14 July 2009

Published in: Capital - models, Risk governance

How much of your model do you need to understand?

A senior manager should at least understand the questions the model is trying to answer, and their impact on the firm's business model, argues Craig Turnbull.

Senior managers don't need to be quants. But they do need to have an awareness of the fundamental limitations of the models that are being employed by the firm in internal, regulatory capital and financial reporting applications. There needs to be an appreciation of what the models leave behind; that financial modeling always has model risk; that calibration is far from an exact science; and that these limitations may create perverse incentives for their people that may conflict with what's in the long-term interests of the firm.

If the firm is holding and writing complex products with complex market/credit risk profiles, there has to be some deep technical understanding of these complexities at a very senior level in order to effectively and responsibly manage the business.

At a more basic level, there needs to be an understanding of the questions that the model is trying to answer and their fundamental ramifications for the firm's business model. For example, if the model is being used to calculate one-year VaR based on market-consistent asset and liability values, this might mean that pricing products at a sub-market-consistent-level is suddenly going to start looking untenable. So this needs to be joined up with the way firm more broadly measures value creation, and there may be a need to recognize that previous practices of, say, managing to GAAP accounting rules may not perform well using a more market-based approach.

This is where enterprise risk management (ERM) comes in. But for ERM to be useful, senior management needs to fully buy into the ERM vision, and what it means for their business models. If it identifies economically non-viable business policies, senior management needs to be willing to listen and learn from those insights. In the global insurance sector, this is happening, but it takes time, and some firms will embrace this more quickly and fully than others.

This can be a challenging process -- it is not an easy message for ERM to take to the board when ERM believe that the firm's most successful product is loss-making, or that the firm is inadequately capitalized. These implementation challenges quickly move from intellectual and technological to cultural and political.

Fundamentally, for business decisions to be fully aligned with ERM, there needs to be a completely holistic and consistent approach to assessing market-related risks and costs in all product lines and in all forms of market risk. Management compensation and structure then needs to be aligned to these metrics as well as defining what exposures MUST be escalated to the boardroom table.

Craig Turnbull is regional head, North America, for Barrie & Hibbert. He joined Barrie & Hibbert in 2000 after graduating in mathematics, statistics and finance and spending a year at Watson Wyatt Investment Consultants. He qualified as a Fellow of the Institute of Actuaries in 2003. He has worked in the insurance ALM area throughout his Barrie & Hibbert career, developing research and leading consultancy and support to clients in Europe, South Africa and North America. In February 2008, Craig moved to New York City to open Barrie & Hibbert's first office outside the UK.

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