Risk Management…or Risk Measurement?
What do these books have in common?
“The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron”
“When Genius Failed: The Rise and Fall of Long-Term Capital Management”
“The Black Swan: The Impact of the Highly Improbable”
“Against the Gods: The Remarkable Story of Risk”
They are all about risk management and they all rub shoulders with best-selling books . OK, they haven’t quite made Oprah’s book club as yet… but have patience. I recall when I qualified way back in 1987 no one could have imagined that a book on risk management would venture out of an actuarial reading list. Well, so much for being trained to predict the future.
Sadly, these days one does not have to visit the local best selling business book lists to peruse at the latest corporate crash sites. The TV reports and newspapers are full of the stuff. Disgraced CEOs, CFOs, CROs and even reinsurance managers are now targets of the paparazzi.
Enoch Powell, the controversial British politician, once remarked, “All political lives end in failure.” Are risk managers destined to suffer the same fate?
My guess is that the fallen CEOs and Boards of Directors felt totally safe in the hands of these responsible looking, well-qualified risk management individuals. The trouble was both that the CEOs and Boards of Directors assumed that the company’s risks were being well-managed and it is quite likely that the risk manager did not have any influence regarding product design or pricing. It’s all too often the case that it is only after the product is on the street and the damage has been done that the risk manager is involved. Then he or she is reminded that the company must “deliver the year end numbers.”
The Economist once questioned, “What’s the single most important price in the world?” The popular answers were the price of oil, American interest rates, and the dollar. However, none of these–The Economist argued–may be as important as the price of Chinese wages.
So now that we know what the most important prices are, how do we manage these risks? We don’t! I would like to argue that we can’t truly eliminate risk. We can only measure risks and determine the most effective ways to protect ourselves, either through avoidance (changing our activities) or mitigation (protection, such as reinsurance, hedges, etc.).
The discipline of risk measurement results in the formulation of appropriate risk management policies, which then leads to the establishment of reserves, capital adequacy, risk margins and procedures that aim to both recognize and reduce extreme tail events.
Highly rated reinsurers hold huge catastrophic reserves for tail events. Even our most infamous Black Swan event, the World Trade Center, did not bring down reinsurers or insurers. Those recent mark-to-market mega balance sheet write downs on the asset side by the banks and AIG, just did not have a corresponding contingency reserve on the liability side to absorb the financial impact. However, it should be noted that the herd effect of bankers led to lots of simultaneous World Trade Center-sized financial events.
So what are the conclusions? It’s time that the CEO and the Board of Directors realize that this responsibility cannot simply be delegated away and also that the risk management process is as crucial in the opening gambit as it is in the end game. The C-Suite must take an active interest in the risk parameters that are driving the models. Risk management is here to stay! So fellow actuaries, let’s work together with senior management to make sure our companies and clients stay out of the crash-site books at Amazon.