to have charters.  Less so for committees of company employees.  These can be included in the ERM Framework, rather than as separate documents.
  • Job Description for the CRO – Without a clear job description many CROs have found that they become the scapegoat for whatever goes wrong, regardless of their actual authority and responsibilities before hand.

With written policies in place, the board can hold management accountable.  The CEO can hold the CRO responsible and the CRO is able to expect that may hands around the company are all sharing the risk management responsibilities.

More on ERM Policies on WillisWire.

http://blog.willis.com/2015/01/erm-in-practice-risk-policies-and-standards/

http://blog.willis.com/2014/02/erm-practices-policies-and-standards/

 

The ERM Pioneers and the Settlers – Let’s not have another range war!

January 24, 2015

Most of the people with CRO jobs are pioneers of ERM.  They came into ERM from other careers and have been working out what makes up an ERM process and how to make it work by hard work, trial & error and most often a good deal of experience on the other side of the risk – the risk taking side.

As ERM becomes a permanent (or at least a long term) business practice, it is more likely that the next generation of CROs will have come up through the ranks of the Risk function.  It is even becoming increasingly likely that they will have had some training and education regarding the various technical aspects of risk management and especially risk measurement.

The only problem is that some of the pioneers are openly disdainful of these folks who are likely to become their successors.  They will openly say that they have little respect for risk management education and feel strongly that the top people in Risk need to have significant business experience.

This situation is a version of the range wars in the Wild West.  The Pioneers were the folks who went West first.  They overcame great hardships to fashion a life out of a wilderness.  The Settlers came later and were making their way in a situation that was much closer to being already tamed.

Different skills and talents are needed for successful Pioneers than for successful Settlers.  Top among them is the Settlers need to be able to get along in a situation where there are more people.  The Risk departments of today are large and filled with a number of people with a wide variety of expertise.

Risk will transition from the Pioneer generation to the Settler generation of leadership.  That transition will be most successful if the Pioneers can help develop their Settler successros.

How to Show the Benefits of Risk Management

January 2, 2015

From Harry Hall at www.pmsouth.com

Sometimes we struggle to illustrate the value of risk management. We sense we are doing the right things. How can we show the benefits?

Some products such as weight loss programs are promoted by showing a “before picture” and an “after picture.” We are sold by the extraordinary improvements.

The “before picture” and “after picture” are also a powerful way to make known the value of risk management.

We have risks in which no strategies or actions have been executed. In other words, we have a “before picture” of the risks. When we execute appropriate response strategies such as mitigating a threat, the risk exposure is reduced. Now we have the “after picture.”

Let’s look at one way to create pictures of our risk exposure for projects, programs, portfolios, and enterprises.

Say Cheese

The first step to turning risk assessments into pictures is to assign risk levels.

Assume that a Project Manager is using a qualitative rating scale of 1 to 10, 10 being the highest, to rate Probability and Impact. The Risk Score is calculated by multiplying Probability x Impact. Here is an example of a risk table with a level of risk and the corresponding risk score range.

Level of Risk

Risk Score

Very Low

< 20

Low

21 – 39

Medium

40 – 59

High

60 – 79

Very High

> 80

Figure 1: Qualitative Risk Table

Looking Good

Imagine a Project Manager facilitates the initial risk identification and assessment. The initial assessment results in fifteen Urgent Risks – eight “High” risks and seven “Very High” risks.

Figure 2: Number of Risk before Execution of Risk Response Strategies

We decide to act on the Urgent Risks alone and leave the remaining risks in our Watch List. The team develops risk response strategies for the Urgent Risks such as ways to avoid and mitigate threats.

Figure 3: Number of Risks after Execution of Risk Response Strategies

After the project team executes the strategies, the team reassesses the risks. We see a drop in the number of Urgent Risks (lighter bars). The team has reduced the risk exposure and improved the potential for success.

How to Illustrate Programs, Portfolios, or Enterprises

Now, imagine a Program Manager managing four projects in a program. We can roll up the risks of the four projects into a single view. Figure 4 below illustrates the comparison of the number of risks before and after the execution of the risk strategies.

Figure 4: Number of Program risks before and after the execution of risk response strategies

Of course, we can also illustrate risks in a like manner at a portfolio level or an enterprise level (i.e., Enterprise Risk Management).

Tip of the Day

When you ask team members to rate risks, it is important we specify whether the team members are assessing the “before picture” (i.e., inherent risks) or the “after picture” (i.e., residual risks) or bothInherent risks are risks to the project in the absence of any strategies/actions that might alter the risk. Residual risks are risks remaining after strategies/actions have been taken.

Question: What types of charts or graphics do you use to illustrate the value of risk management?

New Year’s ERM Resolution – A Risk Diet Plan

December 31, 2014

Why do you need an aggregate risk limit?

For the same reason that a dieter needs a calorie limit.  There are lots and lots of fad diets out there.  Cottege Cheese diets, grapefruit diets, low carb, low fat, liquid.  And they might work, but only if you follow them exactly, with absolutely no deviation.  If you want to make some substitution, many diets do not have any way to help you to adapt.  Calories provide two things that are desparately needed to make a diet work.  Common currency for substitutions and a metric that can be applied to things not contemplated in the design of the diet.

So if you do a calorie counting diet, you can easily substitute one food for another with the same calorie count.  If some new food becomes available, you do not have to wait for the author of the diet book to come up with a new edition and hope that it includes the new food.  All you need to do is find out how much calories the new food has.

The aggregate risk limit serves the exact same role role for an insurer.  There may be an economic capital or other comprehensive risk measure as the limit.  That risk measure is the common currency.  That is the simple genius of VaR as a risk metric.  Before the invention of VaR by JP Morgan, the risk limit for each risk was stated in a different currency.  Premiums for one, PML for another, percentages of total assets for a third.  But the VaR thinking was to look at everything via its distribution of gains and losses.  Using a single point on that distribution.  That provided the common currency for risk.

The diet analogy is particularly apt, since minimizing weight is no more desirable than minimizing risk.  A good diet is just like a good risk tolerance plan – it contains the right elements for the person/company to optimum health.

And the same approach provided the method to consistently deal with any new risk opportunity that comes along.

So once an insurer has the common currency and ability to place new opportunities on the same risk basis as existing activities, then you have something that can work just like calories do for dieters.

So all that is left is to figure out how many calories – or how much risk – should make up the diet.

And just like a diet, your risk management program needs to provide regular updates on whether you keep to the risk limits.

 

Transparency, Discipline and Allignment

October 27, 2014

Firms that have existed for any length of time are likely to have risk management.  Some of it was there from the start and the rest evolved in response to experiences.  Much of it is very efficient and effective while some of the risk management is lacking in either efficiency of effectiveness.  But some of the risk management that they might need is either missing or totally ineffective.  It is somewhat hard to know, because risk management is rarely a major subject of discussion at the firm.  Risk management happens in the background.  It may be done without thinking.  It may be done by people who do not know why they are doing it.  Some risks of the firm are very tightly controlled while others are not.  But the different treatment is not usually a conscious decision.  The importance of risk management differs greatly in the minds of different people in the firm and sometimes the actions taken to reduce risk actually work against the desired strategy of the firm.  The proponents of carefully managed risk may be thought of as the business prevention department and they are commonly found to be at war with the business expansion department.


 

Enterprise Risk Management (ERM) is an approach to risk management that provides three key advantages over traditional, ad hoc, evolved risk management.  Those advantages are:

Transparency

Discipline

Alignment

ERM takes risk management out of the background and makes it an open and transparent primary activity of the firm.  ERM does not push any particular approach to risk, but it does promote openly discussing and deciding and documenting and communicating the approach to each major risk.  The risk appetite and tolerances are decided and spoken out loud and in advance in an ERM process, rather than in arrears (and after a major loss) as is more often the case with a traditional risk management program.

Transparency is like the math teacher you had in high school who insisted that you show your work.  Even if you were one of those super bright math geeks who could just do it all in your head and immediately write down the correct answer.  When you wrote down all of the steps, it was transparent to the math teacher that you really did know what you were doing.  Transparency means the same sort of thing with ERM.  It means showing your work.  If you do not like having to slow down and show your work, you will not like ERM.

ERM is based upon setting up formal risk control cycles.  A control cycle is a discipline for assuring that the risk controlling process takes place.  A discipline, in this context, is a repeatable process that if you consistently follow the process you can expect that the outcomes from that process will be more reliable and consistent.

A pick-up sports team may or may not have talent, but it is guaranteed not to have discipline.  A school team may have a little talent or a lot and some school teams have some discipline as well.  A professional sports team usually has plenty of talent.  Often professional teams also have some discipline.  The championship sports teams usually have a little more talent than most teams (it is extremely difficult in most sports to have lots more talent than average), but they usually have much more discipline than the teams in the lower half of the league.  Discipline allows the team to consistently get the best out of their most talented players.  Discipline in ERM means that the firm is more likely to be able to expect to have the risks that they want to have.

ERM is focused on Enterprise Risks.  In RISKVIEWS mind, Enterprise Risks are those risks that could result in losses that would require the firm to make major, unexpected changes to plans or that would disrupt the firm (without necessarily causing losses) in such a way that the firm cannot successfully execute the plans.  Enterprise Risks need to be a major consideration in setting plans.  Through discussions of Risk Appetite and Tolerance and returns for risks and the costs of risk mitigations, ERM provides a focus on alignment of the risk management with the strategic objectives of the firm.

To use another sports analogy, picture the football huddle where the quarterback says “ok.  Everyone run their favorite play!”  Without ERM, that is what is happening, at least regarding ERM at some companies.

Alignment feeds off of the Transparency of ERM and Discipline provides the payback for the Alignment.

Just Stop IT! Right Now. And Don’t Do IT again.

June 16, 2014

IT is a medieval, or possibly pre-medieval practice for evaluating risks.  That is the assignment of a single Frequency and Severity pair to each risk and calling that a risk evaluation.

In the mid 1700’s Daniel Bernoulli wrote:

EVER SINCE mathematicians first began to study the measurement of risk there has been general agreement on the following proposition: Expected values are computed by multiplying each possible gain by the number of ways in which it can occur, and then dividing the sum of these products by the total number of possible cases where, in this theory, the consideration of cases which are all of the same probability is insisted upon. If this rule be accepted, what remains to be done within the framework of this theory amounts to the enumeration of all alternatives, their breakdown into equi-probable cases and, finally, their insertion into corresponding classifications.

Many modern writers attribute this process to Bernoulli but this is the very first sentence of his “Exposition of a New Theory for Measuring Risk” published in 1738.  He suggests that the idea is so common in his time that he does not cite an original author.  His work is not to prove that this basic idea is correct, but to propose a new methodology for implementing.

It is hard to say how the single pair idea (i.e. that a risk can be represented by a sing frequency/severity pair of values) has crept into basic modern risk assessment practice, but it has. And it is firmly established.  But in 1738, Bernoulli knew that each risk has many possible gain amounts.  NOT A SINGLE PAIR.

But let me ask you this…

How did you pick the particular pair of values that you use to characterize any of your risks?

You see, as far as RISKVIEWS can tell, Bernoulli was correct – each and every risk has an infinite number of such pairs that are valid.  So how did you pick the one that you use?

Take for an example, the risk of a fire.  There are an infinite number of possible fires that could happen.  Some more likely and some less likely.  Some would do lots of damage some only a little.  The likelihood of a fire is not actually always related to the damage.  Some highly unlikely fires might be very small and low damage.  Hopefully, you do not have the situation of a likely high damage fire.  But all by itself, you could make up a frequency severity heat map for any single risk with many points on the chart.

FS

So RISKVIEWS asks again, how do you pick which point from that chart to be the one single point for your main risk report and heat map?

And those heat maps that you are so fond of…

Do you realize that the points on the heat map are not rationally comparable?  That is because there is no single criteria that most risk managers use to pick the pairs that they use.  To compare values they need to have been selected by applying the same exact criteria.  But usually the actual criteria for choosing the pairs is not clearly articulated.

So here you stand, you have a risk register that is populated with these bogus statistics.  What can you do to move away towards a more rational view of your risks?

You can start to reveal to people that you are aware that your risks are NOT fully measured by that single statistic.  Try revealing some additional statistics about each risk on your risk register:

  • The Likelihood of zero (or an inconsequential low amount) loss from each risk in any one year
  • The Likelihood of a loss of 1% of earnings or more
  • The expected loss at a 1% likelihood (or 1 in 100 year expected loss)

Try plotting those values and show how the risks on your risk register compare.  Create a heat map that plots likelihood of zero loss against expected loss at a 1% likelihood.

Those values are then comparable.

So stop IT.  Stop misinforming everyone about your risks.  Stop using frequency severity pairs to represent your risks.

 


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