Risk Management can be a strange and deathly game. Normally one would expect that the more the demand of Probability of Insolvency (POI) is decreased:
This appears to be true in situations where Risk Management is hardly developed and POI-Demands are relatively modest (5%-2.5%).
Increasing POI-Demands
However, depending on the type of risk, beyond certain POI-Demands (smaller than roughly 2.5%) , the costs of Risk management measures, maintenance and capital requirements become higher than the average expected Loss-reduction, resulting in - on average - lower profits.
Of course, these extra risk management investments and capital requirements can financed by raising consumers prices, but - on balance - this will result a smaller market corresponding with a lower profitability level.
The question can be asked if this still is what we, management and consumers, intended to achieve.......?
Next, in our passion to reduce Risk to an even more extreme low level, we can get carried away completely...
Excessive POI-Demands
When POI-Demands get to levels of 1% or less, a remarkable psychological effect enters the Risk management arena.
Management perceives that the Risk-level is now actually so low that they cannot fail anymore.
In their ambitious goal to outperform the profit level of their competitors, management gets overconfident and reckless. What would you attempt to do if you knew you could not fail?
When POI-Demands are set to levels of 0.5% or less (as they are mostly now in 2010) it becomes almost impossible to beat your competitors with an approach of 'taking more risk'. Even if one would try to manage or hedge these extra risks 'best' in the market. In the long-term, the price of this risk would equal or beat the expected loss.
In this situation some managers get desperate and instead of considering things 'right', they see only one option 'left'....
WAR, Working Around the Rules, comprises actions like:
It's perhaps hard to admit, but as actual developments show, we've entered the final WAR phase. Some Examples: subprime, Madoff accounting, BP-deep horizon oil failure, bank multipliers, etc, etc.
In all these examples, managers (are pushed to) become over-creative by working around the rules to deliver what they've promised: more profit.
However this approach always results in
This development, resembles the 2010 situation in the Insurance and Banking industry where, after each financial debacle, POI-Demands where successively decreased to a 0.5% level and have resulted in marginal profits and a highly volatile Profits or even losses. Pension Funds (NL: 2.5% POI-Demand) appear to be the next patient the operating table.....
The situation is out of control. Nothing really seems to help anymore....
Yes, but that's for another blog as this one is getting too long...
Related links:
- Why excessive capital requirements harm consumers, insurers and...(2010)
- Presentation - Modelling of Long-Term Risk (2010)
- the more Prevention- , Risk-reduction- and Damage-control-measures will be taken
- the less actual Risk and corresponding Loss will actually occur
- the higher the resulting average yearly profit
- the lower the resulting yearly profit volatility
This appears to be true in situations where Risk Management is hardly developed and POI-Demands are relatively modest (5%-2.5%).
Increasing POI-Demands
However, depending on the type of risk, beyond certain POI-Demands (smaller than roughly 2.5%) , the costs of Risk management measures, maintenance and capital requirements become higher than the average expected Loss-reduction, resulting in - on average - lower profits.
Of course, these extra risk management investments and capital requirements can financed by raising consumers prices, but - on balance - this will result a smaller market corresponding with a lower profitability level.
The question can be asked if this still is what we, management and consumers, intended to achieve.......?
Next, in our passion to reduce Risk to an even more extreme low level, we can get carried away completely...
When POI-Demands get to levels of 1% or less, a remarkable psychological effect enters the Risk management arena.
Management perceives that the Risk-level is now actually so low that they cannot fail anymore.
In their ambitious goal to outperform the profit level of their competitors, management gets overconfident and reckless. What would you attempt to do if you knew you could not fail?When POI-Demands are set to levels of 0.5% or less (as they are mostly now in 2010) it becomes almost impossible to beat your competitors with an approach of 'taking more risk'. Even if one would try to manage or hedge these extra risks 'best' in the market. In the long-term, the price of this risk would equal or beat the expected loss.
In this situation some managers get desperate and instead of considering things 'right', they see only one option 'left'....
WAR
'Working Around (the) Rules"
WAR, Working Around the Rules, comprises actions like:
- Taking (extra) risks on non-measurable or non-measured financial transactions, or or 'non-obligated-reporting risks'
- Manipulating, disguising or mitigate risk information, or risk-control reports
- Misuse legally allowed methods and accounting principles to create legally unintended financial effects or transactions
It's perhaps hard to admit, but as actual developments show, we've entered the final WAR phase. Some Examples: subprime, Madoff accounting, BP-deep horizon oil failure, bank multipliers, etc, etc.
In all these examples, managers (are pushed to) become over-creative by working around the rules to deliver what they've promised: more profit.
However this approach always results in
- More short-term profits
- Less long-term profits
- Sudden bankruptcy in the end
This development, resembles the 2010 situation in the Insurance and Banking industry where, after each financial debacle, POI-Demands where successively decreased to a 0.5% level and have resulted in marginal profits and a highly volatile Profits or even losses. Pension Funds (NL: 2.5% POI-Demand) appear to be the next patient the operating table.....
The situation is out of control. Nothing really seems to help anymore....
Solutions
Are there any solution to prevent this solvency meltdown process?Yes, but that's for another blog as this one is getting too long...
Related links:
- Why excessive capital requirements harm consumers, insurers and...(2010)
- Presentation - Modelling of Long-Term Risk (2010)
Posts
LinkedIn Actuary-Info Group
Another great post.
ReplyDeleteNeil Bodoff has suggested that this reasoning will mean that risk management will end up with companies actually taking MORE risk. http://wp.me/pevO4-81
One version of what you call WAR is to take only risks that are not measured with your risk model. The folks who make their money off of selling risks to insurers will work day and night to find and structure risks that do not register on the capital models. See the Law of Risk and Light http://wp.me/pevO4-bi
Finally, there way to actually directly calculate the combined effect of increasing security and decreasing profits. Treat the profits of the firm as an annuity income and the POI as death of the firm and calculate the NPV of the future earnings of the firm. See Managing the Invisible by Bill Panning http://papers.ssrn.com/sol3/papers.cfm?abstract_id=913682 This calculation actually gives a positive NPV impact of some risk management efforts and negative for others. For this calculation, we usually use an event such as downgrade to rating level BBB as the trigger for earnings to cease, rather than insolvency. Because most firms go into run-off when they can no longer sell business and owners get little if any of future earnings after that point.
In that manner, ratcheting outside demands for higher security can be shown to directly reduce the value of the firm.