Mar 27, 2011

Zero Problems Risk Management

More and more we actuaries and risk managers become aware that our risk models can't just be based on numbers and statistics exclusively.

Some examples:

Systemic risk
The recent financial crisis made it clear that a 'mono risk approach' on a sole risk-object (mortgage, fund-investment) is insufficient.

Investments and loans are embedded in a worldwide sea of connected financial instruments and reinvestments. Systemic risk has to be included in our models.

Main challenge here is that systematic risk essentially depends on macroeconomic and (mostly) irrational factors. Further, systemic risk is related to the structure and dynamics of the market. More than numbers.....

Supervisory Herding Risk
In their effort to control and support financial institutions like banks, pension funds and insurance companies, country supervisors, regulators and 'accounting standards boards', defined a meticulously set of guidance rules (Basel I/II/II, Solvency I/II, Qis-I-V, IFRS, FAS, AIFMD, FTK, FIRM, etc.,etc.)

Financial institutions not only confirmed and adopted to those new rules, but - in their rush and driven by cost and time pressure - also implicitly (and often unintentionally) declared those same imposed rules and rationales as their own business 'Risk Appetite'. This way, most financial Institutions became so called: 'Supervisory Compliant'.

Instead of  expliciting their specific company-targets and successively developing their own correspondent risk appetite and risk framework, they incorporated the supervisor's risk philosophy. 

Without a sound own (board) risk vision that would undoubtedly have included some extra safety on 'company specific risk issues', financial institutions became - like a herd - all in the same way extremely vulnerable to (less defined) external risks.


Overregulation increases Herding Risk

Financial institutions all measure and respond to regulated risks in the same way. Supervisory Herding Risk is born.....

Too Much Focus Risk
As a consequence of pre-subscribed risk categories and ruling by law or (accounting) standards, there's the risk of 'too much focus' on specific risks while forgetting, denying or neglecting other important risks. Remember, the devil is in the (correlating) details....

Here's a useful, but not exhaustive, checklist to keep track on your risk models...

Average Premium Risk Diversification Risk Matching Risk
Commodity risk Employer Continuity Risk Operational risk
Compliance Risk Environmental Risk Outsourcing Risk
Compliance Risk Equity Risk Oversight Risk
Concentration Risk Herding Risk Price Inflation Risk
Counterparty Risk Interest rate risk Property Derivatives Risk
Coverage Ratio Risk IT Risk Reinsurance Risk
Credit Risk Legal risk Reinvestment risk
Culture Risk Legislative Risk Reputation risk
Currency Risk Liability Risk Sex Calculation risk
Default Risk Liquidity risk Strategic risk
Deflation risk Longevity Risk System Risk
Disaster Risk Market Risk Systemic Risk
Discount Risk Matching Risk Wage Cost Inflation Risk

ALM Simplifying Risk
Univariate models are killing and even multivariate models have proven to be too vulnerable and too limited in the recent crisis. It's not just about correlation and covariance matrices. What we need is an self-explaining model. A model  that predicts or generates expected values in an economic context, depending on exogenous economic variables like inflation rate, GDP-Level, etc. and that is based on the same structured historical economic data-set.

We need 'Asset Liability Modeling New Style' and not only Stress Testing or
advanced and excellent Crash Modelling as well explained by EMB.

Geopolitical Risk
With Europe and Japan as recent examples, it's clear that risks come from everywhere around the world.

The consequence of earthquakes (Japan, Australia), a possible  country default (Ireland, Greece, Portugal, ..), political instability (Libya, Ivory Coast, ..), war threat (Vietnam,Iraq, ..), financial easing (US, Europe,...), on our economic system, prices and financial institutions seems substantial and - moreover- predictable.

More than just trying to catch and capitalize these kind of risks in our risk models, we need to develop (financial) mechanisms and products that can cope as best as possible with these kind of risks.

The Riskmap 2011, Managing Risk | Maximising Opportunity, offers a good description of the actual risks that influence our lives and risk models.

A nice example is the recent (unexpected) leading role that France took in action against Libya.  'Riskmap 2011' mentions the 'Arabic Poll 2010' that clearly shows (despite the lack of sympathy for president Sarkozy) the trust and sympathy for France. France clearly outperforms the US and president Obama  unfortunately has lost the trust of the Arabic world... Take a look at the next slide summary (or the original complete pdf):  

Arab Public Opinion Poll 2010 Summary

The Arabic poll shows that the prime minister of Turkey, Erdogan, has clearly gained  the confidence and trust of the  Arabic countries. With Ergodan, Turkey - at the cross road between East and West - takes a leading role in the 'World Risk Management Process'.  Ergodan's Risk Philosophy, invented  by the Turkish Foreign Minister Ahmet Davutoglu,   is 'Zero Problems'.....

Perhaps that should be the philosophy of actuaries too...

Zero Problems

From now on 'Modeling Risk' is more than just a financial exercise.
It's building scenario's, mechanisms and products that can cope with this risky world.  Success as actuary or risk manager!

Related Links:

- Committee (behaviour) assessment tool
Control Risks:Riskmap 2011
- Arabic Poll 2010
- Supervisory Compliant
- Maplecroft Risk Maps 
- EMB: How to Model a Crash (REVO) 

Mar 16, 2011

Fukushima Risk Management

With all due respect for the Japanese risk managers, engineers and the Japanese people in general: The latest 2011 M=8.9 Earthquake in Japan made clear that the current Risk Models, as well as Risk Management itself, have tragically failed.

Shortcomings in headlines:
  • Underestimation of the probability of a M=8.9 (M>8) event
  • Risk Modeling mainly focused on 'direct' earthquake effects
  • Underestimation of cumulative correlated devastating effects that occurred as a consequence of a combination of Earthquakes, Tsunamis, Nuclear Disasters and Physical Concentration (4 reactors in a row!).

It's true, the worldwide annual frequency of a serious earthquake with a magnitude of 8 or more (M>8) seems small....

Yet - no matter how low the probability- the consequences (loss) is unacceptable if the damage in case of an event (like an earthquake M>8) is not manageable, exceeds a country's financial recuperation power, or devastates thousands of lives...

End of Time?
Lots of worrywarts think the end of time has come, as severe earthquakes are increasing.

Simple statistics show that this is not (yet ?) the case:

The expected average Magnitude value of all earthquakes with M>=7 over the period 1950-2011 (March) is Ma=7.6 with a standard deviation of SD= 0.4. The average value of the last 10 years turns out Ma=7.4 with the same SD (0.4).

Nevertheless, when we examine the graphic more closely, there seems a light (significant?) increase in large magnitude earthquakes in recent decades.....

Back to the year 0
For what it's worth, the average magnitude for M>=7 earthquakes over a longer period from 0 to 2011 (March) , turns out in line with Ma=7.6 and a SD=0.44. Or in graphics:

History Earthquakes in GoogeMaps
Finally, take a look at the history of all earthquakes with a magnitude of 7 or higher on GoogleMaps... (take look at your country!)

Earthquakes, Magnitude> 7, years 0-2011 weergeven op een grotere kaart

Let's hope and pray for the Japanese people that that the brave engineers who are fighting the current meltdown at Fukushima will succeed and survive.....

Related links
- Spreadsheet (Excel) Earthquakes 0-2011 (March), M>=7
- Crash Course Earthquake calculation by Professor Nicholas Pinter
- Effect of Seismic Risk Measures on Japanese Housing Prices
- Earthquake Software
- Download Earthquake data from USGS
- Earthquake Safety of Nuclear Power Plants
- PPT:Japan’s Nuclear Energy Program(2003-2004)
- Design criteria Japanes Nuclear Plants  
- Prediction of ground motion
- Seismic Risk Evaluation (2004)
- Earthquake Facts 
- Earthquake FAQS 
- GeoBatch: Earthquakes (history M>=7)
- GoogleMaps: Earthquakes (history M>=7)

Mar 11, 2011


IMF evaluated its role and performance in the recent financial and economic crisis.

In a 2011 crisis report with the short title: 'IMF Performance in the Run-Up to the Financial and Economic Crisis:IMF Surveillance in 2004–07 ', IMF concludes that the main cause of their inadequate response during the crisis was:


IMF’s ability to detect important vulnerabilities and risks and alert the membership, was undermined by a complex interaction of factors, many of which had been flagged before but had not been fully addressed.

The IMF’s ability to correctly identify the escalating risks was hindered by:
  1. A high degree of groupthink 
  2. Intellectual capture
  3. A general mindset that a major financial crisis was unlikely
  4. Inadequate analytical approaches
  5. Weak internal governance
  6. Lack of incentives to work across units and raise contrarian views
  7. A review process that did not “connect the dots” or ensure follow-up
  8. Some impact of 'political constraints'....

IMF suggests some recommendations on how to strengthen its ability to discern risks and vulnerabilities and to warn in the future. Main point is to enhance the effectiveness of surveillance: it is critical to clarify the roles and responsibilities of the Board, Management, and senior staff, and to establish a clear accountability framework.

Looking forward, IMF needs to
  1. Create an environment that encourages candor and considers dissenting views
  2. Modify incentives to “speak truth to power”
  3. Better integrate macroeconomic and financial sector issues

  4. Overcome the silo mentality and insular culture; Deliver a clear, consistent message on the global outlook and risks.

Recognize Groupthink
Groupthink is not just something happening to IMF or 'other organisations'. We, financial institutions, all suffer somehow or somewhat from the Groupthink Virus.

How can we recognize Groupthink?
Derived from an article by Irving Janis, the inventor of the word Groupthink, let's take a look at some explicit signs of Groupthink:

  1. Winning Mood syndrome
    A common illusion of success (Folie à deux), invulnerability, over-optimism, unanimity and risk-taking as a consequence.
  2. Collective rationalization
    Managers, employees discount warnings and do not reconsider their assumptions
  3. Repression or Ridicule
    Direct pressure on and ridicule of  individuals who express disagreement with or doubt about the majority view or the view of the leader
  4. Fear
    Fear of disapproval for deviating from the group consensus. Fear from or doubt about expressing your opinion.
  5. Manipulating
    Remaining silent in a discussion is implicitly interpreted as agreeing.Obviously 'wrong' arguments are used to achieve a certain goal or policy.
  6. Disrespect
    Stereotyped views of out-groups or enemy leaders as evil, weak or stupid. Good or serious ideas of colleagues are rejected on basis of the source instead of 'judged by the facts'.
  7. Moral Blindness
    Unquestioned belief in the inherent morality of the in-group. Lack of discussion about ethical or moral aspects of certain decision.
  8. Miscommunication and Misinformation
    Information, bottom up or top-down is (deliberately) strongly filtered
  9. Idolization
    Idolization of the leader or of certain five star employees.

Lessons Learned
If you recognize some of the above signs in your organization, it is time for action.
Discuss it, do not accept it and if you cannot change it... LEAVE!

A humorous example of Misinformation are the quotes of Iraq's minister of (Mis)Informaton, Al-Sahaf, during the 2003 Iraq war.
Enjoy, laugh and learn.....

Make sure your board presentation is not based on' sahaf-statements' but on simple provable actuarial facts....

Related links/sources:
- 8 signs of groupthink
- What is Groupthink?
- IMF Crisis Report 2011

Mar 6, 2011

Actuary Bill Gates

For those of you that -just like me - didn't know that Bill Gates is actually a qualified actuary....

Bill Gates.., a man with a great vision and the same size of philanthropic heart. More information about Bill on the 'Bill and Mellinda Foundation' website, were another actuarial statement is launched:

All Lives Have Equal Value

With all due respect for Obama: Bill gates for president!

- 2010 Annual Letter from Bill Gates

Mar 5, 2011

Supervisory Compliant, is it enough?

Risk management is tricky business... Being 'Officially Compliant', 'Just Compliant' or in other words "Supervisory Compliant", is not enough to help your CEO survive with your company in the complex market battle!

Whether you're an Actuary or Risk Manager of an Insurance company, Bank or a Pension Fund, the risk of being 'Supervisory Compliant' is simply : bankruptcy!

Becoming 'Supervisory Compliant' in complex programs like Solvency-II, Basel III or Legal Pension Fund Risk Frameworks, consumes so much time and effort, that almost no time seems to be left for contemplating or doing the essential Risk Management work properly.

Just being 'Supervisory Compliant' implies:  constantly running after the Supervisor to become  'just in time' officially compliant and not having enough time to think about the (f)actual relevant risks.

Supervisory Compliance becomes very frighting when Risk Appetite and Valuations are rashly based upon the minimum Supervisory requirements, as is (e.g.) the case in the Dutch Pension Fund legal framework. Boards stop thinking about the actual risks and feel compliant and satisfied once the Supervisory Compliance Boxes are checked.

A new look at compliance
Let's take a look from a new point of view at the complete Risk Management Compliance Field:

In basis there are three types of 'being compliant':

  1. Supervisory Compliant
    When you're Supervisory Compliant, you officially comply to all legal Risk Management compliance requirements. Your Supervisor is happy...

  2. Professional Compliant
    You comply to your own professional Risk Management standards. You are happy...  but what about your Supervisor? Comply or Explain....

  3. Success Compliant
    Being Success Compliant implies that all Risk Management requirements that are key to have success - e.g. key to survive in the market on the long run - are met.

Let's zoom in at some specific areas in this chart:

Bias areas
It's perhaps hard to admit, but in our attempt to be complete, we define and manage a lot of (small) risks that do actually exist, but are in fact not really or limited relevant with regard to company continuity.

Distinctive Character area
The Distinctive Character area is perhaps the most interesting area. To get grip on this area urges us to 'Think outside the Circle'.

By doing so we'll be able to manage risks that  our competitors fail to do. Here we can achieve 'Distinctive Character' by managing risks more efficient or by turning risks into profits. Examples are: Derivatives that limit our investment risks. Specialized experience rating (rate making) on your portfolio on basis of characteristic and unique risk profiles.

Tricky area
The tricky area is the area that consists of Supervisory Risks you tend not to find important, but that are very important for achieving success in the market. Tricky areas could e.g. be: Deflation Risk, Longevity Risk or Take Over Risk.

Reversed Thinking area
This is perhaps the most interesting risk area.

To explore this area you'll not only have  to 'think outside of your circle', but - just like in reversed stress tests with Banks - try to think backwards, to find out what could cause a certain event or loss.

This reversed thinking process succeeds best as a group. Group members should be professionals and non-professionals from different types of business, education and background.

A successful group mix could e.g. consist of : an actuary, an accountant, a manager, a marketing manager, a compliance officer, an employee, a client, a shareholder representative and last but not least the receptionist.

Try to find time to manage your company to new heights and stop being just 'Supervisory Compliant'.....