Boring is Beautiful*

Over the last 18 months, we have had the extraordinary opportunity to witness a financial catastrophe unfolding worldwide. This catastrophe has laid bare failings in our regulatory frameworks. But perhaps more dramatically, it has exposed breakdowns in risk management practices in financial institutions that genuinely believed that they had properly identified and managed their risk.

The property and casualty (P&C) insurance sector is by far the least glamorous of the financial services sectors. This is perhaps why it has proven to be in such a good position to weather these financial storms. Some life insurers with exposure to guaranteed investment products and some multi-line insurers with broader exposure to derivative markets may have stumbled, but pure P&C carriers have performed surprisingly well.

The relative success of the P&C industry is worth mentioning because it is this industry that has the best expertise in understanding, evaluat- ing and quantifying risk. Indeed, there are several guiding insurance principles that could be applied more broadly to the risk management challenges of other financial services sectors.

RESERVE ADEQUACY AND PEER REVIEW

In selling a policy, an insurer is making a contractual commitment that its capital will be made available to offset losses of those who purchase such a policy. The industries’ core operating arithmetic is that while the sum total of future liabilities cannot be determined with 100% accuracy, insurers will make provision on their balance sheet for such future liabilities in the form of asset reserves.

For obvious reasons, the property and casualty industry and its regulators have worked hard to make the valuation of future liabilities as much of a science as possible. Today, professional actuaries are formally responsible for determining the adequacy of required reserves. In this process, they make provision for such arcane things as IBNR (claims which are “incurred but not yet reported”) and worst-case scenarios (PFAD — a provision for adverse deviation). I mention these technical, actuarial mechanisms not to impress or bore, but instead to illustrate the degree to which our industry invests in the true professional discipline of appropriate reserving. We go one step further:we insist the reserving adequacy of each insurer be regularly peer-reviewed by an external actuary that must countersign on the statements and affirm reserve adequacy.

What is the application of this principle to the broader financial services marketplace? It tells us we do not in fact need to invent new forms of regulation. We already have a regulatory framework capable of managing this type of risk effectively in our sector. We simply need to expand the model’s scope to encompass the activities of global financial players and require peer-reviewed evaluation of the forward liability risk of newer financial instruments.

THE RISK OF MORAL HAZARD

Much has been written about “moral hazard” and about how best to avoid it in the underwriting of insurance policies. Broadly speaking, moral hazard describes the following idea: if humans have the opportunity to transfer their total risk to another without cost, they will do so. Worse, the incentive to transfer risk grows in direct correlation with the increase in that risk. Worse still, this costless risk transfer actually incents immoral behaviour.

And how does this concept apply to our recent financial system’s travails? The U. S. sub-prime mortgage marketplace is a textbook illustration of moral hazard run amok. Mortgage originators were able to generate large fee income through the activity of making loans, but were able to transfer to others 100% of the risk that such loans would not be repaid. As the demand grew for more origination to feed the enormous appetite for packaged, securitized assets, the temptation to originate bad loans grew as it became more remunerative. Additionally, bonuses paid for growth in fee income encouraged increasingly risky behaviour throughout the system among originators and packagers. The consequence of this misalignment of interests has now been painfully made clear.

The proper identification of moral hazard risk is at the heart of the training for junior underwriters in our industry. It does not seem to have been on the curriculum of junior capital markets regulators, or even the chairman of the U. S. Federal Reserve (who recently declared himself “shocked” by this tragic but perfectly explicable and predictable human behaviour).

THE COMPELLING HUMAN LOGIC OF RISK RETENTION

Human instinct is always torn between the desire to maximize reward and simultaneously minimize risk. Where insurance is available, individuals have an added trade-off variable to include in their analysis: how much are they willing to pay to transfer the risk of loss to others? But our industry has learned over time that even those paying a fair premium to secure some degree of risk transfer should also be required to retain some additional financial obligation by means of some form of a “co-insurance mechanism” — think the “deductible” on your car insurance.

Experience has taught us that when some portion — even a very small one — of the potential loss is shared by the insured, less risky behaviour ensues. How can this principle be applied more broadly to the issues of the day? Collateralized Debt Obligations (CDOs) are packaged bundles of risks where none of the loss is borne by the originator of the risk. It is now evident that moral hazard fueled the creation of more and more CDOs with higher and higher percentages of bad risks. But the lack of any coinsurance or deductible mechanism amplified this disastrous behaviour by the institutions originating the loans and those packaging the bundles.

So, what specifically could insurance principles suggest to thaw credit markets and re-establish a viable securitization market? How about a Retained Risk Rating framework, with a minimum requirement for retained risk by the risk’s originator? Perhaps a regulation requiring that a minimum 25% of each loan be retained might enable the remaining 75% to be securitized safely. And perhaps CDOs with higher retained ratios (30%, 50%, etc.) would be worthy of higher ratings. Insurance experience suggests that the higher the percentage of risk retained, the lower the likelihood that loans unlikely to be re-paid would in fact be made in the first place!

THE IMPORTANCE OF EXPOSURE AND ACCUMULATION MANAGEMENT

As a matter of common practice, insurers make provisions for anticipated future losses. These provisions will include an expected portion of total losses attributable to “catastrophe.” For practical purposes, these tend to be a direct result of dramatic weather conditions or geological disasters. Key to analyzing risks of this severity is effective “exposure” and “accumulation” management.

“Exposures” are simple enough to define, quantify and manage. The logical concern is familiar to anyone who was taught as a child not “to put all your eggs in one basket.” From an insurer perspective, what that in fact means is that you can have too much market share if that significant share is disproportionately located in too small a territory or category of risk. Grizzled veteran underwriters terrorize new recruits with the horror story of the large insurer that discovered that, after the devastation of Hurricane Andrew, its two biggest agents in Florida dominated the same narrow strip on that state’s coast — exactly where that Category 5 storm made landfall.

But it is not the “exposure management” part of the equation that has the broader application. What really matters is the “accumulation” calculation. The definition here is perhaps more complex; suffice to say, that “accumulation” is the product of exposures multiplied by the maximum possible loss per exposure (i. e. the cost to re-build the total number of hurricane-exposed houses if every house is a total loss).

So how does this type of analysis help in thinking through our recent financial travails? Well, it helps us to understand how so many smart folks got the value of so many CDOs so wrong. It is easy enough to analyze the cases in which institutions simply held too much of a single asset class. One European bank, for example, turned out to be holding 30-billion Euros worth of “Alt A” U. S. mortgages. This was simply mismanagement of exposures.

But the holders of large securitized portfolios actually believed themselves to be properly managing risk. Their multibillion dollar investments in CDOs (holding mortgages, car leases, credit card balances, etc) appeared to them to represent a diversified portfolio — sufficiently diversified (they thought) to justify the very high leverage ratios they increasingly employed to generate enhanced yields.

Sadly, the collapse in the U. S. housing market was the equivalent of Hurricanes Andrew and Katrina combined. Once you multiplied all the exposures by the accumulated total loss on each — and multiplied the losses by the leverage ratio — you had a true financial catastrophe. All of this was based on a simple breakdown in risk management and a failure to evaluate worst-case scenarios. This is where “accumulations” could have been, and were not in fact, managed properly.

PLANNING FOR THE TECHNICOLOUR SWAN

Today in my dull and boring industry, we regularly review reports analyzing our exposure to 1-in-100 year events and 1-in-250 year events. My reinsurance providers have models — and sell me insurance policies based on these models — to quantify the risk of 1-in -500 year events (the great and inevitable West Coast Quake) and even the 1-in-1,000 year event (don’t ask). The boring P&C industry is unsurprised by “black swans.”We spend our nightmare time imagining flocks of technicolour ones all happening at once!

In the end, we have all seen the risk of not thinking hard enough about risk. I would cautiously suggest (which is as aggressive as us P&C folks get) that those who do so for a living could help ensure that this type of global financial catastrophe never happens again.”