Mar 30, 2014

Chief Actuary Officer

Let's take a look at the governance of financial institutions from a risk management perspective:

Governance Risk Management

Traditional governance focuses on the organisation-structure, decision-structure, influence and power-weights of all stakeholders. Governance Risk Management focuses on how to optimize and monitor risk and value creation for all stakeholders.

Financial Risk Management Monitoring
After defining a companies Mission, Risk Appetite and Strategic Plan, the year-targets and key indicators are not only translated into a tight budget (b) of 'sales targets' and 'profits', but also into 'balance sheet budget targets' (b).

It takes a real well defined 'Governance Risk Management' to split the balance sheet into such parts (Assets, Liabilities & Capital) that responsible officers in the company are able (and can take responsibility) to monitor the actual values (a) monthly or quarterly to the final or adjusted budget values (b).


Officer Role Division
In a well managed and structured financial company the risk-financial roles of the companies officers can be defined as follows:

  1. CIO
    The Chief Investment Officer is primarily responsible for managing the asset actuals A(a) versus the (adjusted) budget A(b). So the CIO has to manage [A(a)-A(b)] in terms of value and within defined  the investment risk budget.
  2. CAO
    Although often unremarked, an important part of the role of the Chief Actuary Officer is to manage the actual liabilities L(a) versus the (adjusted) Liabilities budget L(b).
    This is no easy job, as most longevity and (risk free) discounting of the liabilities are hard to influence.
    Wrapping up: The CAO is responsible for managing [L(a)-L(b)].

    Often the role of the CAO seems to be limited to insurers or pension funds. However, also banks need an actuarial officer, as more and more (product) risks on the bank's balance sheet become economic, demographic and bio-related (mortality, disability, lifestyle).  
  3. CRO
    Often the Chief Risk Officer is seen as someone at arms length reporting about risks to the (supervisory) board. However, one of the main roles of the CRO is to monitor Capital and Capital Requirements. He/She is responsible for realizing the sustainability of the company by managing the (adjusted) Capital budget C(b) while being confronted with continuously changinge Capital actuals C(a). So the CRO is responsible for monitoring [ [C(a)]-C(b)].  

AIRCO Management
Once the targets are set and responsibilities are defined, the hard part of managing a financial institution starts: Cooperation between the Actuarial, Investment, Risk and Capital Organisation (AIRCO) Chiefs.

During a budget year, all individual defined AIRCO budgets and actuals continuously change in practice.
As capital risk development is the complex result of Asset and Liability volatility, capital management and monitoring by (primarily) the CRO manager becomes extra complex. Especially in market crises situations (tail risks), where traditional (linear) correlations between AIRCO components fail by definition. It's the responsibility of the CRO to continuously balance between all stakeholders interests in narrow cooperation with the CAO and CIO, while staying on track with regulatory requirements.

This task is not easy, as AIRCO Management is not a one dimensional mission or game:
  • Run-off
    Often AIRCO Management is merely based on regulatory AIRCO requirements, based on run-off portfolios and one-year period confidence levels (e.g. 99.5% [Solvency-II] or 99,9% [ Basel-II/III] ).
  • Continuous business model 
    However this run-off approach is only based on a kind of default situation with a very low probability (< 1%). It's much more likely (> 99%) that a financial company will exist for more than one year.

    Therefore, adding one or more variations of 'continuous business model approaches' to the existing run-off approach on a board's table, will give the board a more (realistic) insight on the heavy an balanced decisions to be taken to continue and control a sustainable risk-return strategy. 

To manage the complex of AIRCO effects, it's often helpful to set up an Asset Liability Capital Team (ALC-Team) within a financial institution. Main task of this team is to manage risk and returns across all AIC-axes in line with the strategic plan, the defined risk-return appetite and actual regulatory requirements.

The ALC-Team consists of the CAO, CIO an CRO and could in practice be chaired by the board's CFO, or CFRO.
This ALC-Team :
  • proposes board adjustments and monitors the risk-return targets and matching policy
  • makes clear what the often paradoxical and/or conflicting effects of risk-return management are for all stakeholders on basis of different future business continuity models (e.g. Run-off, Continuous business, etc.)
  • Makes clear and advises what measures the board can take due to the impact on ALC of different business models views, changes in economic risks and changes in regulation.
  • operates on basis of ALC reporting information,"Own Risk Assessment" reports, external Economic Risk Reports and external Regulatory Change Information.

One of the most tricky pitfalls in capital management is that a financial institution tries to solve all budget variances and regulation changes only by adjusting its investment policy.

If adjusting is done 'on the fly', without considering the risk-return targets and (even worse) through the mental filter of just one of the stakeholders interests (e.g. 'shareholder value), a financial company implicitly risks to lose track of the overall strategic business targets.

If an economic or regulatory change influences the risk-return objectives, all possible instrumental options to respond, have to be taken into account. One of the most forgotten instruments to respond to market changes, is 'product management' or (new) 'product development'.

Yet, nevertheless the fact that existing (product) contracts are (short term) often hard to adapt, 'product management' is one of the most vital instruments to apply regarding the management of long term risk-return objectives.

Therefore AIRCO Management requires a planned an controlled Stakeholder Management Process in a financial institution.

Stakeholder Value (Risk) Management
Managing a company's stakeholder value implies that the effects of the economic, regulatory and own-company changes on the risk-return objectives are continuously balanced across all stakeholders (Shareholders, Clients, Asset Managers, Board/Employees).

Apart from 'HR value management', regarding possible board and employee reward and benefits adjustments, the instruments to manage and  balance Stakeholder Value:

A-1  Asset Value management
C-1. Capital Management
C-2  Shareholder Value management
L-1  Product Value Management
L-2  Client Value management

are presented in the next chart:

Managing a financial institution in this challenging financial decade (2010-2020) is a complex operation with multidimensional regulation and business risk-return targets. Financial Boards have to manage more truths at the same time in a highly volatile economic risk-return environment.

Surviving in this complex world urges boards to step from a traditional predictable managing approach to a more responsive managing approach, where stakeholders value is continuously monitored and adapted to the real world environment.

This new 'survival approach' urges to improve communication, process information and reporting across Assets, Liabilities and Capital Management within the organisation.

Establishing an ALC-Team approach could be a first step to improve the control on risk-return management within the organisation across all stakeholders and actively using all 'stakeholders value tools' in a balanced way.

Last but not least, the role of the Chief Actuary Officer should be more clearly defined. The CAO is, in line with Client Value objectives, primarily responsible for an adequate liability en product management, that's key in balancing the risk-return objectives of a financial institution.


- Cartoon: Government Risk Management by Todd Nielsen
Risky Business – Making Phenomenal Decisions
   (While Not Forgetting the Risk)

Mar 1, 2014

Too Big to Tail

At the end of 2012 the author of the famous book The Black Swan and professor of risk engineering at the NYU, Nassim Nicholas Taleb, published his new book Antifragile.

Antifragile is a term Taleb defines to describe things that benefit more (have more upside) from random events or shocks, than they are harmed by (have downside).

In other words, antifragile things are those that benefit from stress and disorder.

Inevitably, this  ' E=MC2 ' book will change the foundations of Risk Management coming decade. Antifragile should be qualified as 'compulsory reading' for all actuaries, CFO's, CEO's and risk or investment managers.

It's impossible to summarize Taleb's Antifragile insights in a single blog, Therefore I'll focus on some examples and the major principles.

Also I would like to point at two more less known and 'mathematical based' text-books(downloadable and in progress) that are related to his popular (non-mathematical) book Antifragile:
  1. Taleb Textbook: Fat Tails Math, Probability and Risk in the Real World
  2. Taleb Textbook: Fat Tails and (Anti)fragility 

What's Investment Risk?
In a presentation ("Actuaris: From Backroom to Boardroom"; Dutch) to over 200 actuarial professionals at 'Actuarieel Podium' on October 1st 2013 in Utrecht, Jos Berkemeijer discussed, questioned and challenged some major actuarial profession principles. One of these actuarial principles is the:

Concept of Investment Risk

Inspired by Taleb's view on investment risk, I asked my audience to rank the next randomly presented stock charts in order of decreasing risk.

Can you manage?

As expected, most actuaries chose Stock Chart I or II as 'most risky'. Apart from a few Taleb-conscious actuaries, all of them chose Chart III as 'least risky'.

And that last choice is indeed the choice we're trained to qualify as least risky. The way we're brought up, is that risk equals volatility, ultimately resulting in a dangerous and wrong conclusion: non-volatility = 'no risk'.

However, according to Taleb, the opposite is true: Chart III represents the most risky stock.


Because the company or investment fund that's behind Stock Chart III doesn't have any real experience with 'managing risk' at all !!

Taleb's Turkey
In another way, Stock Chart II is risky as well. Chart III shows limited risk and exponential growth.
As Isaac Newton already stated: What goes up must come down
Therefore Stock III is a risky investment as well, despite it's limited volatility.

The fact that Chart II Stocks must come down is well illustrated by Taleb's Turkey example   

"A turkey is fed by a butcher.  Every day it is confirmed to the turkey and the turkey’s economics department and the turkey’s risk management department and the turkey’s analytical department that the butcher loves turkeys. And every day brings more confidence to that statement. 
The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey.

So with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal and “it is very quiet” and soothingly predictable in the life of the turkey.

This example also makes clear that black swans are not just big negative impact events. The events of a black swan event depend on the position of the observer.

Least Risky
At the end we have to conclude that, despite the largest volatility, Stock III is the least risky investment, because the company or investment fund behind this stock chart, has learned to 'deal' with risk.

Dealing with investment risk is just like raising your child. You try to protect your child against life threatening events (defaults), while at the same time you encourage it to take limited (non life threatening) risks, so it may learn to prevent and absorb damages (losses) in order get better in resisting future other risks. 

Or.., to put it in a philosophical way, as defined by rabbi Anthony Glickman:

 “Life is long gamma.”
“Life benefits from volatility and variability”

Antifragile Essentials
Now after this popular intro, let's conclude with some fundamental principles of Taleb:
  1. Antifragile
    An investment portfolio (strategy) can be qualified as 'Antifragile' if it benefits more form shocks (high-impact events or extreme volatility, up to a certain level) than it suffers.

  2. Optionality & Investment Strategy
    • What makes you antifragile?
      Executing a option strategy
    • Traditional investment strategies: 'too much focus'
      Traditional investment strategies (e.g. Mean-Variance optimization, profit maximization or risk budgeting) all have explicit goals ('focus') that make their performance outcomes very parameter and model dependent. Because 'medium' risks can be subjected to huge measurement errors, the often 'medium' or 'moderate' risk attitude of these strategies can become catastrophical.

      Traditional investment strategies are not designed to explicitly cope with Negative Black Swans events. Neither are they designed to profit from 'disorder clusters': volatility, uncertainty, disturbances, randomness and stressors.

      Most important: traditional investment strategies are not set for maximal profiting of Positive Black Swans!
    • Barbell strategy
      The essence of an 'optionality investment strategy' ('barbell strategy') can be formulated as a 'dual attitude' of extreme risk aversion by playing it ultimate safe in some areas (robust to negative Black Swans) and extreme 'risk loving' by taking a lot of small risks in others (open to positive Black Swans), hence achieving antifragility.

      As a consequence this barbell-strategy reduces the downside risk, e.g. the elimination of the risk of ruin. In fact any strategy that removes the risk of ruin is a kind of barbell strategy. It's a strategy of limited loss and large possible outcome.
    • More Data, Better Outcome?
      Quit contrary to what we as actuaries would expect, Taleb explains in his book Antifragile that the more data you get, the less you know what’s going on, and the more iatrogenics (damage from treatment in excess of the benefits) you will cause.

Some risks are simply too small or too big to Tail. Try to approach them in an Antifragile way.....

Although the new insights and theories of Taleb are quit appealing, there's still a lot of work to do to make it work in practice.

Fortunately, you may read Taleb's book Antifagile online, or simply download it.


Taleb Links

Other Link