Actuarial Review - August 2005

Risk Management Research Imperatives
By Donald F. Mango
Reprinted with permission from the July 2005 issue of the North American Actuarial Journal.
The actuarial profession is aligning itself towards enterprise risk management (ERM), both in North America and around the world. This is unquestionably the right way to proceed, for ERM is not a fad, but the emerging science of a well-run company. The development of ERM in a firm parallels the core capabilities of a complex organism: information on external environment (via senses) and internal conditions; a processing center receiving reliable, timely and accurate information; an evaluation framework to decide upon action and response; a motor system to effect those actions and responses; and an overarching feedback system to ensure stability and sustainability. When viewed in this light, ERM can be seen as nothing less than the natural evolution of human systems and collectives. Borrowing from Tolstoy: what then must we do?
From a research standpoint, the needs are nothing short of critical. The first priorities should be to shore up the fundamentals, and build the foundation of ERM. This should include:

framing of traditional practice areas as ERM for insurance, retirement, and benefit systems;

establishing parallels between traditional practice areas and broader financial services risk management;

conducting joint research across the traditional practice areas, to build the actuarial core of risk analytics; and

conducting joint research across all industries, to develop the industry-neutral core of risk analytics.

While far from simple, these priorities can be addressed using traditional research approaches. The main challenges facing the actuarial profession in this space are logistical - coordination and communication.
What I will spend the remainder of this editorial discussing are what might be called the "second-story" priorities which may require a next generation evolution in research approach. The four areas I will focus on are:

Strategic Interaction Effects

Liquidity Risk

Operational Risk

Value Demonstration

1. Strategic Interaction Effects
Scientists are realizing that collective systems exhibit interaction effects that cannot be predicted from the behavior of the individual elements. J. Doyne Farmer of Santa Fe Institute has published several papers showing that capital market price volatility can in part be explained by the interaction of competing trading strategies among different types of traders. Avinash Persaud of Gresham College has written repeatedly on the paradoxical impact of market-sensitive risk management policies on banking system stability. His premise: introduction of market-based risk based capital requirements leads to uniformity of risk appetite among participants, and therefore uniformity of response to market volatility. The uniformity compounds and reinforces itself as participants react to each others' reactions, leading to market crises. Applying similar logic to the insurance market, it is likely that strategic interaction plays a material role in insurance pricing cycles.
When studying such systems, researchers must be wary not to extrapolate incorrectly from local conditions. These systems are non-linear, and the strategy assessment is multilateral not unilateral. Theories and policy recommendations may only be testable using nontraditional scientific approaches and media. Examples include simulated economies and agent-based models. Possible worthwhile research goals include strategy robustness testing (which plan works best, factoring in all the possible things others could do?) and policy recommendations (how should regulators monitor and control the system to maximize stability?). This is a great opportunity for collaboration outside insurance and retirement systems.
2. Liquidity Risk
Liquidity is defined as the ability to enter or exit a financial position (i.e., buy or sell an asset or derivative), in the volume needed, at a reasonable price, in the desired timeframe. Failure on any of these fronts is known as a "liquidity crisis," and is symptomatic of market incompleteness and inefficiency. Liquidity crises are becoming more common in the broader financial markets. One possible cause: liquidity requires diversity of opinion and losers, both of which are in increasingly shorter supply.
Per this definition, one could make the case that insurance cycles are actually liquidity cycles: not only price fluctuates, but also products offered and companies offering them. If insureds cannot secure the coverage they want, in the amounts they want, when they want, from their perspective the market has failed and there is a liquidity crisis.
Liquidity underlies the effectiveness of any hedging program - it presumes you can find a viable counterparty who can deliver in time. It sounds good in principle, but it is imperative that we acknowledge there are no outer space beings at the end of the counterparty rainbow. We are in a closed financial system. Hedging means transfer, and after the hedging stops, at some point the risk comes to rest in someone's portfolio. This retained risk must be evaluated at some point. The science of that evaluation involves concrete definitions for risk preferences and appetites, and expressions of utility.
Low liquidity valuation - private equity, opaque hedge funds, and real estate - is already an area of tremendous research in broader financial services. We must seize the opportunity to consolidate the risk evaluation framework across other low liquidity products - like most insurance products!
3. Operational Risk
This represents a great opportunity for actuaries. Per "International Convergence of Capital Measurement and Capital Standards," from the Basel Committee on Banking Supervision, "operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk."
The opportunities for actuarial contribution are clear. First, commercial property casualty insurance could be characterized as "insured operational risk." Also, best practice thinking in the analysis of operational risk is gravitating towards an actuarial approach-exposure bases, driver variables, frequency, severity, correlation, and convolution. See Ali Samad-Khan's "Why COSO is Flawed."
However, the research challenges are also substantial. Consider the case of a failed insurer. The causes of the failure may include under-pricing, under-reserving, uncontrolled growth, or poor management. In the context of the Basel definition, these certainly sound like operational risks. The lines between "operational risk" and "underwriting risk," "pricing risk," or "reserving risk" need to be much more clearly defined before insurer ERM can advance. There are also what are termed "soft operational risks"-management integrity, succession planning, key person risk and knowledge concentration, knowledge management, intellectual property, leadership compensation schemes. These risks arguably outweigh the more quantifiable technical risks, yet the science is in its infancy.
4. Value Demonstration
This could arguably be the Holy Grail of ERM efforts-the creation of tangible value for an organization. In 2003, the CAS put out a research proposal looking for evidence of ERM value in the capital markets. A preliminary feasibility review found no apparent evidence, and the research project was tabled-for now, anyway. I believe this research effort was merely premature, since looking to the capital markets for evidence of ERM value merely shifts the recognition burden to the capital markets. This presupposes that capital market analysts are already to the point where they can (a) understand ERM programs, (b) quantify their value, and (c) justify pricing companies with ERM programs at a premium. A tall order, given the state of the science which we are hoping to help build!
Similar conclusions were drawn by the writing team behind the SOA's new textbook "Insurance Industry Mergers and Acquisitions." The authors found that: valuations are not as scientific as we would like; the perceived value of actuarial involvement in M&A should be elevated; more typical capital market M&A metrics (e.g., earnings multiples, betas) play a large role in insurer valuations; and many hidden costs of integration (i.e., operational risks!) don't get factored into the decision. The bottom line: until M&A uses ERM as a core part of due diligence, the presence or absence or ERM may not drive value decisions. Instead, any apparent ERM value may initially be asymmetric - tempering downsides, bad things not happening, granting the benefit of the doubt in crisis. ERM may be first perceived as a necessity whose absence leads to a price discount, before it is viewed as a strategic advantage whose presence means a price premium.