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13
ERM
Black Swans,
Fat Tails and
Spherical Cows
Risk Management
Risk management is a structured framework that allows the
management of risk. Risk can be broken down into many categories;
the Solvency II break down is: Market, Credit, Insurance, Investment,
Operational and Liquidity. But this is by no means a unique
dissection. In order to help bring some rigour and consistency,
ISO (International Organisation for Standardisation) has a draft of
guidelines on principles and implementation of risk management.
The basic risk framework covers a process as shown in Figure 1.
Figure 1
A C T U A RY A U S T R A L I A April 2009
14
review
Once risks have been identified there are many ways to treat them
considered in the ISO guidance. The list below is not necessarily
mutually exclusive nor appropriate in all cases:
avoid
change the likelihood
change the consequences
share the risk (e.g. insure / reinsure / outsource)
retain the risk
ERM Influences
Rating agencies
The leading rating agencies (e.g. A.M. Best, S&P, Moodys and Fitch)
have been strong supporters of the development of ERM practices
and it became an important component of the financial strength
ratings process. S&P were the most active in incorporating ERM
explicitly into their ratings process as a separate rating category.
Once the treatment has been selected, then monitoring and review
is required to ensure that the organisations risks are developing
as expected. This is similar to the Actuarial Control Cycle (specify
a problem, develop a solution, monitor the consequences thereof,
and repeat the process) at the heart of actuarial work.
Black Swans
15
Prize and Long Term Capital Mangement fame) may agree with
him in hindsight! George Box also has a similar view: all models
are wrong, some models are useful.
This is not to say models arent helpful, but that they need to
be combined with experience, business acumen and judgment,
and are used properly. It is important to know what is and what
is not included. They also have a strong part to play in what
if analysis. The recurring mathematics / modelling can explain
everything claim is an ideological fiction. It also exemplifies
confirmation bias looking only for evidence that fits the thesis.
Small changes in average behaviour do not give good evidence
for whats happening in the tails, e.g. a smaller number of large
banks may increase stability on average, but due to globalisation
and interconnectedness, the tail risk becomes extreme (e.g.
Fannie May and Freddy Mac). Even a fat-tailed
distribution may understate the frequency
and size of some risks.
Fat Tails
Many loss distributions have simple
underlying assumptions in order to
make the mathematics solvable.
They provide answers, to several
decimal places and are based
on mathematics; for some people
this provides comfort.
It is likely that the process of risk
does not follow the mathematical model rules. David Viniar (CFO
of Goldman Sachs) observed in the Financial Times in 2007, that
the bank had seen 25 standard deviation moves several days
in a row. This quote was meant to point out how extreme the
market moves were, but it also points out how extremely wrong
the models were. These extreme movements are unlikely to
be from a conventional probability distribution, even a fat tailed
one. Mandelbrot suggests that multifractal techniques might be
applied to financial data to provide a better estimate for risk and
volatility. There is a risk that a model may become over simplified
and lose the link to the real world.
Spherical Cows
Spherical cow is a metaphor
for highly simplified models of
reality. It is from a mathematical
joke where the punch line is
the mathematicians solution
to improve milk production
and starts with Consider a
spherical cow. The point of
the joke is that model builders
will often reduce a problem to its
simplest form, in order to make
What to Do?
Models have a useful part to play and clear communication of
the parts of the risk that are and are not modelled is crucial
information in order to be able to use the models as a useful input
to making strategic decisions. But too much belief in the specific
numbers could be dangerous and give false security. Models must
be connected to the real world, used and validated by a firms
management for them to become a useful tool.
Good analysis and advice from specialist advisers (who may have
wider access to data and more experience of particular areas
e.g. reinsurance) is a crucial step in an effective and efficient risk
management strategy. For example, ensuring that the reinsurance
programme purchased is robust and represents good value when
considering the risks being undertaken by the
insurance entity.
The communication skills of the actuarial
profession have never been more needed.
Jeremy Waite
waitejg@willis.com
A C T U A RY A U S T R A L I A April 2009