EXPERT IN

ON THE CURRENT FINANCIAL CRISIS:

NPUT

DID ERM FAIL?

By Robert Wolf

As part of the series on The Evolution of Enterprise Risk Management,

this article gleans the thoughts, commentary and insight from the authors
of the recently developed e-book titled, Risk Management: The Current
Financial Crisis, Lessons Learned and Future Implications.

he current financial crisis has been

called a financial tsunami by former Federal Reserve Chairman Alan
Greenspan. Many are calling it the worst
financial crisis since the Great Depression.
Its ramifications are far-reaching and will
question risk management practices for
years. What lessons have already been
learned? What can we, the premier enterprise risk management (ERM) profession,
offer in terms of thoughts, insights, suggestions and proactive solutions to mitigate
future problems? I believe this is a great
opportunity for the actuarial profession.
We can make a difference by sharing our
recommendations for ERM best practices.
Weve taken an important step toward
this goal, a step inspired, in part, by The
Economist magazine, which recently issued
a call for papers on the financial crisis from
experts in the field.
Representatives from the Joint Risk
Management Sections of the Society of
Actuaries (SOA), The Casualty Actuarial
Society (CAS) and The Canadian Institute
of Actuaries (CIA), the SOAs Investment
Section, the International Network of
Actuarial Risk Managers, and the Enterprise
Risk Management Institute International,
coordinated a Call for Essays on Risk
Management: The Current Financial Crisis,
Lessons Learned and Future Implications.
The response was tremendous. Presented
here are excerpts of the insightful information from some of the essays submitted.

16

The Actuary

february/march 2009

EXCERPTS FROM THE EXPERTS

One of the topics discussed was how interconnected our economy really is, and how
the bursting of one bubble (in housing) was
able to collapse the entire economic house
of cards around the world.

voking discussions and commentary. Even

though the authors of the essays worked
independently, there are some clear commonalities and consensus between the
papers. Enterprise risk management did not
fail. It was never applied.

In his essay, Risk Management and the

Financial Crisis: Why Werent We Protected?
Mike Batty, FSA, CERA, a consultant at
Deloitte Consulting LLP, says:

When bad things happen, there is a perception

that ERM was unsuccessful. When bad things
do not happen or good things do, does that
mean ERM is a success? We havent had a major
terrorist event in the United States since 2001. Is
enterprise risk management being rewarded for
that? Should it? Or is it just fortunate luck that a
similar catastrophic event of such magnitude
hasnt happened in the last seven years?

Due to the explosion of the originateto-distribute business model (fueled

by the growth of securitization) underwriters of suspect home loans were
freed from significant responsibility for
whether the loans could ever conceivably be repaid.
They passed the questionable loans
onto highly-leveraged investors and
then focused on their core competency,
making more loans. As the demand for
these mortgage-backed securities skyrocketed, underwriters tapped pools of
more and more suspect borrowers.
Some discussions of the crisis have reflected on one question: did ERM fail? After all,
companies touted to have a strong enterprise risk culture were brought down by the
decisions and strategies that, in hindsight,
were clearly not in their best long-term
interests. There are many ways to learn from
recent events. The submitted essays and the
resultant e-book, which is downloadable
at www.soa.org/essays, offer thought-pro-

Our profession faces this dilemma with

employers and clients every day. If events
turn out better than expected, we are
accused of being overly cautious and categorized as naysayers. When bad things
happen, or at least results come in worse
than expected, we are told we missed the
target. So goes the ongoing saga of an
enterprise risk management professional.
In part two of this series, I mentioned a
more realistic approach to gauge the value
ERM brings to the table. We should not
necessarily search for a success story, but
focus on the necessary changes in corporate culture that would produce a prudent
ERM framework. Although enterprise risk
management adds value in balancing risks
and rewards, it is not meant to convey
that it can eliminate risk in its entirety.
Unfortunately, this is how the public values risk management.

In gleaning the lessons learned essays, several aspects of enterprise risk management
are identified that are clearly necessary
for its success. Without these necessary
conditions, it is apparent that the discipline
ultimately fails. These aspects relate to a
culture that requires alignment of desired
performance with incentives of managing
risk and reward, and not just reward. There
are many lessons to be learned from the
essays. I suggest that five critical lessons for
prudent enterprise risk management can be
gleaned from the essay writers. They are:
Incentive compensation requires
appropriate alignment with desired
performance.
Nobody should have the authority to
make decisions without accountability.
Do not assume the risks that you have
not managed today, will be manageable tomorrow.
Remember the M in ERM is for
management. Modeling is only the
analytic tool.
Assume that in crisis mode, everyone
behaves the same.

Incentive Comp Alignment

In the two previous installments of this
series about how actuaries make a difference in the enterprise risk management
discipline, I mentioned aligning incentive
compensation with ERM goals. This must
be a critical component, if not the critical
component, in developing a prudent ERM
culture and framework. Never has it been
more apparent than during an analysis of
this crisis how key such a framework, when
not existent, can be. It produces disincentives to even care about the risk tolerances
of the organization. Our profession has a
great opportunity to develop best practices
in devising incentive compensation systems
that are linked to risk-adjusted ultimate outcomes, rather than just outcomes.
In his essay, Neil Bodoff, FCAS, MAAA, senior
vice president at Willis Re., says:
when reporting profit a key reform
crucial to mitigating future crises is to
ensure that we always measure profit on
a risk adjusted basis.

Further, he lists two critical reasons:

1. It provides more meaningful information about profitability, 2. It reduces the
incentive to take excessive risk in order
to increase profits.
In his essay, Your Mother Should Know,
Dave Ingram, FSA, CERA, MAAA, FRM, PRM,
senior vice president, Willis Re., says:
Under most compensation programs,
the business manager will be incented
to continue business regardless of the
risk. They are incented AGAINST risk
management.
Overall, lets face it. How are most of us
rewarded in incentive compensation?
Results. Did our division achieve 10 percent growth? Yes. Did we maintain at least
a minimum targeted profit margin? Yes.
Great. Heres your bonus. No reflection or
consideration is generally given as to how
risky your procedures and strategies were in
achieving your goals or how conservative or

february/march 2009

The Actuary

17

aggressive your accounting was to reflect the

profit. Just get it.
In his essay, Should You Have a Chief
Skeptical Officer? Max J. Rudolph, FSA,
CERA, CFA, MAAA, owner, Rudolph Financial
Consulting, LLC., concludes:
When a firms culture is driven by
growth and manager incentives ignore
risks taken, it is only a matter of time
until the process implodes. People will
naturally gravitate to practices that
enhance their pay. Thats why it is called
incentive pay.
Lets think about Wall Street. Say GM misses
the profit target that Wall Street projected.
The stock drops. Then GM implements a
comprehensive ERM framework. Wall Street
shrugs. When a company reports profits
to its shareholders, it is based on certain
accounting conventions. The element of
risk taking is very tricky and nearly impossible to glean out of a balance sheet today.
Shareholders love profit, but if it can some

18

The Actuary

february/march 2009

way be risk adjusted, the amount of profit actually released may better bring to
balance risk-return tradeoffs needed and
increase transparency.

compensation programs will undergo

a transformation as companies attempt
to rid themselves of inducements to
exceed stated risk tolerances.

As a profession, actuaries analyze, compute,

and price risk-adjusted performance in the
pricing of insurance products every day.
We certainly can provide this same skill
set to help devise such a plan for incentive compensation. Granted, it would be a
bold undertaking. It would require extensive
reworking of compensation systems and, for
that matter, accounting regimes.

This is and has been the biggest hurdle in

developing an ERM culture within an organization. This is our greatest opportunity to
lead the way.

In his essay, Reaffirming Your Companys

Commitment to ERM in light of the Financial
Crisis, Prakash Shimpi, FSA, CERA, global
practice leader, ERM at Towers Perrin, further states:
Although this has been a topic of discussion for some time, the current crisis
has demonstrated that compensation
practices can be at odds with managing risk appropriately. We believe that

Aligning Authority with

Accountability
It is well understood that this crisis began
with the housing bubble in the United
States. The original underwriters of risky
mortgages passed them on to leveraged
investors, creating additional capacity.
Investors did not perform appropriate due
diligence and were not concerned about
the lack of a prudent ERM framework.
The original underwriters were, in essence
absolved from any further accountability.
Louise Francis, FCAS, MAAA, serves as the
CAS vice president in Research and is the
founder of Francis Analytics and Actuarial

Data Mining, Inc. She states in her essay,

The Financial Crisis: An Actuarys View:

and talks of how a very popular risk metric

(VaR) actually added fuel to the fire.

What makes this scheme particularly

disastrous is that in the 21st century,
Ponzi mortgages were packaged and sold
to investors and then trillions of dollars of
derivatives were constructed based on
the underlying mortgages, magnifying
the problem by orders of magnitude.

Right now, things look pretty good,

so go ahead and make big bets. The
problem is that right now is not the
appropriate time horizon for measurements of risk.

Optimizing any risk and return decision making requires an appropriate alignment of
authority and accountability. Without this

Paul Conlin, FSA, an actuary at Aetna, states

in his essay, The Financial Crisis: A Ripple
Effect of Incentivized Disorder:
a primary insurer can transfer risk
to a reinsurer, but always remains on
the hook if the reinsurer defaults. A
mortgage loan must be a permanent
arrangement between the lender and
borrowerif this is not acceptable to
either, no problem: no deal.
Assume We Cannot Get Rid of
the Risk Tomorrow
In his essay, Against the Grain: The Wisdom
of Countercyclical Capital, Jay Glacy, ASA,
CERA, MAAA, ERM practice leader, Milliman,
Inc., talks about the pro-cyclicality of capital

Focus on Management as well

as Risk
In his essay, Batty says:

In his essay, Ingram says:

Well, there are two different approaches
to risk that firms in the risk taking business use. One approach is to assume

Our scenario analysis should focus on

when a company can lose money and how
they can recover within a strategic risk
management process.
alignment you are left with return decision
making (not risk and return) and suboptimal results.

assuming they will be in place tomorrow, is a

dangerous assumption. The primary insurer
should always consider the potential liquidity
risk that would arise should reinsurers run for
cover under crisis mode.

that they can and will always be able

to trade away risks at will. The other
approach is to assume that any risks will
be held by the firm to maturity.
So the conclusion here is that at some
level, every entity that handles risks
should be assessing what would happen
if they ended up owning the risk that
they thought that they would only have
temporarily.
Traditional risk management historically
assumed that one could easily dish off or transfer risks at any time. In crisis mode however,
the option to trade away risks disappears. This
increases risks an organization thought it had
transferred from its balance sheet. As actuaries,
we see this all the time in assessing concentration risk. Catastrophe reinsurance may be there
today, but could be more expensive tomorrow.
Relying on todays risk transfer schemes, and

With the likelihood of extremely rare

events always in question, and knowing
our inherent biases in assessing them,
we may find it beneficial to downplay
the role of tail probability in our analysis,
and instead ask questions such as: Are
we comfortable with the knowledge that
such scenarios might occur? How can we
mitigate the risk? How should we react if
those situations begin to play out?
This gets to the point made in part two of this
article series where I emphasized the need
to get away from the focus on the 1-in-1,000
year event. We just dont know. We have had
many so-called 1-in-1,000 year events recently. Too many risk metrics used in capital
markets are based on normal distributions.
This clearly understates the chances of bad
outcomes, especially domino-affected ones,
catastrophes, and Black Swans.
the quantification of remote probabilities is more difficult than the quantification of possibilities. From the Credit
Crisis Lessons for Modelers essay by Parr
Schoolman, FCAS, vice president at Aon
Benfield Analytics.
Our scenario analysis should focus on
when a company can lose money and
how they can recover within a strategic
risk management process. This evolution
is taking place in insurance companies
today (i.e., recovery management over

february/march 2009

The Actuary

19

survival management) and is a necessary

aspect of prudent enterprise risk management culture.
In his essay, Derivatives, AIG and the Future
of Enterprise Risk Management, Michael
G. Wacek, FCAS, president & chief executive officer at Odyssey America Reinsurance
Corp. says:
A self-disciplined company with an
effective ERM program does not merely
take its risk management cues from how
its risks look from the outside. It seeks to
model and limit the actual risks inherent
in its business plan and balance sheet.
Our profession has a great opportunity to
leverage the ERM evolution in recovery management from the insurance industry to help
guide the greater financial services industries
and beyond.
Assume Everyone Behaves the
Same Way in Crisis Mode
The power of an enterprise risk framework, as
mentioned in parts one and two in this series
of articles, centers on the reflection of correlation and catching the domino effects. Gauging
and measuring correlation is certainly the key.
A necessary condition for the success of gauging the correlation of risks should get away
from measuring past metrics of relationships
of how two variables move together. Instead,
it should consider how decision makers might
behave in a tail scenario.
Each new market crisis demonstrates
that correlation in stressed environments is much higher than historical
averages would indicate, Schoolman
states in his essay.
Risk managers should always be
aware that marginal analysis can pro-

20

The Actuary

february/march 2009

duce incorrect results. They should

follow my mothers caution what if
everybody did that? and look into
their statistics more carefully, Ingram
writes in his essay.
In crisis mode, everyone seems to do the
same thingpanic. Relying too much on
the market price to gauge the value of
anything is unreliable if the information is
unreliable.
In his essay, Transparency and Liability
Valuation, Philip E. Heckman, ACAS, president of Heckman Actuarial Consultants Ltd.,
writes:
Here we are led to draw a distinction between wild markets and free
markets. A wild market is unregulated
and unscrutinized. Information flows
are purposely impeded for competitive
reasons and reduced to trickles from
rumor and espionage. No one knows
what anyone else is doing, and pricing is
blind and haphazard. In such a market,
there are no safeguards against anticompetitive behavior and no guarantee that
the market will clear.
Conclusion
As pre-eminent thought leaders in the greater
enterprise risk discipline, we should continue
working with employers and clients to foster
discipline. This is needed to create a corporate culture speaking to the missing elements
of management that underlined the causes of
the financial crisis. We have an opportunity
to be the thought leaders, to provide a focal
point where enterprise risk management not
only encompasses the holistic modeling of
the interconnectivity of risk (which has been
our bread and butter). We can apply our
own experiences to share what has worked
and not worked, providing this leadership to
the broader financial services industry and

beyond. Our analytical skill set has prepared

us to design analytical frameworks where
the prudence of ERM will be enhanced by
incorporating management decisions that
consider behavior, authority, and incentivized decision-making of people within an
enterprise and balances rewards and accountability. Our profession clearly has a voice. This
is obvious from our enthusiastic response to
the aforementioned Call for Essays. We have
standards of practice and codes of ethical
conduct. We have analytical minds that can
develop not only the probabilistic modeling
of exogenous events, but also a prudent ERM
structure that contemplates the risk of the
decisions and reactions of people.
In his essay, Rudolph concludes:
When a business line brings a new
idea to the CEO, he should be able to
ask, Have you run this past the Chief
Skeptical Officer and does she concur
with this proposal? The CSO (could also
be referred to as the Common Sense
Officer) might not always be popular,
but the improved decisions made will
allow the CEO to more confidently execute the companys strategic plans.
Lets go and reserve our place at the table.
We have an opportunity to serve. A
Robert Wolf, FCAS, MAAA, FCA, is a staff actuary for the
Society of Actuaries. He can be reached at rwolf@soa.org.