Showing posts with label financial risk. Show all posts
Showing posts with label financial risk. Show all posts

Sep 7, 2011

Irrational Risk

Actuarial work is demanding..., so you're arriving late at your hotel that night. The hotel manager has only two rooms left. These two rooms are exactly the same, except for one aspect: The fire alarm.....

The manager tells you that in the event of a nighttime fire due to the usual causes, guests in Room 1, equipped with Alarm 1, have an actuarial calculated  2% chance of dying. Guests in Room 2, equipped with Alarm 2, have only a 1% chance of dying.

However - things in life are always complicated -  there's a slight problem.....

According to the manager...... The wiring of Alarm 2 is such that it sometimes causes electrical fires that increase the risk of dying in a nighttime fire by an additional 0.01%.

In other words, Alarm 1 is associated with a 2% risk of death and Alarm 2 is associated with a 1% + 0.01% (betrayal) risk of death.

What room do you choose as a professional actuary?

According to a study by Gershoff and Koehler, most participants choose the room with Alarm 1. This,  even though this room 1 has double the increased risk of fire death, according the researchers. Reason: most participants found the tiny risk of "betrayal" (product malfunction) much more frightening than the much larger risk of actually dying.  When people get upset by a tiny risk, they often paradoxically choose the much larger risk.

Personally I think a more imaginable risk 'weighs' stronger than a non-specific abstract risk and in general people are unaware of conditional probability effects......

This simple example proofs that emotion has a strong influence on risk decisions.

Just like in our actuarial profession, risk decisions are often irrational.

It is our duty as actuaries to demystify and to rationalize risk. However, sometimes we're victim of the same emotional bias....

Read more about this interesting subject on:

- Vaccination and betrayal aversion (2011)
- Safety First? The Role of Emotion in Safety Product Betrayal Aversion (2011)

May 1, 2011

The Ten Actuarial Commandments

We all (think to) know The Ten Commandments from the holy scripts by heart, do we?

Now close your eyes to see how far you can get in quoting those simple ten guidelines in life.............

The Ten Commandments for Investors
Just like the Ten Commandments for Man, God - more specific - created The Ten Commandments for Investors. Let's compare the two, while - at the same time - you can check out your Commandment-Memory on Man as well:

Risk-Return-Supervision Development
As you may have noticed, The Ten Commandments are a mix of rules-based and principles-based principles.

Just as in our own life, it's interesting to see how we apply and implement these two different kind of rules during the evolution of a financial institution (insurance company, pension fund, bank, etc.):

In time, the ideal supervision model consists of three phases:

  • Phase I: No rules
    In this phase we cannot value or the company. Chances are substantial the company is 'at risk'.

  • Phase II: Rules-Based Supervision
    In phase Ia 'Rules' are mostly perceived as 'Have to's" . As a result Risk will be reduced, but Return as well. Once the board, actuaries and financial specialists are becoming aware and will see the advantages and new possibilities of managing risk. 'Have to's" will develop into 'Want to's" . The Risk-Return Ratio will increase  and even a better Return will result.

  • Phase III: Principles-Based Supervision
    Just like with the implementation of Rules-based Supervision, in case of Principles-Based Supervision, the Financial Institution needs time to adept to the new situation. At first there might be a unbalance between Risk and Return. It takes time to calibrate Risk and Return again.

    After a while actuaries, investors and management will translate Rules-Based principles into own rules that fits the company's specific risk in an optimal way. The company will be able to take more risk and to optimize its own Risk-Return Ratio.

Take a look at your own company's development and see for yourself where you fit in on the Risk-Return-Supervision lines....

It might be possible that you have to conclude that you aren't able to increase your Risk-Return ratio in the end. In this case it's likely you've become (so called) 'Supervisory Compliant': Your risk appetite probably corresponds more or less with the supervisor's minimal risk view. Instead of redefining your own risk appetite and restructuring your products from a risk-management perspective you merely implied new regulations and supervisor guidelines. As a result your Return and Risk-Return Ratio implode....

Ten Actuarial Commandments
Having learned the possible effects of supervisory rules in practice, we may now conclude with The Ten Commandments for Actuaries.

The Ten Commandments for Actuaries
  1. There's only one God, as he's omnipotent he's also an actuary.
    As you're only an actuary: be humble.....    Remember: As God wants something in Return, you'll have to take Risk!!
  2. Reality can't be comprised in a model.
    Use your brains. A model is a help, not a decision machine. Don't mix up God with Risk or Chaos. Chaos for us humans (actuaries) can be defined as "Unrecognized Order" (quote). 
  3. Never blame anything or anyone than yourself for an unexpected or negative outcome.
  4. Be consistent, act sustainable. But change your opinion just in time, if circumstances or facts urge you to do so.
  5. Alway show respect to others, even if you think different. Appreciate where you come from. Nobody is perfect, not even you.
  6. As there is no 'right' model, never criticize other models, actuaries or other people. Try to give your opinion without slaughtering the other.
  7. Never advice or state anything you do not really mean or cannot defend.If you're not sure or don't know, tell it or get help.
  8. Always cite your sources or give credits to others that helped you.
  9. Don't 'steal' the advice.
    Never include the final decision to be taken in your advice. Wrap up arguments, consequences and present scenario's so the board has to make a choice and not you.
  10. Don't get carried away by results, reports or performances of others.
    Stick to your own consistent approach.

Apply supervisory rules and actuarial commandments in a conscious way...

Dec 3, 2010

God’s Definition of Risk

To snap things in the right perspective, now and then it's good practice to consider how actuarial science really started:

Yes, like Laplace stated in his masterwork 'Théorie Analytique des Probabilités', it all began with 'games of chance'... and - today -  perhaps it still is.....

From 'gaming', probability theory developed to 'actuarial science' and finally to 'risk management'.

Risk Levels
Today we distinguish three main types of risk levels:

Risk Level 1
In fact what we are modeling mostly, are the risks we know, the 'known risks'... These risks are the familiar operational, financial and compliance risks

Risk Level 2
These are the strategic risks. Risks related to new markets, mergers and acquisitions, investments, but also business development, brand and reputation risks.

Risk Level 3
These are the unpredictable, the so called 'unknown, unknown risks'.

The Rumsfeld definitions of risk levels
A similar more humorous, but also interesting definition of risk levels, has been given by the United States Secretary of Defense  Donald Rumsfeld  during the Iraq War:
  1. Known Knowns
    There are known knowns; there are things we know that we know
  2. Known Unknowns
    There are known unknowns; that is to say, there are things that we now know we don’t know
  3. Unknown Unknowns
    But there are also unknown unknowns; there are things we do not know we don’t know."

If we're honest, we'll have to admit that even our 'known known' and 'known unknown' risks in our models in reality have a high 'unknown unknown' origin.

Or, as Barry du Toit at Riskworx shows in an excellent paper called 'Risk, theory, reflection: Limitations of the stochastic model of uncertainty in financial risk analysis' : our stochastic model of uncertainty is powerful but limited.

It's (p.e.) an illusion to use 'standard deviation' as a stand alone measure for risk. We must be aware to apply our models without a healthy portion of 'common sense'. Or, to put it in air-plane words:

The danger inherent in 'altimeter usage' is that its unquestioning use will stop pilots from using a range of more intuitive risk measures, such as looking out of the window!

God’s definition of risk
There is no ultimate "God’s definition of risk", we'll have to manage with our limited models as a help to our Risk Insight. Success!

Sources and related links:
- Limitations of the stochastic model of uncertainty in financial risk analysis
- Laplace: analytic theory of probabilities (English)
- Strategic Management of Three Critical Levels of Risk
- Managing Projects in the Presence of Unknown Unknowns

Jul 14, 2010

Solvency II Project Management Pitfalls

When you - just like me - wonder how Solvency (II) projects are being managed, join the club! It's crazy...., dozens of actuaries, IT professionals, finance experts, bookkeepers accountants, risk managers, project and program managers, compliance officers and a lot of other semi-solvency 'Disaster tourists' are flown in to join budget-unlimited S-II Projects.

On top of it all, nobody seems to understand each other, it's a  confusion of tongues..... 

Now that the European Parliament have finally agreed upon  the Solvency II Framework Directive in April 2009, everything should look ready for a successful S-II implementation before the end of 2012. However, nothing is farther from the truth.....

Solve(ncy) Questions in Time
The end of 2012 might seem a long way of...
While time is ticking, all kind of questions pop up like:
  • How to build an ORSA system and who owns it?
  • What's the relation between ORSA and other systems or models, like the Internal Model
  • Where do the actuarial models and systems fit in?
  • What are financial, actuarial, investing and 'managing' parameters, what distinguishes them, who owns them and who's authorised and competent to change them?
  • How to connect all IT-systems to deliver on a frequent basis what S-II reporting needs......?
  • How to build a consistent S-II IT framework, while the outcomes from QIS-5 (6,7,...) are (still) not clear and more 'Qisses' seem to come ahead?
  • Etc, etc, etc, etc^10

The Solvency Delusion
Answering the above questions is not the only challenge. A real 'Solvency Hoax' and other pitfalls seem on their way....

It appears that most of the actuarial work has been done by calculating the MCR and SCR in 'Pillar I'.

It's scaring to observe that the 'communis opinio'  now seems to be that the main part of the S-II project is completed. Project members feel relieved and the 'Solvency II Balance Sheet' seems (almost) ready!

Don't rejoice..., it's a delusion!  The main work in Pillar II (ORSA) and Pillar III (Reporting, transparency) still has to come and - at this moment - only few project managers know how to move from Pillar I to Pillar II.

Compliancy First, a pitfall?
With the Quantitative Impact Study (QIS-5) on its way (due date: October 2010) every insurer is focusing on becoming a well capitalized Solvency-II compliant financial institution.

There is nothing wrong with this compliance goal, but 'just' becoming 'solvency compliant' is a real pitfall and unfortunately not enough to survive in the years after 2010.

Risk Optimization
Sometimes, in the fever of becoming compliant, an essential part called "Risk Optimization" seems to be left out, as most managers only have an eye for 'direct capital effects' on the balance sheet and finishing 'on time', whatever the consequences......

Risk Optimization is - as we know - one of the most efficient methods to maximize company and client value. Here's a limited (check)list of possible Risk Optimization measurements:

1. Risk Avoidance
- Prevent Risk
   • Health programs
   • Health checks
   • Certification (ISO, etc)
   • Risk education programs
   • High-risk transactions
      (identify,eliminate, price)
   • Fraud detection
      (identify,eliminate, price)
   • Adverse selection
      (identify, manage, price)

- Adjust policy conditions
   • Exclude or Limit Risk  
   • Restrict underwriter
      (excess, term, etc)

- Run-off portfolios/products

2. Damage control
- Emergency Plans (tested)
- Claims Service, Repair service
- Reintegration services

3. Risk Reduction
- Diversification

- Asset Mix, ALM
- Decrease exposure term
- Risk Matching
- Decrease mismatch
- Outsourcing, Leasing

4. Risk Sharing
- Reinsurance (XL,SL,SQ)
- Securitization, Pooling
- Derivatives, Hedging
- Geographical spread
- Tax, Bonus policy

5. Risk Pricing
- Exposure rating, Experience rating
- Credibility rating, Community rating
- Risk profile rating

6. Equity financing
- IPO, Initial Public Offering
- Share sale, Share placement
- Capital injections

Solvency-II Project Oversight
Just to remind you of the enormous financial impact potential of 'Risk Optimization' and to keep your eye on a 'helicopter view level' with regard to Solvency-II projects and achievements, here's a (non-complete but hopefully helpful) visual oversight of what has to be done before the end of 2012.....

(Download big picture JPG, PDF)

Be aware that all Key Performance Indicators (KPIs), Key Risk Indicators (KRIs) and Key Control Indicators (KCIs) must be well defined and allocated. Please keep also in mind that one person’s KRI can be another’s performance indicator(KPI) and a third person’s control-effectiveness indicator.

Value Added Actions
As actuaries, we're in the position of letting 'Risk Optimization' work.
We're the 'connecting officers' in the Solvency Army, with the potential of convincing management and other professionals to take the right value added actions in time.

Don't be bluffed as an actuary, take stand in your Solvency II project and add real value to your company and its clients.

Related Links:

- A Comparison of Solvency Systems: US and EU
- UK Life solvency falls under qis-5
- Determine capital add-on
- Reducing r-w assets to maximize profitability and capital ratios
- Risk: Who is who?
- Balanced scorecard including KRIs (2010)
- Solvency II, Piller II & III
- Risk Adjusted Return On Risk Adjusted Capital (RARORAC)
- ERM: “Managing the Invisible" (pdf; 2010)
- Unlocking the mystery of the risk framework around ORSA
- Risk  based Performance: KPI,KRI,KCI
- Risk of risk indicators (ppt;2004)
- Defining Risk Appetite
- Risk appetite ING KPI/KRI
- Board fit for S II?
- How to compute fund vaR?
- Technical Provisions in Solvency II
- Insurers should use derivatives to manage risk under Solvency II 
- Solvency Regulation and Contract Pricing in the Insurance Industry
- Overview and comparison of risk-based capital standards 
- Solvency II IBM
- Reinsurance: Munich Re  , Reinsurance solvency II

Jul 5, 2010

Exceptional Longevity Predictable

A genome-wide association study (Paola Sebastiani et al) based upon 1055 centenarians, showed that Exceptional Longevity (EL)  - living 90 years or more - can be predicted with 77% accuracy!

EL Genetic Passport
This research development will have major impact on 'life insurance' and pensions. With an EL Genetic Passport in your pocket, you'll have the power to conclude with 77% certainty whether it's profitable (or not) to buy life insurance or to invest more or less in your pension fund.

Genetic Loss by GAS
To prevent major losses caused by 'adverse selection', life insurance companies and pension funds have no other choice left, than to base life insurance premium prices and pension contributions on 'genetic passport information'.

Just like it's (from a company's perspective) devastating to sell mortgages to people who cannot afford it, it's also killing to sell life annuities to people who have knowledge of getting 90 years or older with 77% certainty.

As Genetic Adverse Selection (GAS) also negatively affects current provisions and value of an insurance company or pension fund, GAS development effects should be included and estimated in actual liability calculations.

Without doubt, GAS will generate large Genetic Losses in the next decades. Perhaps GAS can be qualified as a substantial new kind of risk in Pillar I calculations.

Related links - Sources:
- Science: Genetic Signatures of Exceptional Longevity in Humans
- PDF: Genetic Signatures of Exceptional Longevity in Humans
- BU: Signatures of Human Exceptional Longevity (video)
- Centenarians in some European countries, 2007

Aug 30, 2009

DCF: Discounted Crash Flow

I remember in a 2007 client panel discussion I was chocked to hear that three large company CFOs of name and fame, without blinking an eye, stated that they were running their company on basis of a narrow quarterly time schedule, no longer. Long term investments? Out of the question. Pension obligations? Rather not, please... Project payback periods: 3-6 months, in exceptional cases a maximum of a year.

What was happening?
How come, CFOs have become that short term focused?

It's easy to come up with answers that pass the buck:
  • Extraordinary shareholder demands
  • Bonus Structure,
  • Greed, Grab Culture
However, despite and behind all this, there is a deeper cause.

Thinking concept
This short term focus, that is not limited to CFOs, is the logical consequence of the way our thinking and modeling has developed during the last decades:
  • we try to exclude risk at any price, instead of managing it.
  • we struggle and sometimes even fear to transform long term cash flows into discounted cash values or NPVs

According to a 2002 survey, more than 85% of the CFOs say they use NPV-analysis in at least three out of four decisions.
As actuaries we're also part of this family of Discounted Cash Flow (DCF) Experts. Some of us might even have thought there's nothing more to learn about DCF...

Of course we understand every technical detail of our DCF-model, but let's take a look at some classical aspects of the DCF technique from a different angle. I'll call this angle the I-View, with the I of Important.....

DCF properties
As we know the value of a future cash flow (cf ) , depends strongly on the choice of the discount rate (r) and the moment in time (t) of the cash flow. The further away (in time) the cash flow and the higher the discount rate, the lower the DCF value.

From an I-View perspective one might say that in the DCF of a constant cash flow, the contribution of the cash flow in year 10 is ruffly half as Important (UnImportant-effect) as a cash flow in year one, assuming a discount rate of 7%.

Another way of saying: This one off cash flow is only of 51% Importance to us.

Although this might not surprise you, a often heavy underestimated effect is that the UnImportant-effect rapidly increases in case a particular discounted cash flow in year (t) is part of and expressed as a percentage of a discounted fixed term (or perpetual) cash flow stream. This is illustrated in the next graph (base: r= 10% discount rate).

De relative contribution of a cash flow t, soon loses more and more Importance when it's part of a constant cash flow stream. As the term of this cash flow increases to infinity, the relative contribution of any 'one year cash flow' becomes rapidly UnImportant.

I-View 1: Discount Rate Adjustments
As we know, the choice of the discount rate depends on the type of cash flow. Cash flows with substantial risks are often discounted with an adjusted (higher) r, according to the (CAPM) formula:
r = rf + β×(rm - rf)
with: rf = risk free rate, rm = expected return on the market and β = (beta) a measure of the (opposed to the market) cash flow risk.

It's obvious this CAPM-method amplifies the mentioned 'UnImportant-effect' of long term cash flows.

In times of financial crisis, when we're inclined to become more risk averse, the 'UnImportant-effect' grows even more, as we are inclined to adjust r for fear:

r = rfear + rf + β×(rm - rf)

Moreover in general, the longer the cash flow term, the higher the (compound) expected risk, and therefore the higher the discount rate (r). Instead of a constant r, there's a need for a variable r, rt, that increases in time, intensifying the 'UnImportant-effect'.

I-View 2: Discount Rate of Liabilities
Another DCF example: A pension fund has extremely long term liabilities. A cash flow of - let's pick - 50 years ahead, is no exception, but only accounts for about 14% of its cash flow in the discounted liabilities of the pension fund (abstracting from mortality and assuming a discount rate of 4%), and is therefore implicit considered (rated) less Important compared to more recent cash flows. Because there's no real or substantial market for long term cash flow pension obligations, r is even harder to define. Increasing r for this risk is like putting the cart before the horse: The UnImportance effect will increase. For internal valuation r should be decreased instead of increased, but how.....?

I-View 3: Short term Ruin Probability Nonsense
A third effect is that a 0.5% yearly ruin probability sounds safe, but nevertheless compounds up to a risk of 14% over a period of 30 years and even more on the long term.
Years Cum.Ruin Risk
1 0.5%
10 4.9%
20 9.5%
30 14.0%
40 18.2%
50 22.2%
60 26.0%
70 29.6%
80 33.0%
90 36.3%
100 39.4%
FCLTOS, Financial Companies with Long Term Obligations, like banks, insurance companies or pension funds are by definition companies that have to stay ruin proof on the long term. Managing these kind of companies on short term ruin and certainty models is completely nonsense.

However, there's nothing much FCLTOS can do about it. A long-term certainty level of 99.5% (0.5% ruin risk) over a period of 40 years would imply a yearly certainty level of 99.9875% (0.0125% ruin risk). Even if it would be possible to minimize the technical risks to such a low level, it would be overshadowed by unquantifiable external outside risks (e.g. nature disasters). Anyhow, government regulators should define a target with regard to an appropriate choice of a long-term certainty level and should distinguish between short term and long term certainty in their models.

These examples illustrate that the management FCLTOS, giving these DCF-like methods, do not have another choice than to focus on the near future (5-10 years) and - by method - are not obliged and therefore also not will focus on the long term effects.

Managing FCLTOS, is like navigating an oil tanker from A to B between the ice floes. You have to avoid the short term (nearby)
risks (the ice floes) while at the same time keep sight and hold direction on your long term target (port B) in order to succeed.

Translated to a pension fund: manage your liquidity on the short term and your solvency and coverage-ratio on the long term. Any captain of an oil tanker would certainly be discharged immediately when he would make a dangerous change in course today to avoid an actual clear, but in the future certainly changing (moving targets) ice floe situation 50 km ahead. Yet, government regulators and supervisors are forcing pension fund 'captains' to undertake such ridiculous actions.

Steering on short term recovery plans , publishing and publicly discussing coverage-ratios and finally 'valuing pension funds' solely on market value (given that the market for extreme {> 30 years} long term assets and liabilities is extremely 'thin' and volatile), is therefore dangerous and apparently wrong (nonsense) and leads to discounted crash situations.

But there's more that contributes to discounted crash management......

One off negative cash flow in the future
Let's compare two (almost) equal cash flows, CFa and CFb:
- CFa: 30 year constant cash flow of yearly $1,
- CFb: like CFa, but in year 25 a one off negative cash flow : -$1

Although a negative cash flow of $1 in year 25 will probably ruin the activities an cash flows in later years, the NPV of the two cash flows only differ slightly and the calculated IRR of CFb (9.76%) is also just slightly lower than the IRR of CFa (10%).

One might argue that because CFb is obviously a more risky cash flow, the adjusted r has to be raised. This is true, but nevertheless intensifies the so called UnImportant-effect: the relative weight of the 'year 25 cash flow' in the NPV decreases.

Last but not least, what explains the short term attitude and those extreme short periods of several years or months, some CFOs practice as a time frame to run and control their company ?

Certainty Erosion
These extreme short periods are the consequence of the No. 1 concern for CFOs:

The fundamental and increasing lack of ability to forecast results

Let's do some rule of thumb exercise....

Assume the certainty level of calculating a sound financial forecast in the next period (year, quarter, month) is estimated by a CFO at C%.

Now take a look at the next table (on the right) that shows the average extrapolated certainty level (AC) over a number of periods P.

In formula:

Some examples from the table:
  • A CFO that estimates the 'next quarter result' with a certainty level of 70% (C=0.7), will probably not burn his fingers by presenting a full year forecast with an average expected certainty level of 44%.
  • A CFO of a company hit by the current financial crisis, estimates the certainty of his companies January results at 60%. The board announces it's not able to estimate the full year result. Right they are, with a 60% monthly certainty level, the full year result would have a certainty level of only 12%.....
  • Even a CFO with a superb forecast certainty level of 90%, will be cautious with a 5-year forecast (certainty level 74%).
  • A 'best of class actuary' that estimates the certainty level of his data at 90% on a yearly basis, will have a hard time in answering question about the certainty level of his projections over 14 years (50%?).

The I-View consequence of this 'compound certainty development' is that even at high levels of (yearly) certainty, the (average) certainty of cash flows after already a few years in the future, erodes.

The effects of Certainty Erosion are enormous. The wall of haziness that is created in a few years - at even high levels of certainty - is astonishing. Never 'believe' a long term one point forecast. Always request variance and certainty level(s) of presented forecasts.

We may conclude that DCF is a superb technique as such to analyze and value cash flows. To prevent ending up in a 'crash flow', DCF has to be implemented by professionals who realize that the essential point of DCF is not just the technique itself, but the way the parameters, used in the DCF-models, are defined.

In order to be able to really take responsibility in managing a company, the Board of a company should be involved in the selection and consequences of the deeper and underlaying DCF-parameters. Enough work for actuaries it seems....

Related Links:
- Some comments on QIS3, (Long term certainty levels)
- Quantifying Unquantifiable Risks