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Expert Input On The Current Financial Crisis: Did ERM Fail?

Expert Input

On The Current Financial Crisis: Did ERM Fail?

By Robert Wolf

As part of the series on The Evolution of Enterprise Risk Management, this article gleans the thoughts, commentary and insight from the authors of the recently developed e–book titled, Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications.

The current financial crisis has been called a "financial tsunami" by former Federal Reserve Chairman Alan Greenspan. Many are calling it the worst financial crisis since the Great Depression. Its ramifications are far–reaching and will question risk management practices for years. What lessons have already been learned? What can we, the premier enterprise risk management (ERM) profession, offer in terms of thoughts, insights, suggestions and proactive solutions to mitigate future problems? I believe this is a great opportunity for the actuarial profession. We can make a difference by sharing our recommendations for ERM best practices.

We've taken an important step toward this goal, a step inspired, in part, by The Economist magazine, which recently issued a call for papers on the financial crisis from experts in the field.

Representatives from the Joint Risk Management Sections of the Society of Actuaries (SOA), The Casualty Actuarial Society (CAS) and The Canadian Institute of Actuaries (CIA), the SOA's Investment Section, the International Network of Actuarial Risk Managers, and the Enterprise Risk Management Institute International, coordinated a Call for Essays on "Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications."

The response was tremendous. Presented here are excerpts of the insightful information from some of the essays submitted.

EXCERPTS FROM THE EXPERTS

One of the topics discussed was how interconnected our economy really is, and how the bursting of one bubble (in housing) was able to collapse the entire economic house of cards around the world.

In his essay, "Risk Management and the Financial Crisis: Why Weren't We Protected?" Mike Batty, FSA, CERA, a consultant at Deloitte Consulting LLP, says:

"Due to the explosion of the originate–to–distribute business model (fueled by the growth of securitization) underwriters of suspect home loans were freed from significant responsibility for whether the loans could ever conceivably be repaid. ...

"They passed the questionable loans onto highly–leveraged investors and then focused on their core competency, making more loans. As the demand for these mortgage–backed securities skyrocketed, underwriters tapped pools of more and more suspect borrowers."

Some discussions of the crisis have reflected on one question: did ERM fail? After all, companies touted to have a strong enterprise risk culture were brought down by the decisions and strategies that, in hindsight, were clearly not in their best long–term interests. There are many ways to learn from recent events. The submitted essays and the resultant e–book, which is downloadable at SOA.org/Essays, offer thought–provoking discussions and commentary. Even though the authors of the essays worked independently, there are some clear commonalities and consensus between the papers. Enterprise risk management did not fail. It was never applied.

When bad things happen, there is a perception that ERM was unsuccessful. When bad things do not happen or good things do, does that mean ERM is a success? We haven't had a major terrorist event in the United States since 2001. Is enterprise risk management being rewarded for that? Should it? Or is it just fortunate luck that a similar catastrophic event of such magnitude hasn't happened in the last seven years?

Our profession faces this dilemma with employers and clients every day. If events turn out better than expected, we are accused of being overly cautious and categorized as naysayers. When bad things happen, or at least results come in worse than expected, we are told we missed the target. So goes the ongoing saga of an enterprise risk management professional. In part two of this series, I mentioned a more realistic approach to gauge the value ERM brings to the table. We should not necessarily search for a success story, but focus on the necessary changes in corporate culture that would produce a prudent ERM framework. Although enterprise risk management adds value in balancing risks and rewards, it is not meant to convey that it can eliminate risk in its entirety. Unfortunately, this is how the public values risk management.

In gleaning the lessons learned essays, several aspects of enterprise risk management are identified that are clearly necessary for its success. Without these necessary conditions, it is apparent that the discipline ultimately fails. These aspects relate to a culture that requires alignment of desired performance with incentives of managing risk and reward, and not just reward. There are many lessons to be learned from the essays. I suggest that five critical lessons for prudent enterprise risk management can be gleaned from the essay writers. They are:

  • Incentive compensation requires appropriate alignment with desired performance.
  • Nobody should have the authority to make decisions without accountability.
  • Do not assume the risks that you have not managed today, will be manageable tomorrow.
  • Remember the "M" in ERM is for management. Modeling is only the analytic tool.
  • Assume that in crisis mode, everyone behaves the same.

INCENTIVE COMP ALIGNMENT

In the two previous installments of this series about how actuaries make a difference in the enterprise risk management discipline, I mentioned aligning incentive compensation with ERM goals. This must be a critical component, if not the critical component, in developing a prudent ERM culture and framework. Never has it been more apparent than during an analysis of this crisis how key such a framework, when not existent, can be. It produces disincentives to even care about the risk tolerances of the organization. Our profession has a great opportunity to develop best practices in devising incentive compensation systems that are linked to risk–adjusted ultimate outcomes, rather than just outcomes.

In his essay, Neil Bodoff, FCAS, MAAA, senior vice president at Willis Re., says:

"... when reporting profit a key reform crucial to mitigating future crises is to ensure that we always measure profit on a 'risk adjusted basis.'"Further, he lists two critical reasons:

"1. It provides more meaningful information about profitability, 2. It reduces the incentive to take excessive risk in order to increase profits."

In his essay, "Your Mother Should Know," Dave Ingram, FSA, CERA, MAAA, FRM, PRM, senior vice president, Willis Re., says:

"Under most compensation programs, the business manager will be incented to continue business regardless of the risk. They are incented AGAINST risk management."

Overall, let's face it. How are most of us rewarded in incentive compensation? Results. Did our division achieve 10 percent growth? Yes. Did we maintain at least a minimum targeted profit margin? Yes. Great. Here's your bonus. No reflection or consideration is generally given as to how risky your procedures and strategies were in achieving your goals or how conservative or aggressive your accounting was to reflect the profit. Just get it.

In his essay, "Should You Have a Chief Skeptical Officer?" Max J. Rudolph, FSA, CERA, CFA, MAAA, owner, Rudolph Financial Consulting, LLC., concludes:

"When a firm's culture is driven by growth and manager incentives ignore risks taken, it is only a matter of time until the process implodes. People will naturally gravitate to practices that enhance their pay. That's why it is called incentive pay."

Let's think about Wall Street. Say GM misses the profit target that Wall Street projected. The stock drops. Then GM implements a comprehensive ERM framework. Wall Street shrugs. When a company reports profits to its shareholders, it is based on certain accounting conventions. The element of risk taking is very tricky and nearly impossible to glean out of a balance sheet today. Shareholders love profit, but if it can some way be risk adjusted, the amount of profit actually released may better bring to balance risk–return tradeoffs needed and increase transparency.

As a profession, actuaries analyze, compute, and price risk–adjusted performance in the pricing of insurance products every day. We certainly can provide this same skill set to help devise such a plan for incentive compensation. Granted, it would be a bold undertaking. It would require extensive reworking of compensation systems and, for that matter, accounting regimes.

In his essay, "Reaffirming Your Company's Commitment to ERM in light of the Financial Crisis," Prakash Shimpi, FSA, CERA, global practice leader, ERM at Towers Perrin, further states:

"Although this has been a topic of discussion for some time, the current crisis has demonstrated that compensation practices can be at odds with managing risk appropriately. We believe that compensation programs will undergo a transformation as companies attempt to rid themselves of inducements to exceed stated risk tolerances."

This is and has been the biggest hurdle in developing an ERM culture within an organization. This is our greatest opportunity to lead the way.

ALIGNING AUTHORITY WITH ACCOUNTABILITY

It is well understood that this crisis began with the housing bubble in the United States. The original underwriters of risky mortgages passed them on to leveraged investors, creating additional capacity. Investors did not perform appropriate due diligence and were not concerned about the lack of a prudent ERM framework. The original underwriters were, in essence absolved from any further accountability.

Louise Francis, FCAS, MAAA, serves as the CAS vice president in Research and is the founder of Francis Analytics and Actuarial Data Mining, Inc. She states in her essay, "The Financial Crisis: An Actuary's View":

"What makes this scheme particularly disastrous is that in the 21st century, Ponzi mortgages were packaged and sold to investors and then trillions of dollars of derivatives were constructed based on the underlying mortgages, magnifying the problem by orders of magnitude."

Optimizing any risk and return decision making requires an appropriate alignment of authority and accountability. Without this alignment you are left with "return" decision making (not "risk and return") and sub–optimal results.

Paul Conlin, FSA, an actuary at Aetna, states in his essay, "The Financial Crisis: A Ripple Effect of Incentivized Disorder":

"... a primary insurer can transfer risk to a reinsurer, but always remains on the hook if the reinsurer defaults. A mortgage loan must be a permanent arrangement between the lender and borrower—if this is not acceptable to either, no problem: no deal."

ASSUME WE CANNOT GET RID OF THE RISK TOMORROW

In his essay, "Against the Grain: The Wisdom of Countercyclical Capital," Jay Glacy, ASA, CERA, MAAA, ERM practice leader, Milliman, Inc., talks about the pro–cyclicality of capital and talks of how a very popular risk metric (VaR) actually added fuel to the fire.

"Right now, things look pretty good, so go ahead and make big bets. The problem is that 'right now' is not the appropriate time horizon for measurements of risk."

In his essay, Ingram says:

"Well, there are two different approaches to risk that firms in the risk taking business use. One approach is to assume that they can and will always be able to trade away risks at will. The other approach is to assume that any risks will be held by the firm to maturity. ...

"So the conclusion here is that at some level, every entity that handles risks should be assessing what would happen if they ended up owning the risk that they thought that they would only have temporarily."

Traditional risk management historically assumed that one could easily dish off or transfer risks at any time. In crisis mode however, the option to trade away risks disappears. This increases risks an organization thought it had transferred from its balance sheet. As actuaries, we see this all the time in assessing concentration risk. Catastrophe reinsurance may be there today, but could be more expensive tomorrow. Relying on today's risk transfer schemes, and assuming they will be in place tomorrow, is a dangerous assumption. The primary insurer should always consider the potential liquidity risk that would arise should reinsurers run for cover under crisis mode.

FOCUS ON MANAGEMENT AS WELL AS RISK

In his essay, Batty says:

"With the likelihood of extremely rare events always in question, and knowing our inherent biases in assessing them, we may find it beneficial to downplay the role of tail probability in our analysis, and instead ask questions such as: Are we comfortable with the knowledge that such scenarios might occur? How can we mitigate the risk? How should we react if those situations begin to play out?"

This gets to the point made in part two of this article series where I emphasized the need to get away from the focus on the 1–in–1,000 year event. We just don't know. We have had many so–called 1–in–1,000 year events recently. Too many risk metrics used in capital markets are based on normal distributions. This clearly understates the chances of bad outcomes, especially domino–affected ones, catastrophes, and Black Swans.

"... the quantification of remote probabilities is more difficult than the quantification of possibilities." From the "Credit Crisis Lessons for Modelers" essay by Parr Schoolman, FCAS, vice president at Aon Benfield Analytics.

Our scenario analysis should focus on when a company can lose money and how they can recover within a strategic risk management process. This evolution is taking place in insurance companies today (i.e., recovery management over survival management) and is a necessary aspect of prudent enterprise risk management culture.

In his essay, "Derivatives, AIG and the Future of Enterprise Risk Management," Michael G. Wacek, FCAS, president & chief executive officer at Odyssey America Reinsurance Corp. says:

"A self–disciplined company with an effective ERM program does not merely take its risk management cues from how its risks look from the outside. It seeks to model and limit the actual risks inherent in its business plan and balance sheet."

Our profession has a great opportunity to leverage the ERM evolution in recovery management from the insurance industry to help guide the greater financial services industries and beyond.

ASSUME EVERYONE BEHAVES THE SAME WAY IN CRISIS MODE

The power of an enterprise risk framework, as mentioned in parts one and two in this series of articles, centers on the reflection of correlation and catching the domino effects. Gauging and measuring correlation is certainly the key. A necessary condition for the success of gauging the correlation of risks should get away from measuring past metrics of relationships of how two variables move together. Instead, it should consider how decision makers might behave in a tail scenario.

"Each new market crisis demonstrates that correlation in stressed environments is much higher than historical averages would indicate," Schoolman states in his essay.

"Risk managers should always be aware that marginal analysis can produce incorrect results. They should follow my mother's caution 'what if everybody did that?' and look into their statistics more carefully," Ingram writes in his essay.

In crisis mode, everyone seems to do the same thing—panic. Relying too much on the market price to gauge the value of anything is unreliable if the information is unreliable.

In his essay, "Transparency and Liability Valuation," Philip E. Heckman, ACAS, president of Heckman Actuarial Consultants Ltd., writes: "Here we are led to draw a distinction between 'wild' markets and 'free' markets. A wild market is unregulated and unscrutinized. Information flows are purposely impeded for competitive reasons and reduced to trickles from rumor and espionage. No one knows what anyone else is doing, and pricing is blind and haphazard. In such a market, there are no safeguards against anticompetitive behavior and no guarantee that the market will clear."

CONCLUSION

As pre–eminent thought leaders in the greater enterprise risk discipline, we should continue working with employers and clients to foster discipline. This is needed to create a corporate culture speaking to the missing elements of management that underlined the causes of the financial crisis. We have an opportunity to be the thought leaders, to provide a focal point where enterprise risk management not only encompasses the holistic modeling of the interconnectivity of risk (which has been our bread and butter). We can apply our own experiences to share what has worked and not worked, providing this leadership to the broader financial services industry and beyond. Our analytical skill set has prepared us to design analytical frameworks where the prudence of ERM will be enhanced by incorporating management decisions that consider behavior, authority, and incentivized decision–making of people within an enterprise and balances rewards and accountability. Our profession clearly has a voice. This is obvious from our enthusiastic response to the aforementioned Call for Essays. We have standards of practice and codes of ethical conduct. We have analytical minds that can develop not only the probabilistic modeling of exogenous events, but also a prudent ERM structure that contemplates the risk of the decisions and reactions of people.

In his essay, Rudolph concludes:

"When a business line brings a new idea to the CEO, he should be able to ask, 'Have you run this past the Chief Skeptical Officer and does she concur with this proposal?' The CSO (could also be referred to as the Common Sense Officer) might not always be popular, but the improved decisions made will allow the CEO to more confidently execute the company's strategic plans."

Let's go and reserve our place at the table. We have an opportunity to serve.

Robert Wolf, FCAS, MAAA, FCA, is a staff actuary for the Society of Actuaries. He can be reached at rwolf@soa.org.