Soft-Risk Management

Never heard of of Soft-Risk Management? After this blog you'll never forget!

Google
This month Google's world class co-founders Page and Brin announced (SEC filing) they'll sell 17% of their shares (at today’s prices valued at $5.5 billion) in the next five years.

As a consequence their voting rights will be reduced to 48%, implicating they will no longer have a majority control. “They are both as committed as ever to Google...”, Google said in an e-mailed statement.
Why this statement? Was there anyone who doubted this?

Of course Google is still and will hopefully stay a strong company and a strong brand. Nevertheless - without jumping the conclusions - it's clear that this low-key announcement, although it doesn't seem to have any direct financial consequences, might turn out to be the straw that breaks the camel's back in Google's life cycle development. This kind of company press release is in fact a 'disguised risk indicator', or in other words a :

Soft-Risk Indicator (SRI)

A SRI may be defined as 'knowable' information about a company, that could influence the company's value now or in the future , but doesn't seem to have enough (financial) power to do so now or on its own

Although just one ignored SRI could already be fatal, a combination of two or more SRIs could become a severe risk. A bunch of SRIs could create a chain reaction and lead to a kind of supernova explosion.
It's just like a grain dust explosion. A few grains are no risk, they don't explode. However in an accumulation of grains, one innocent 'hot' grain or a small environmental change in dust concentration, is enough to create a mega explosion. Just like grain dust, SRIs can become a severe risk when the environment (suddenly) changes.
Consequently, an out of the blue 'change of environment' is also a Soft-Ris Indicator on its own.

Don't mix up Soft-Risk with Systemic Risk. Dust particles don't directly 'participate' in one another, in fact they build up to a certain critical density. Soft Risk Loss
SRL = E( SRI_i=1,2..n )It's just the composition of SRIs in combination with the special SRI of 'the change in environment' that creates a major accumulated (explosion) Soft-Risk that may eventually result in a Soft Risk Loss (SRL). However, once the SRL has occurred and has been measured, the corresponding SRI becomes a 'normal' Risk parameter.

Are there more Google SRIs?
Yes! One of the best Soft-Risk Indicator blogs of 2009 is written by Googles leaving lead visual designer Doug Bowman, it's called:

Goodbye, Google

Please read the next extract of Bowman's blog from a risk management perspective, as he explains his decision to leave Google after three years.

- 20 Mar 2009 -

Goodbye, Google

Without a person at (or near) the helm who thoroughly understands the principles and elements of Design, a company eventually runs out of reasons for design decisions. With every new design decision, critics cry foul. Without conviction, doubt creeps in. Instincts fail. “Is this the right move?” When a company is filled with engineers, it turns to engineering to solve problems. Reduce each decision to a simple logic problem. Remove all subjectivity and just look at the data. Data in your favor? Ok, launch it. Data shows negative effects? Back to the drawing board. And that data eventually becomes a crutch for every decision, paralyzing the company and preventing it from making any daring design decisions.

Yes, it’s true that a team at Google couldn’t decide between two blues, so they’re testing 41 shades between each blue to see which one performs better. I had a recent debate over whether a border should be 3, 4 or 5 pixels wide, and was asked to prove my case. I can’t operate in an environment like that. I’ve grown tired of debating such minuscule design decisions. There are more exciting design problems in this world to tackle.

I can’t fault Google for this reliance on data. And I can’t exactly point to financial failure or a shrinking number of users to prove it has done anything wrong. Billions of shareholder dollars are at stake. The company has millions of users around the world to please. That’s no easy task. Google has momentum, and its leadership found a path that works very well. When I joined, I thought there was potential to help the company change course in its design direction. But I learned that Google had set its course long before I arrived. Google was a massive aircraft carrier, and I was just a small dinghy trying to push it a few degrees North.

I’m thankful for the opportunity I had to work at Google. I learned more than I thought I would. I’ll miss the free food. I’ll miss the occasional massage. I’ll miss the authors, politicians, and celebrities that come to speak or perform. I’ll miss early chances to play with cool toys before they’re released to the public. Most of all, I’ll miss working with the incredibly smart and talented people I got to know there. But I won’t miss a design philosophy that lives or dies strictly by the sword of data.

The resemblance between Google and the financial sector is striking.
Can you see it?

Simply replace the next words in the above 'Google, Goodbye' article:

Google => X-Bank, Engineer => Accountant, blue => risk strategy
Design => Risk, border => uncertainty, pixels wide => promille

To help you, just press the next 'replace button' to change the text in the article and read the text again. This looks astonishing familiar, doesn't it?

Replace

More Soft-Risk Indicators
Bowman's blog makes clear that there's another Soft-Risk Indicator, called:

Data Decision Tunnel Vision

• Every decision in only based on data and models.
• Intuition and Fingerspitzengefühl are banned.
• Craftsmanship is not respected, but must be proved in detail with evidence based on facts and data.
• Possible events that can't be translated into (financial) data are not recognized as risk and are ignored.
• Events that don't fit into the data model are reformed until they do fit in
• Micro management confines the development of a helicopter view on the main risks

Although the list of Soft-Risk Indicators is endless, I'll try to list some common examples (mail me if you have more SRIs examples).

Examples of SRIs

• Frequent or unexpected change of CEO or other board members
• Unexplainable or untimely Actuary or Accountant change
• Intentions of board members not in line with policy
• Too good to be true revenues, profits, reporting or communication
• Delay in reporting or publishing
• Lack of transparency
  
• Conflicting statements or publications
• Main (unexplainable) shareholder changes
• Over-explaining by board members
  
• Unexpected main reallocation of assets
• Vacancy or Recruitment stop; Reorganizations
• A company takes extremely more risk after a HQ-Risk Analysis
• Increasing customer dissatisfaction
  

Soft-Risk or Risk?
Most of the SRIs are not present or recognized as Risk in our models. Why? Simply because SRI losses are not in the data we analyze. This could be (1) because of the very low occurrence probability of a SRI loss (the loss simply didn't occur yet), or (2) because most of the SRIs aren't identified as SRI or Risk at all, as they simply do not exist yet. Just like a sleeping virus, they might come into Risk Existence on basis of (unknown) future (environmental) changes.

The key difference between 'Risk as we now it' and a SRI is that a SRI is by definition 'not measurable'. SRIs manifest themselves directly in practice as a (non-directly traceable) loss occurrence.

VaR Models fail
This also implicates that our traditional VaR models are definitely wrong, because they only include 'risks of the past' en no 'future risks', e.g. Soft-Risks. These VaR-models significantly underestimate the risk in the tail.
Problem is that as VaR-probabilities are getting smaller and smaller (0.5% or less) it also gets increasingly more difficult to prove the models are right. Consequently the VaR-model loses his power.
Backtesting and recent studies show that we ought to be able to identify most bad VaR models, but the worrying issue is that we can't find any good models, moreover because SRIs are not in the model.

Denying Soft-Risk Indicators: The Meltdown
You might think 'Who cares about SRIs if you can't measure them?". Well, let's see what happens if we deny Soft Risk Indicators.

The most likely dead-end meltdown scenario of denying Soft-Risk Indicators goes something like this:

• The first years of a company's life is a race for revenues. Risk Management is on the second plan, as there's little to lose.
  
• After a few years revenues and profits grow, but become vulnerable and volatile. A new Board is appointed and a Risk Management Plan (RMP) comes in place to stabilize and improve results and to guarantee continuity.
• After the RMP has shown fantastic results for some years, some strange unexpected serials of events (SRIs) happen. The Board consciously discusses the effects of these events and concludes their company's results are not infected by the events. Moreover, company results are better than ever and the company's RMP has proven to be (Titanic) watertight.
  
• To be sure and transparent the Board checks its conclusions by ordering an external risk audit. The external auditor is just as biased as the Board and confirms the Board's conclusions: RMP is O.K.!
  
• Suddenly there's a totally unexpected big accident, a substantial one of loss. At first things still look under control, but soon the situation takes over. The board is no more in control. The company is lost.
  
• Soon all stakeholders are flabbergasted. How could this happen?!

Well it's clear, what happened is that the Board misinterpreted and neglected early warning signs and SRIs, resulting in a company meltdown.

How to prevent a melt down?
To prevent a situation like the one above, the board should

1. Set up a SRI-Register
   
2. Order the RM-Department to include SRIs in their risk model
3. Discuss the integral SRI-register monthly in the Board meeting
4. Interprete the SRIs, and take proactive actions to prevent the SRIs from becoming critical. This is Board's Craftsmanship!

As continuity is a company's main goal, managing uncertainty is the Board's main responsibility.

Redefining Risk
Once we realize that Soft-Risks are crucial in Risk Management, how can we include them in our Integral Risk Model (IRM)?
First we'll have to redefine Integral Risk as follows:

(1) I-Risk = Integral Risk = Measurable Risk + Unmeasurable Risk
(2) I-Risk = Integral Risk = Hard Risk + Soft Risk
(3) I-Risk = ∑( Threat_j x Vulnerabilityj x Cost_j ) +∑ E(SRI_i=1,2..n)

Keep in mind that the Integral Risk is not a number, as the SRL is not measurable. If you can't force your brain to 'quantum think' this way, just imagine the Integral Risk as the total company value (at stake).

Cleaning up
First 'cleaning up' action we can do is to investigate the relationship (correlation, covariance matrix, etc.) between each past assumed Soft-Risk event and the Vulnerability of each Hard Risk event. This tells us probably something of the influence (correlation) of certain (combination of) SRIs on the traditional Hard Risk parameters.

Probably this research will show that some of the SRIs could even be defined as Hard Risk variables. Unfortunately this investigation - as explained -won't tell us anything about the real unmeasurable Soft-Risks. The problem remains.....

Managing Soft-Risk
The real main problem is : If you can't measure Soft-Risk, how can you be sure your 'Soft-Risk Management' (SRM) is successful, as you can't measure the effects of your actions either?

This seems to be an insolvable problem. Insolvable because of what Bowman in fact calls our 'mono data mind set'. We are not trained in taking decisions without data. As we are not trained, we become unsure. Unsure about the risk of the impact of our decision, that is unmeasurable as well. Full circle, we're back where we started.

However, there's a way out of this paradox, it's called

Principle Based Risk Management

Before we dive deep, let's first take a step back and have a look at two important actual developments, (1) the Global Warming Problem and (2) Solvency II.

(1) Global Warming Problem
During recent decades scientists have developed different global warming models that contradict each other. The real climate is far too complex to be modelled. We could spend millions of dollars on research to find the ideal model, we will never succeed!

Step by step the leaders of this world recognize that they'll have to manage the global warming in a different way. It's no longer important whether or not there exists a provable global warming problem. The main question is whether we are willing to live up to the principle: "You don't foul your own nest"

This way of principle-based thinking requires reflection on the level of 'spaceship earth', on a 'global' level. However, simultaneously, it urges for acting in line on a 'local' level.

Although related with The Precautionary Principle, Principle Based Risk Management is much more fundamental. It's an adequate tool for fighting Soft-Risks.

(2) Solvency II
In our aim to strengthen the insurance industry solvency, implementation of Solvency II bears the a risk of an overshoot. Instead of managing risks first and in a better way, we translate every risk into capital requirements, consequently increasing the cost of doing business and insurance premiums. It's the perfect example of putting the cart before the horse. Although we expect Solvency II measures to work out in a better solvency, in reality we don't know, as this 'capital-increase scenario' hasn't been tested before and can't be tested. The presumed positive effect could just as well be adverse.

In our aim to avoid risk, we've created another additional risk. A risk we can't measure (yet). Yes, unfortunately, Solvency II is a SRI as well.

Instead of making Solvency II obligatory, a far more effective Principle Based response from the Regulator would have been:

"Prove us that you manage your own risks"

Back to Soft-Risk Management
It's not that difficult managing Soft Risks Principle Based. In fact we all have experience with Soft Risk Principle Based decisions when we decided to have friendship, marry, or to have a child. Or did you calculate the 'lifetime present value' of your child?

Try to apply the above principles in your own company or in your own department. Just start by investigating your Soft-Risk Indicators and start managing soft and hard risks Principle Based.

What principles can we formulate to manage Soft-Risk?

Well actuarial folks.... that's food for another blog as this blog is getting far too long..... O.K. .... I wont keep you waiting, just one Principle Based one-liner that tackles a whole bunch of SRIs at once

Bonuses are only paid in case of
High Customer Satisfaction

Related (additional) Sources:
- Unmeasurable measures: The lawlessness of great numbers
- The Risk Equation
- An Additional Way of Thinking... :The Quantum Perspective
- From Principle Based Risk Management to Solvency Requirements
- Measuring the unmeasurable
- Managing Extraordinary Risk (2009, Towers Perrin)
- Measuring the Unmeasurable: Balanced Scorecard
- NYT: Risk Mismanagement
- Backtesting Value-at-Risk Models (2009)
- Quality control of risk measures: backtesting VAR models
- Metrics: Overmeasuring Our Way to Management

Once-in-a-Century Credit Tsunami

When will the next crisis happen and what magnitude will it be?
Investor or actuary, this question puzzles our mind, isn't it?

In the Financial Analysts Journal (January/February 2010) professors Guofu Zhou and Yingzi Zhu raised a similar key question:

“Is the Recent Financial Crisis Really a ‘Once-in-a-Century’ Event?”

Actually Zhou and Zhu did research on a 'October 2008 congress quote' by Alan Greenspan:

We are in the midst of a 'once in a century' credit tsunami
--------------------------------------------------------

--------------------------------------------------------

Zhou and Zhu Research
Given the fact that the Dow Jones Industrial Average (DJIA) dropped more than 50 percent, from 14,164 on 9 October 2007 to 6,547 on 9 March 2009, Zhou and Zhu answered the question whether a drop of 50% would be likely to occur once in a century.

Using daily data on the DJIA from 26 May 1896 to 19 June 2008, Zhou and Zhu estimated the long-term average DJIA-return (sample) at µ = 7.4% (excluding dividends) and the long-term volatility, known as the sample standard deviation, at s = 18.2% a year.

DowJones Industrial Average
May 1896 - June 2008
Average return: 7,4%
Standard deviation: 18.2%

On basis of the long-term data, Zhou and Zhu calculated the probability for the market to drop more than 50 percent from a high to a low over a 100-year horizon, considering two different models:

1. Random Walk Model, excluding dividend
2. Long Run Risks Model: complex dynamic simulation model, including consumption growth, dividend growth and asset prices

Here is the summarized outcome of their calculations:


As is clear on basis of the Long-Term Risks Model (LTR-Model), no matter what average return or standard deviation, the probability of a 50% draw down over a 100-year horizon is practically almost 100%.

50% draw down over an n-year horizon?
Given these results of Zhou and Zhu, we can now easily and (very) roughly approximate the probability, P(n), of a 50% draw down over an n-year horizon.


with r= P(1). We now roughly 'fit' P(n) to the results of the Long-Term Risks Model as follows:


It turns out the LTR-Models roughly corresponds with one year '50% draw downs probabilities' between r=4% and r=10% [r=P(1)].
As is clear from the table above, even over a 10-year period there's a substantial probability, somewhere between 33% and 65%, of a 50% market breakdown.

Also we can be more than 90% sure to become a witness of a market tsunami once in a lifetime......

The next market tsunami
Up to the next market tsunami, I would guess...., as tsunamis don't have a memory or allow themselves to fit into statistics or models like the ones mentioned above. Unlike natural sea-tsunamis, we - ourselves - are responsible for creating these 'financial tsunamis'.

Irrational Risk Attitude
But even if we are aware of the risk and are not responsible for creating the risk, we have an irrational risk attitude as human beings.
With the recent (2010) Haiti earthquake fresh in mind, let's take a look at the way we deal with the probability of an earthquake.

Los(t) Angeles .....................?
According to the 2007 Working Group on California Earthquake Probabilities (WGCEP 2007) the probability of a magnitude 6.7 or larger earthquake over the next 30 years striking the greater Los Angeles area is 67% (mark the similarity in our P(n) table!).

Yet we deny this reality and 'hope' for the better. Perhaps if every city would have to value the estimated fair value of this earthquake expectation in his balance sheet, things would change. However, I doubt.....

People act irrational with regard to Risk. If we can't manage it, we deny it. If we can manage it, we screw it up!

Sources
- Article Is the Recent Financial Crisis Really a ‘Once-in-a-Century’ Event?
- Wall Street Journal article, October 2008: Greenspan
- Credits: CFA Institute
- California Earthquake Probabilities
- Download Spreadsheet of tables used in this blog

US Employment Rate Halleluja

As a professional actuary, just take a look at the next selected "Dave Rosenberg's charts" , showing:

• Chrt2: The true measure of US Joblessness end 2009: 17%
• Chrt3: Median duration of unemployment rose to 20.5 weeks
• Chrt5: Overall employment rate is 58%, lowest since 1983

You don't have be an actuary to understand the importance of a healthy Employment-to-population ratio, given the increase of the 'aging population' in the next decades....

As an expert in statistics, would you say we're on the right track?
What would you advice US?

Used Sources:
- Excellent original article by Dave Rosenberg (pdf)
- The lost decade
- Forget Unemployment, The Real Nightmare Is EMPLOYMENT
- Dutch: De Amerikaanse banenhoax

Actuary - Best Job in the World

'Actuary' ranks as the best job for 2010, based on research into 200 different positions in this year's exclusive CareerCast.com Jobs Rated report and published by The Wall Street Journal.

Using five key measurement criteria – stress, working environment, physical demands, income and hiring outlook – the Jobs Rated report seeks to compare and contrast careers across a multitude of industries, skill levels and salary ranges, sorting them into a definitive ranked list of jobs.

So why is Actuary rated number one?
For starters, the position ranks especially well for its low physical demands and stress levels, finishing 2nd and 3rd, respectively, out of all 200 jobs. But more importantly, it is actuary's consistently strong performance overall that helped the job rise to the top of the 2010 Jobs Rated list.

Who says being an actuary is boring?
Interested in a zero unemployment profession?

Risk Management Humor

Happy new year! At the start of 2010 let's have some 'serious fun' with the next

Actuarial Risk Management Puzzle Joke

Three actuaries and three accountants are traveling by train to visit a 'Risk Management Conference'. At the station, the three accountants each buy tickets and watch as the three actuaries buy only a single ticket.

"This looks very risky. How are three people going to travel on only one ticket?", one of the accountants asks.

"Watch and you'll see! Take notice of our brand new risk management approach", one of the actuaries answers.

They all board the train. The accountants take their respective first class seats, but all three actuaries cram into a restroom and close the door behind them.

Shortly after the train has departed, the conductor comes around collecting tickets. He knocks on the restroom door and says, "Ticket, please." The door opens just a crack and a single arm emerges with a ticket in hand. The conductor takes it and moves on.

The accountants were deeply impressed by the actuarial approach and agreed it was - after all - quite a clever idea without any substantial risk.

So, completely confident and with even more Risk Management skills gained at the inspiring Conference, the accountants decide to copy the actuaries new risk approach on the return trip and save some money (accountants have always been clever with money!). When they get to the station they buy a single ticket for the return trip.

To their astonishment, this time the actuaries don't buy a ticket at all. "This is reckless, how are you going to travel without a single ticket?", one of the perplexed accountants asked. "Watch and you'll see! Take full notice of our latest risk management approach" answered an actuary.

When they board the train the three accountants cram into a restroom and the three actuaries cram into another one nearby. The train departs.

Stop
Here the story stops for a moment. Let's find out if you qualify as a Actuary Risk Manager (ARM) or - otherwise - could better have become an accountant.

Can you finish the story? What was the alternative Risk management Plan of the actuaries?

Just check the next box (or go to the original Actuary-Info Blog site) to find the right answer.......

Solution

Shortly afterward, one of the actuaries leaves his restroom and walks over to the restroom where the accountants are hiding. He knocks on the door and says, "Ticket, please."

Conclusions
What conclusions can we draw from this simple story?

• Risk Management is a game without end
  
  
• The effect of Risk Management Conferences is threefold:
  
  1. Some attendants get smarter
  2. Others get overconfident
  3. Final result: Increasing Risk, instead of decreasing Risk
  
  
• There's an old Dutch saying that expresses the danger of increased Risk Management :
  
  
  "A warned man counts for two"
  
  
  
• If we want to reap the fruits of Risk Management, accountants and actuaries have to start working together, instead of struggling and competing each other.
  
  
• Risk Manager Profile and qualifications
  Insight, creativity and integrity are important requirements to become a professional Risk Manager. Unfortunately, this is not enough.
  
  To tackle Risk Management in a company, you need the best potential crook around. One who's willing to settle his salary and earnings for a little less than he would have earned as a real crook, in return for having a respectable job and not risking to end up in jail. You could call it the Personal Risk management of the Risk manager. Employers that settle for an inferior Risk Manager, know one thing for sure: someday somebody more 'crooky' than 'your risk manager' will tear your company down!

With some humor, we've gained new insights in the challenging world of Risk Management. Anyway, a Happy & Healthy 2010 !

Control Leverage

Key question is whether 'adding more control' will stabilize financial institutions like banks, insurance companies or pension funds.....

With all the - apparently failing - new legislation of the last decade already in place and new control measures like Solvency II and the strengthening of the Basel II Framework ahead, one might - at least - question whether we're on the right track with this intensified 'control approach'.

Will adding more control
empower or paralyze financial institutions?

In other words: Is the Control Leverage Effect positive or negative?

Insurance
In an FT-Adviser article called 'Solvency II costs are unsustainable', Joy Dunbar reports that the ABI (Association of British Insurers) has warned that the costs of implementing Solvency II regulations could destabilize the industry across Europe.

To gain more control (financial stability), European Insurers are obliged to implement Solvency II measures by the end of 2012, starting already in 2010.

Impact Solvency II
The increasing control costs and capital demands of Solvency II will have an enormous impact om the insurance market:

• Recapitalization: Insurers need to acquire fresh equity capital (billions of Euros) in the market
  
• Over-Capitalization: More 'dead' capital is created in financial institutions, resulting in declining investment returns in insurance.
• Market shake out: Companies will exit the market
• Pricing effects: prices (premiums) will rise, cover will be reduced

Banks
Whereas the European Insurers are on a more or less 'blind track' with regard to the implementation of Solvency II, the banks - according to chairman of the Basel Committee Mr Wellink - stressed that "decisions on the final proposals and their calibration will be made only after a thorough analysis of the impact assessment and the comments received on the consultative documents. The Committee will ensure that implementation of the new standards is consistent with financial market stability and sustainable economic growth".

The real problem
One doesn't have to be an actuary or financial expert to conclude that we're at the end of the road where adding more of the same type of control measures will substantially stabilize our system.

Without diving deep into real life quantitative analyses, let's get a helicopter-view and take a look at an average 'Control-Return Matrix' to do some 'rule of thumb' exercises...

Rule of thumb Control-Return analyses

Phase I
A few decades ago, starting in the good old sixties of the twentieth century, there where only limited control measures in place (control=0). The average Return on Equity (ROE) of a company was (e.g.) 6% and although Value at Risk (VaR) didn't yet exist as such, the 6% ROE could easily swap between (e.g.) +15% and -50%.

Financial markets where not that developed as today (no derivatives, , CDS, etc). Systemic risk was almost non-existent and accounting principles where based on the simple and relatively stable method of 'historical cost'.

The need for 'more control' was clear to everybody. More control implied lower costs, 'more opportunity insight' and 'more risk control'.
More control turned out to be a good investment and would lead to realizing a better return (ROE) in combination with a lower risk (Var) and a higher 'upward potential'. Every stakeholder was happy.

Phase II
Getting into the eighties and nineties of the twentieth century, 'control' had done its major job and still did, as it was able to manage the few relatively small recessions in those years.

With the help of the oncoming heavy computers, the first baby steps regarding new risk management techniques and ALM (Asset Liability management) were taken.

This way major risks (VaR) could further reduced, sometimes at the cost (expense) of a small reduction of the ROE. But this small effect was largely compensated by the 'fallacy high returns' in the high trust market.

Phase III
At the beginning of the Twenty First Century a new recession made clear the financial environment had substantially changed:

• New techniques, models and the use of modern computer software led to new markets and new products like derivatives
• Markets became global, (on face) transparent, in open competition
• A lack of insight with regard to systemic risks
  
• Differences in local supervision, legislation, administration and accounting rules, led to a complex, non-transparent global market.
• In order to be able to compare companies, they had to be valued at 'market value', implicating the birth of more volatile (stock) markets....
• Step by step, the public and media became more conscious. Investors and consumers understood that even if a 0.5% VaR level would be further reduced, it wouldn't make any sense because it would be always overshadowed by the non-trackable, nor manageable, risk of let's say 1 à 2%. And moreover, who would trust his money to a bank that would go bankrupt once every 50 or 100 years....
  
  

Investors, Boards, Managers, everyone lost their handrail....

In the recent decade (2000-2010) things got worse :

• Existing control and accounting systems would locally differ and failed to meet the complex demands of the new markets
  
• Supervisors en regulators, normally ahead of the market, were suddenly one step behind and unable to catch up given the actual system of supervision
  
• It had become clear that new financial products ( e.g. CDOs, CDSs, subprime mortgages, swaps, swaptions) had been introduced without a good understanding of their financial construction or risk
• Turbulence in the markets. Relatively stable stocks of big international firms, suddenly appeared remarkably unstable, due to new volatile markets/products and 'fair value accounting'.
• The once so well controlled VaR risk exploded, due to these new types of risk in the market, the fair value accounting principles and the spooky systemic risk.

Way out
Like everyone else - totally flabbergasted - supervisors and regulators immediately grabbed the traditional emergency brake of 'more control'.

Unfortunately, more 'traditional' control in phase III will not have the same effect as in phase I or II. The effects of more traditional control in phase III will be:

• Substantial but unsure decrease of ROE and 'upward potential'.
  The effects are not known upfront and can't be estimated well.
  Sure is that the costs of extra control and 'dead money' will have a negative impact on the ROE.
  
  
• Unknown and questionable reduction of VaR risks, as one thing is sure: the new type(s) of (VaR) risks can not be estimated by our retrospective based models. Probably, all efforts in vain, the remaining actu(ari)al risk level will not be substantially reduced.
  
  
• Trying to 'catch' more 'safe' risk levels (lower α , VaR) will lead to over-capitalization and 'dead' money in the balance sheet and an unbalanced growth of derivatives.
  
  

• The market of derivatives continuous to grow.
  
  The notional value of derivatives held by U.S. commercial banks increased $804 billion in the third quarter to $204.3 trillion.
  
  This, despite the statements of Fed Chairman Bernanke who says he wants to avoid the possible risk of a future speculative bubble.
  
  And despite of Treasury Secretary Geithner who says he wants to reform financial regulation to avoid a future debt disaster.
  
  
• Because the real issues of the financial crisis where not solved, but only covered up with government help (money), new uncontrollable 'bubbles' will keep showing up.
  

Solutions
probably the best solution is not 'more control', but

Other Control

Examples of 'other control' are:

• Obligatory report and central registration of all derivatives under one worldwide supervisory. This way systemic risk analyses won't be 'guess statistics' anymore and can be managed. System risk is one of the weirdest risks to tackle, as is illustrated by the next article:
  
  Why Your Friends Have More Friends Than You Do
  
  Although the Exchange Commission has taken some serious steps in 2009 to regulate and strengthen the over-the-counter ("OTC") derivatives, this process will probably not be rigorous and fast enough to prevent a possible new bubble or collapse.
  All OTC market products should be asap standardized on a centrally administered basis.
  
  
• Limit and control the derivatives market. Maximize the derivative market in respect to the 'normal' market. Limit each companies derivatives in line with his equity. New regulation should also be developed with regard to participating in non defensive (strange) derivatives (e.g. define max. exposure multipliers).
  If not the next bubble is a fact!
  
  
• New derivatives should be subject to approval ('no objection') by the regulator before market launch.
  
  

So it all comes down to the 'right control' leverage.
It's either positive leverage with 'new other control' or negative leverage with 'more of the same traditional control' and waiting for the next bubble. What do you prefer as an actuary?

Sources:
- Contagion in Financial Networks
- Testimony Concerning OTCs (Over-the-Counter Derivatives )
- OCC’s Q3 2009 Report on Bank Trading and Derivatives Activities
- The bigger and riskier monster....
- Tarp facts: The Troubled Asset Relief Program
- The Investment Fallacy

Systemic Risk

In an excellent paper called 'Defining and Measuring Systemic Risk', professor Sylvester Eijffinger of the Tilburg University discusses actual developments around one of the most interesting risk topics of this moment: systemic risk (not to be confused with systematic risk).

Just a short warming up to actually download and read this excellent article:

ESRB
Main target of the 2010 launch of the European Systematic Risk Board (ESRB) is trying to identify and avoid future financial crises before they start. This implies that ESRB's main issue is 'how to detect systemic risks '. All this -of course - under the lead of the European Central Bank (ECB).

First of all the ECB does not have a clear concept of systemic risk, nor in the academia there exists a generally accepted definition. However, the G10 definition provides a good starting point:

Systemic risk
Systemic risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy

This still sounds pretty complex, and it is.
To get the right feeling, take a look at the next diagram illustrating a network of Credit Default Swaps (CDS) contracts:

In his blog 'complexity is our enemy' Steve Hsu, Professor of physics at the University of Oregon, explains in short and in simple words the principles and problems of the Credit Default Swap Market.

Hsu perfectly illustrates why some financial institutions are 'too connected to fail', as opposed to 'too BIG to fail'. Systemic risk is all about complexity.

New early warning models
There are several new models that can predict a financial crisis. Key challenge is to find a model with an indicator that predicts a potential crisis (just in time) with high probability, while at the same time minimizing errors of type I errors (missing crises) and type II false alarm).

One indicator can be qualified as the best current performing indicator: 'The global private credit gap', by Alessi and Detken (2009). This method predicts 82% of the crises correctly and has a 32% share of false alarms. 95% of the crises (price boom/bust cycles) are signaled in at least one of the 6 preceding quarters and the difference in the conditional and unconditional probability of a boom following a signal is 16%

Individual Institutions’ Contribution to Systemic Risk
For measuring risks of individual banks, a measure called CoVaR was developed by Adrian and Brunnermeier. The CoVar model measures the marginal expected shortfall (MES) as used in Value at Risk (VaR) as well as the systemic expected shortfall (SES).
Eijffinger's Conclusion
Finding new early warning instruments that are effective, easy to use, and independent of the interest-rate instrument seems to be an impossible task. And yet there is a solution according to Sylvester Eijffinger: "Central banks should give the growth of (broad) money supply more prominence in their monetary policy strategies."

The ECB with its often criticized monetary pillar may have a head start. Important central banks, such as the Bank of England and the United States Federal Reserve, kept their key interest rates too low for too long leading to a long period of double-digit growth in money supply.

The ECB was more cautious. To be sure, the fall of he risk premium on financial markets, the development of all kinds of exotic derivatives, and these derivatives’ subsequent misuse sowed the seeds for this crisis, but those factors could not have caused the crisis without the plentiful rainfall that allowed those seeds to grow.

Finally
What can pension funds and insurers learn from this?
The answer is simple:

• Make Risk Management top priority nr. 1
• Develop and implement in advance - cross financial institutions - early warning models.
• Insist upon regulators to create a world wide central registration data base that registers and reports all possible derivate transactions in the financial market. Every financial institution has to report every transaction in a preformatted form.
• New financial products are subject to approval ('no objection') by the regulator before market launch.

This way regulators will have a complete transparent view cross financial institutions. Systemic problem solved.

Sources
- Eijffinger:Defining and Measuring Systemic Risk
- The global private credit gap
- CoVaR modelM
- Steve Hsu: complexity is our enemy

Out of the Box Actuary

So you're one of those rare actuaries who thinks he really can think outside of the box?

Well, this is your lucky day. Out of the dark chambers of Actuarial Science, professors developed a brand new test for financial experts like actuaries, to find out if you qualify for the new title

Actuarial Master
Out of the Box Thinking

Most remarkable is that this test consists of only one simple question.

If you manage to give the right answer to this question within 10 seconds you'll qualify for the title. If it takes up to one minute, you'll qualify for your bachelor's degree. If it takes longer, don't be ashamed, just stay "Qualified Actuary".

However, if you don't succeed at all, simply change your title to Actuweary...., nobody will notice ;-).

In case you need help to find the right answer, you are allowed to use this tip.

Now, I will no longer keep you in suspense, here is the key question:

Just click the picture, to find out the right answer!

If you unexpected failed to come up with the right answer, please read the next fabulous blog to escape your expert view:

Are you stuck in a rut? Run from the experts!

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

Actuarial Health Care Reform Puzzle

From a European perspective it's hard to understand why the US Health Care Reform creates such a fuzz.

Behind Health Care Reform
At first sight one might think American values were somehow at stake, as UCLA's Dr. Marc Nuwer, a leading expert on national health care reform, stated back in 2008:

• "To heal our ailing health care system, we need to stop thinking like Americans."
  
  
• "Americans prize individual choice and resist limiting care"
  

As one-sixth of Americans are uninsured and especially elderly people are in need of good (insured) health care, one would expect this group to support this new health reform. Think again, the majority of elderly people voted against a guarantee of health insurance for all Americans:


Not a surprise for actuaries of course, because we were already aware of the interesting age-distribution of the uninsured.



Recently, Tyler Cowen, a economics professor at George Mason University additionally stated : Further health care reform doesn’t now seem to promise much to old people, except spending cuts on them. Given their limited time horizons, old people don’t so much value systemwide improvements, which invariably take some while to pay off.

For those of you who are interested in the background and consequences of pay offs regarding limited time horizons, (generation) discount rates and 'Gamma Discounting', the article Caring about the Distant Future: Why It Matters and What It Means from professor Tyler Cowen is a joy to read.

Certainly a 'must read' for actuaries.

Future Health Care Reform

Anyhow, the House of Representatives passed the sweeping health care bill recently.

Puzzle is that this bill has nowhere to go in the Senate, as the stumbling block is that government will have to compete with the private insurers.

The solution to this problem is as simple as can be:

Implement the headlines of the Dutch Health Care Model

Key elements of the new (2006) Dutch Health Insurance Act are:

• All adults are obliged to buy health insurance and can choose any insurer
• Children (under 18 years) are insured for free
• Low income groups receive financial compensation by tax reduction
• All insurers must offer a (governm. def.) policy to anyone who applies
• Basic benefit package is almost comprehensive
• Insurers get compensation for taking on higher risk patients from the risk equalization fund
• Insurers can offer complementary health insurance packages under free market conditions
• Consumers have the right to change insurer at the end of every calendar year if not satisfied or if they change employer
• Insurers have the role of prudent purchasers of health care
  (value for money)
• Providers are encouraged by insurers to deliver high quality care at low costs

In a 2009 Irish (Dublin) Health Actuary Seminar called 'More for less', the Dutch health actuary Enne Osinga explains more of the consequences of this new (2006) Dutch Health Care Model in a presentation called: The Dutch Experience .

I trust the US succeeds in making this important turn around!

Sources:
- Tyler Cowen: Caring about the Distant Future: Why It Matters..
- Economics
- Yahoo
- CNN
- UCLA
- Health Coverage & Uninsured (2009, 2007)
- RIVM Article:Regulated competition behind the dykes?
- Enne Osinga: The Dutch Experience

Invest or laugh

Every crisis generates his own new quotes. Currently, investment quotes are the top.

Perhaps two of the best investment quotes ever are from AIG Vice Chairman Jacob Frenkel:

"The left side of the balance sheet has nothing right and the right side of the balance sheet has nothing left. But they are equal to each other. So accounting-wise we are fine."

--------------------------------------------

"Credit markets do not function. Why not, because the word credit comes from credibility"

But there's more... A nice summary of investment ROFL quotes can be find on Ian Thomson's blog Investor Jokes.

As actuaries, let's profit from Ian's latest insights and gain some extra education points by studying the next new investment definitions:

• A long term investment: Short term investment that failed.
• Momentum Investing: The fine art of buying high and selling low.
• Value Investing: The art of buying low and selling lower

Probably investors and actuaries will have a hard time understanding each other, as the difference between them is in the 'tail' .....

Also large-cap fund managers have a hard time these days. No wonder everybody starts looking for a small-cap fund manager....
But how do you find one? Ians' answer is simple: Find a good large-cap fund manager, and wait...

Anyhow, keep up your good mood and laughs, as more investment 'animals' will show up next months.....


Let's conclude this blog with an old actuarial warning:

"Where there's smoke, someone gets fired"

P.S. For some more 'serious' investment quotes take a look at 52 Must Read quotes from the legendary Investor Warren Buffett. I'll quote some of the best here:

• I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.
• If past history was all there was to the game, the richest people would be librarians (actuaries?).
• It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
• It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.
• It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
• Price is what you pay. Value is what you get.
• Risk comes from not knowing what you’re doing.
• Risk is a part of God’s game, alike for men and nations.

How can actuaries profit from Buffett's quotes?

Sources:
- Greekshares Jokes
- Ian's Investor Jokes
- Warren Buffett: 52 Must Read quotes

CERA: Actuaries on a new track

Actuaries are taking a new step towards professional risk management.

After the U.S. started in 2007 the initiative for this new direction in the actuarial profession, this month the Society of Actuaries (SOA) signed a treaty with 13 other international actuarial organizations to establish the Chartered Enterprise Risk Analyst (CERA) as the globally recognized enterprise risk management (ERM) credential.



The designation will recognize actuaries globally who meet stringent education requirements in ERM and are governed by a strong code of professional conduct. The “CERA” letters after an actuary’s name indicates to the business world that there is no other type of risk professional better equipped to take a 360-degree view of an organization’s risk profile.

CERAs don’t merely speak to what we can lose, they focus on what we can gain.

Enterprise Risk Management isn't just about dealing with financial risk. ERM is an attitude, a new way of thinking. CERAs will become the boards most reliable advisors, they can't do without.

Sources:
- SOA
- CERA

Reward Wisdom

We all know the quote

'If you pay peanuts you get monkeys'

Unfortunately the opposite is also true:

"If you pay bonuses, you get donkeys"

There is nothing against an attractive yearly bonus reward, based on challenging but nevertheless realistic (long term) goals in line with a confirmed and balanced risk approach.

Excessive bonus rewards however, seduce people to inferior (selling) methods or taking unacceptable (covered) risks.

An excessive bonus reward system always poisons the company and attracts the 'wrong' people. Your company doesn't need high risk takers or 'luck seekers'. Think twice....

Risk IQ Test

What's your Risk IQ?

In a few minutes you'll know by taking this RISK IQ Test.

Actuaries are often born CROs (Chief Risk Officers), so this test will probabely be a peace of cake for any actuary with CRO aspirations.....

Simply scroll through the next Powerpoint presentation from Fintools.

Each slide contains a multiple choice question.
Think about the answer and then scroll (click on the right part of the presentation) to the next slide for the final answer...
RiskIQ

Hope you succeeded....

If not... get some training at Fintools

Original Source: Fintools