Feb 27, 2010

Isle of Risk

Last decades, our perceptions of Financial Risk haven been constantly changing and - for sure - they will continue to do so in the future.

In the sixties and seventies of the 20th century 'risk' was mainly plain 'technical risk'. Risk Management was mainly used to support current strategies, as a defensive instrument.

More de-Tailed studies of risk in the nineties, created new instruments and models to manage (investment) risks. This led to the understanding that it was possible to take more risk because we could understand and manage it in a better way.

Next, at the beginning of the 21th century, these new risk models were expanded and transformed from passive to active instruments. New products and markets were developed by combining, cutting and mixing traditional asset products (stock, bonds, mortgages) with derivates. And just like in chemistry, where mixing innocent individual molecules could lead to an explosive new molecule, the asset markets got flooded with toxic, unknown risk-correlated products.

For most of us it became clear that it was not the risk ingredients (bonds, stocks, derivatives, etc) themselves that caused this turmoil, but our own (irresponsible) behavior, e.g. the way we ourselves were managing the asset products and models. Behavioral Finance was born.

After we poisoned the investment market landscape in the second half of this last decade, things turned for the worse. Instead of looking what we had done, where we were on the risk map and how we could clean up this mess, we kept on building debt and - except for sub prime mortgages - refused to restructure the market 0r to restrict the use of derivatives.
No restrictions nor ethical guidelines on making money just from money (who pays for making money of money?).

Instead, with the latest development High Frequency Trading (1,000 orders per second ! ), covering about 60% of all U.S. equity trading and nearly half of U.S. futures trading, we finally lost our site on what is ethical or not.
Main question is: Who has the guts and the power to stop this development?

Anyway, it's clear that our 'behavior' and a 'map of the risk landscape' are critical in understanding where we are heading with Risk......
Let's start with behavioral finance

Behavioral Finance
One of the world’s best experts in the field of behavioral finance is James Montier.
His book Behavioural Finance is a classical must-read.

In a 2002 classic report titled 'Part Man, Part Monkey', Montier gives a number of common mental investment pitfalls. Here's a sum up of those pitfalls that might apply to actuaries just as well:
  • You know less than you think you do
  • Be less certain in your views, aim for timid forecasts and bold choices
  • Don't get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day
  • Listen to those who don't agree with you
  • You didn't know it all along, you just think you did
  • Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs)
  • Don't take information at face value, think carefully about how it was presented to you

Trinity of Risk

According to Montier the word 'Risk' is perhaps the most misunderstood concept in finance. In classical finance, risk is identified as the relative price volatility (beta). However that's not what risk really is about. 'Downside risk' (ie loss) is what really matters when it comes down to performance measurement. From an investment point of view, risk can be split up into three interrelated elements, the so called 'trinity of risk':
  • Business Risk (risk of business going broke)
  • Financial Risk (risk of using leverage)
  • Valuation risk (the margin of safety)

Valuation risk is the most tricky type of risk, as is explained in an excellent article 'The Biggest Mistakes in Valuation...' by Donald R. van Deventer from Kamakura Corporation. Here's the wrap up of the top 7 valuation mistakes in a humorous "daily life analogy"
  1. The Fake Rolex Watch Mistake
    Ask the investment bank which sold you a fake Rolex what the Watch is worth
  2. The Poker Game Mistake
    Ask someone else playing in the same game how you should bet
  3. The War of the Worlds Mistake
    Believe in a valuation technique Because everyone else thinks it's true
  4. The Cash Card Mistake
    Tell an investment banker exactly how your firm evaluates complex securities
  5. The Carton of Eggs Mistake
    Don't check to see if the eggs are broken, just look at the egg carton before buying
  6. The "My Brother-In-Law Told Me It Was a Good Investment" Mistake
    Bernie Madoff and the rating agencies
  7. The 2+2=5 Mistake
    Technical errors in valuation

Financial Crisis 2008-201x
Back to Montier, who's very clear about the role of Bernanke with regard to the role of the FD in the current
Montier believes Bernanke missed the boat, had poor ideas on how to recover and on top of this, failed to learn from his mistakes. Montier guesses: There are none so blind as those who will not see!

Happy Investor
For those of you who -after all this - don't succeed in becoming a happy investor, Montier has a simple advice on improving (plain) happiness. Here's the wrap up:
  • Don’t equate happiness with money.
  • Exercise regularly.
  • Devote time and effort to close relationships.
  • Pause for reflection, meditate on the good things in life.
  • Seek work that engages your skills, look to enjoy your job.
  • Give your body the sleep it needs.
  • Don’t pursue happiness for its own sake, enjoy the moment.
  • Take control of your life, set yourself achievable goals.

Map of Risk

Risk is an interesting and never ending subject of discussion and development. Drawing a map of Risk, literally helps you to oversee the Risk battlefield. Draw your own map of risk in life to remember where you are, where you've been and where you'll be heading.....

To help you get on the way, take a look at my Isle of Risk

(click the image for a larger image)

James Montier's Links
- Google Book Behavioural investing
- Was It All Just A Bad Dream? (febr. 2010)
- The Little Book of Behavioral Investing
- Applied behavioural Finance (pdf presentation)

Other links:
- High Frequency Trading Is A Scam
- High Frequency Trading Youtube
- FT: Markets: Ghosts in the machine
- High Frequency Trading -- Results from Simulation

Feb 21, 2010

Powerpoint Mortality

Whether you're an actuary, accountant, consultant or salesman, when we take up a new challenging project, we're inclined to spend most of our time on data mining, modeling, reconsidering, detailing, arguing, making things perfect and finally, drawing the conclusions and writing the exhaustive proposal report....

Fortunately - in this case - your right on schedule! You've got exactly one day left before your Board presentation of the project. Still completely in a rush and overexcited about the stunning results of your successful investigation, you start up your laptop to wrap up your proposal report in a full flash Powerpoint presentation.

That night at 01.00 AM, you successfully finish your ppt presentation. Just in time! Completely satisfied about this phenomenal achievement, you e-mail the ppt to Nosica, the Board's secretary you know well. She, as well as the Board, will be impressed by your 'night shift work'. Who said that actuaries had a 9 to 5 job?

The next day, at 14.00 AM you enter the Board room, full of confidence. Your presentation is start-ready, the beamer glows, you're fully concentrated on your audience and in a 'cashing' flow....

After 20 minutes of presentation, including your ten recommended practices and some questions, you leave the 26th floor. All went well...
Time for a drink and a well earned good night sleep...

Next morning, 09.00 AM, the Board's secretary replacement calls you: Your proposal has been declined....

You're flabbergasted, how could this happen? After all this work you've been through.

What went wrong?

The answer is simple, you denied Wayne Burggraff's Law of Presentation:

It takes one hour of preparation
for each minute of presentation time

So next time, in case of a 20 minutes presentation, invest 20 hours of your time in research, development, organizing, outlining, fleshing out, and rehearsing your presentation.
In essence: if you fail to prepare well, you are well prepared to fail.

Tips.....
Here are some practical tips that might help you with your preparation:
  1. Ask yourself: ''If I had only sixty seconds on the stage, what would I absolutely have to say to get my message across."
    -- Jeff Dewar --
  2. The simplest way to customize is to phone members of the audience in advance and ask them what they expect from your session and why they expect it. Then use their quotes throughout your presentation."
    -- Alan Pease --
  3. No one can remember more than three points.
    -- Philip Crosby --

Fear of presentation
As actuaries it's surprising to see that people are more afraid (41%) of speaking to a group than of death (19%).
Now it's clear why we search the help of Powerpoint to 'survive' on stage.

Powerpoint Mortality
We all know Powerpoint..... Powerpoint itself is not good or bad, it's the way you use it.

The mortality rate of Powerpoint is humorously demonstrated by Don McMillan:



Who Needs Powerpoint?

Last January I was heading for a presentation with the help of Powerpoint. Full house. However, on the supreme moment the local beamer gave up. I simply decided to bring my message in an interactive session with my audience, without the help of Powerpoint.

Yes, it was different, challenging and even fun! Because of my thorough preparation - I was able to concentrate on almost everyone of my audience. So...., another Maggid's tip could be:

Prepare your presentation without Powerpoint!

A presentation try out
In the mid nineties my employer's company was heading to get listed at the stock exchange. I remember I had to give a presentation before a panel of 70 international analysts, who would probably raise all kind of difficult questions. In order to prepare 'abap', I called my strategy director as well as my CFO and asked them to act as my 'try out analysts audience'.

I told my colleagues I would give the presentation three times in a row. In the first two presentations they were obliged to interrupt me as much as possible, to raise difficult or weird questions and to put me to test (keeping my humor and concentration). During the third presentation they had to act as normal audience.

To make a long story short: after three presentations, my two colleagues kept their breath in combination with a desperate look in their eyes. I told them not to worry and reassured them my presentation at the analyst session would be successful.

And so it was, as I was fully prepared on every possible question and didn't had the need to look at my ppt presentation, I could fully focus on my audience. Lesson: Make the preparation tough, you'll benefit from it in the final presentation.

The actuarial master
Yes, there are a lot of rules, regarding the use of Powerpoint.
The Golden Rule is that all PowerPoint presentation rules, principles, and guidelines are just secondary to doing what is ultimately right for your audience. Critical point is, you can only break the presentation rules if you know them .

It's just like in actuarial science, once you've become an actuary (a master) the real art of your profession is not anymore in applying equations and methods 'by the book'. Now it comes down to break the existing rules and conventions in a such a professional way, that new risk and social challenges are being (re)solved in a different way. Key point here is that not only your professional skills have to be outrageous, but your presentation skills as well. As the success of a good peace of actuarial craftsmanship, is completely dependent on the way it is presented.

Mindmapping
Let's conclude with some practical free(ware) presentation tips.
Although you're probably aware not to overuse clip art, it's good practice to set up your presentation in a consistent and well polished style.

Of course you can use expensive business packages to illustrate your presentations, but there's also an excellent freeware application called: EDraw Mindmap 4

With the help of Edraw, creating presentations and mind-mapping is a question of minutes.

Enjoy preparing and giving presentations, learn to be(come) yourself on stage and overcome any possible fear of speaking to groups......

Related links:
- EDraw Mindmap 4 (Completely freeware!)
- EDraw Mind Map 1.0
- Edraw Max (not freeware)
- Lovelycharts (free, one application; online)
- Presentation skills (youtube)
- The New Office Math (youtube;Don McMillan )
- Presentation skills (ppt)

Feb 6, 2010

Why VaR fails and actuaries can do better

Perhaps the most important challenge of an actuary is to develop and train the capability to explain complex matters in a simple way.

One of the best examples of practicing this 'complexity reduction ability' has been given by David Einhorn, president of Greenlight Capital. In a nutshell David explains with a simple example why VaR models fail. Take a look at the next excerpt of David's interesting article in Point-Counterpoint.

Why Var fails
A risk manager’s job is to worry about whether the bank is putting itself at risk in the unusual times - or, in statistical terms, in the tails of distribution. Yet, VaR ignores what happens in the tails. It specifically cuts them off. A 99% VaR calculation does not evaluate what happens in the last1%.

This, in my view, makes VaR relatively useless as a riskmanagement tool and potentially catastrophic when its usec reates a false sense of security among senior managers and watchdogs.

VaR is like an airbag that works all the time,except when you have a car accident

By ignoring the tails, VaR creates an incentive to take excessive but remote risks.

Example
Consider an investment in a coin-flip. If you bet $100 on tails at even money, your VaR to a 99% threshold is $100, as you will lose that amount 50% of the time, which obviously is within the threshold. In this case, the VaR will equal the maximum loss.

Compare that to a bet where you offer 127 to 1 odds on $100 that heads won’t come up seven times in a row. You will win more than 99.2% of the time, which exceeds the 99% threshold. As a result, your 99% VaR is zero, even though you are exposed to a possible $12,700 loss.

In other words, an investment bank wouldn’t have to put up any capital to make this bet.

The math whizzes will say it is more complicated than that, but this is idea. Now we understand why investment banks held enormous portfolios of “super-senior triple A-rated” whatever. These securities had very small returns.

However, the risk models said they had trivial VaR, because the possibility of credit loss was calculated to be beyond the VaR threshold. This meant that holding them required only a trivial amount of capital, and a small return over a trivial capital can generate an almost infinite revenue-to-equity ratio.

VaR-driven risk management encouraged accepting a lot of bets that amounted to accepting the risk that heads wouldn’t come up seven times in a row. In the current crisis, it has turned out that the unlucky outcome was far more likely than the backtested models predicted.

What is worse, the various supposedly remote risks that required trivial capital are highly correlated; you don’t just lose on one bad bet in this environment, you lose on many of them for the same reason. This is why in recent periods the investment banks had quarterly write-downs that were many times the firm wide modelled VaR.


The Real Risk Issues
What. besides the 'art of simple communication', can we - actuaries - learn from David Einhorn?

What David essentially tries to tell us, is that we should focus on the real Risk Management issues that are in the x% tail and not on the other (100-x)% .

Of course we're inclined to agree with David. But are we actuaries truly focusing on the 'right' risks in the tail?

I'm afraid the answer to this question is most often : No!
Let's look at a simple example that illustrates the way we are (biased) focusing on the wrong side of the VaR curve.

Example Longevity
For years (decades) now, longevity risk has been structurally underestimated.

Yes, undoubtedly we have learned some of our lessons.

Todays longevity calculations are not (anymore) just based on simple straight on mortality observations of the past.

Nevertheless, in our search to grasp, analyze and explain the continuous life span increase, we've got caught in a interesting but dangerous habit of examining more and more interesting details that might explain the variance of future developments in mor(t)ality rates.

As 'smart' longevity actuaries and experts, we consider a lot of sophisticated additional elements in our projections or calculations.

Just a small inventory of actuarial longevity refinement:
  • Difference in mortality rates: Gender, Marital or Social status, Income or Health related mortality rates
  • Size: Standard deviation, Group-, Portfolio-size
  • Selection effects, Enhanced annuities
  • Extrapolation: Generation tables, longitudinal effects, Autocorrelation, 'Heat Maps'

X-Tails

In our increasing enthusiasm to capture the longevity monster, we got engrossed in our work. As experienced actuaries we know the devil is always in the De-Tails, however the question is: In which details?

We all know perfectly well that probably the most essential triggers for longevity risk in the future, can not be found in our data.
These triggers depend on the effect of new developments like :

It's clear that investigating and modeling the soft risk indicators of extreme longevity is no longer a luxury, as also an exploding increase of lifespan of 10-20% in the coming decades seems not unlikely.
By stretching our actuarial research to the the medical arena, we would be able to develop new (more) future- and shock-proof longevity models and stress tests. Regrettably, we don't like to skate on thin ice.....

Ostrich Management

If we - actuaries - would take longevity and our profession as 'Risk Manager' more serious, we would warn the world about the global estimated (financial) impact of these medical developments on Pension- and Health topics. We would advice on which measures to take, in order to absorb and manage this future risk.

Instead of taking appropriate actions, we hide in the dark, maintaining our believe in Fairy-Tails. As unworldly savants we joyfully keep our eyes on the research of relative small variances in longevity, while neglecting the serious mega risks ahead of us.

This way of Ostrich Management is a worrying threat to the actuarial profession. As we are aware of these kind of (medical) future risks, not including or disclaiming them in our models and advice, could even have a major liability impact.

In order to be able to prevent serious global loss, society expects actuaries to estimate and advice on risk, instead of explaining afterwards what, why and how things went wrong, what we 'have learned' and what we 'could or should' have done.

This way of denying reality reminds me of an amusing Jewish story of the Lost Key...

The lost Key
One early morning, just before dawn, as the folks were on their way to the synagogue for the Shaharit (early morning payer) they notice Herscheleh under the lamp post, circling the post scanning the ground.

“Herschel” said the rabbi “What on earth are you doing here this time of the morning?”

“I lost my key” replied Herscheleh

“Where did you lose it?” inquired the rabbi

“There” said Herscheleh, pointing into the darkness away from the light of the lamp post.

“So why are looking for you key in here if you lost it there”? persisted the puzzled rabbi.

“Because the light is here Rabbi, not there” replied Herschel with a smug.

Let's conclude with a quote, that - just as this blog- probably didn't help either:

Risk is not always apparent,
but its invisibility is no longer an excuse for ignoring it.

-- Bankers Trust on risk management, 1995 --

Interesting additional links:

Feb 1, 2010

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( SRIi=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:


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 Fingerspitzengef├╝hl 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 =( Threatj x Vulnerabilityj x Costj ) + E(SRIi=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