17 December 2009

Published in: Corporate strategy, Risk governance

What 2009 has taught us about risk planning

Jacob Rosengarten argues that the more an organization goes through the process of examining potential sources of extreme loss, the more prepared it will be for any future event

The year 2009 continued to reinforce the importance of developing a comprehensive understanding of how risks should be sized in an organization, recognizing that, from time to time, low-probability (therefore hard-to-predict) and high-impact events materialize.

There is now, more than ever, a need to develop a risk planning framework that:

1. Identifies those core strategies on which risk should be placed to drive profitability, and establishes appropriate risk limits. Creating a robust limit structure is an admission that, from time to time, risk models, however mathematically elegant, can fail. On that day, a firm's ultimate protection will derive from the limits it has in place.
2. Recognizes that both profits and losses should be plan-driven and enjoyed/incurred in areas where the firm has a demonstrated strategic edge. Conversely, avoid risks which are not part of your firm's strategic edge. In other words: make money and lose money for the "right reasons" - reasons that are plan-driven.
3. Avoids businesses whose profit "opportunities" require unusually large notional net limits to be exposed in return for relatively small premiums.
4. Recognizes the interconnectedness of seemingly uncorrelated activities in periods of market stress. In 2008-2009, the headlines dealing with the world's financial woes are also bound together with the following stories: historically low interest rates, massive government borrowing, future inflation risk, liquidity crises, a decline in economic activity (and so declines in insured values), soft pricing, increased risk of litigation, risk model failures, important bankruptcies, increased regulatory activity and declines in asset values. We have learned again, in 2008-2009, that if the stress is big enough, industries and economies will tend to react in a similar way and in a similar time-interval making any correction more violent. In 2009, the insurance industry and many other industries, continue to live the consequences of this story.
5. Understands how much capital should be at risk from any core and non-core activity, as well as from the collection of all such strategies.
6. Demonstrates that the multiple objectives that are typically part of any business plan are internally consistent with the planning framework.
7. Leads to contingency planning exercises to prepare for the consequences of low-probability but high-severity events. These exercises should demonstrate that, for each stress scenario examined, the firm sized its risk bets appropriately and maintained adequate liquidity and solvency buffers.

Nobody can predict exactly how these low-probability events will unfold. But the more any organization goes through the exercise of examining potential sources of extreme loss, the more prepared it will be for any future event. Even if future events do not unfold exactly as simulated in the planning exercise, there may still be enough similarities that the key organizational risks and related mitigating factors will have been examined and discussed.

As Mark Twain once observed: "History does not repeat itself, it rhymes." There is great value in trying to anticipate what these future rhymes might look like.

Jacob Rosengarten is chief enterprise risk officer at XL Capital Ltd