Death by Solvency

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:

• 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...

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"

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

1. More short-term profits
2. Less long-term profits
3. 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)

Insolvency and GDP

Global insolvency rises further in 2009 and will stabilize at a high level in 2010.
Those are the main conclusions of the world’s leading credit insurer Euler Hermes.

Euler Hermes is forecasting a 33% rise in corporate insolvencies worldwide in 2009.

In 2008, half the global increase in insolvencies resulted from financial restrictions whereas in 2009 the main factor has been the economic recession. Due to unemployment and weak recovery, business insolvencies will remain at high levels in 2010.

Insolvency growth champions with rocket growth of 75% or more are Spain, Ireland and the Netherlands (as well as the Baltic countries).


Insolvencies have soared by more than 35% in the United States and Northern and Eastern Europe.

Relationship GDP & Insolvency

The relationship between GDP and insolvency is quit interesting.

Corporate insolvency turns out to be different from one country to another.

Although there are differences, the change in insolvencies over time - rather than their absolute numbers - turns out to be strongly related to the change in GDP.




In short one might conclude:

Declining GDP implies inclining insolvencies

Strong local differences
The strong GDP-Insolvency relationship of the Global Insolvency Index (GII) is also - in a slightly different way- visible on zone or country level.


For each of the 33 countries that are analyzed by Euler Hermes, the insolvency index is calculated using a basis of 1997=100.

Next, the GII is calculated as the weighted sum of the national indices.

Each country is weighted according to its share of total aggregate GDP (at current exchange rates).



As actuaries we're all interested in in 'credit spreads'...

Questions:

1. Is there any relationship between 'credit spreads' and 'insolvency rates'?
2. Would insolvency rates influence our business in any way....?

Sources:
- Press release, Euler Hermes Nov. 17, 2009
- Insolvency Outlook Euler, Hermes February 2009