Calibrating Risk…

It is axiomatic that the business of (re)insurance is all about understanding risk, and being able to analyze, price, structure and manage it in such a way as to be able to meet any and all valid claims as and when they are made.

So, one would think that establishing what a company’s appetite for risk actually is would be fairly straightforward. In reality, it is not, because it is practically impossible to establish a comprehensive framework simply through the creation of a set of rules. Rules and limits are merely the starting point.

Paradoxically, an over-emphasis on “risk management” can even increase the potential for an entity to accept risks that are beyond the level it should be willing to take because of the “not seeing the wood for the trees” bias. Any CRO worth the title will be aware that it is identifying the possible aggregations and unexpected links which is the problem, even if one has established a carefully layered set of individual risk limits.

All of this stems from the fact that the real world is not just complicated, but complex- and it is the complexity that creates the issues. One can try to “corral” the complicated within a reasonably sophisticated rules-based system; but complexity resists such an approach, such that rules can engender a dangerous complacency that an entity’s risks have all been defined and “boxed”.

One area in which ignoring complexity can cause real problems is in terms of whether risks behave in a linear way. In a complicated system linearity governs; in a complex one a tiny change can have a massive impact (the butterfly wing effect). After all, events such as hurricanes are not linear in their consequences, even though the scale used gives that impression. A Category 5 is much more destructive than a Category 4.

Similarly, one can de-compose a complicated system into its component structural parts, but in complex systems the components interact with and influence each other in unexpected ways, making it difficult, if not impossible, to calibrate all potential outcomes. Of course, many systems have boundaries defined by natural laws in terms of scale, but in other areas, such as frequency, the boundaries are much less defined, if at all- just consider the current North Atlantic hurricane season and the frequency of “named” storms. Yes, a more active season was forecast, but we doubt that anyone foresaw just how active that meant.

Complicated systems are also usually controllable, whereas complex systems are not, exhibiting so-called emergence tendencies. Trying to act upon them can have disproportionate and unintended consequences.

Any seasoned CAT modeler will riposte: “But we know all this!” And that is true. However, that does not mean that one can calibrate with any real certainty what the true scale of the risks of loss are. The charts that one sees in annual reports are estimates, not limits, and, as we have seen over the past few years, the trend in frequency and scale of natural catastrophes is increasing, which begs the question of whether the risks are truly “controllable”.

At Awbury, we recognize that we are always operating within a complex system, which evolves and changes, sometimes rapidly. No fixed set of rules or limits would be able to cope with such a dynamic environment. Therefore, successful organizations must have risk management systems that are also dynamic and adaptive.

The Awbury Team

CEO Survivorship Bias…

Within the US and elsewhere, for the past several decades there has existed what can only be called the “Cult of the CEO”. This has been reflected in the disproportionate way in which their compensation packages have diverged from those of lesser mortals as well the often undue deference paid to their statements and public musings, let alone what may happen within the confines of the businesses which they run. Of course, there are exceptionally-talented individuals, who demonstrably add value and make a difference. No doubt each of us involved in the realm of finance and (re)insurance has a view on that- and we are not going to “name names” here.

However, each and every one of them is merely mortal, with individual flaws and biases just like the rest of Humanity. The characteristics of successful CEOs, and how they are identified and selected, has its own sub-discipline within the study of behavioural corporate finance, so we read with interest a recent paper by Marius Guenzel (Wharton) and Ulrike Malmendier (UC Berkeley) entitled “The Life Cycle of a CEO Career”.

Wrapped within the academic prose are some interesting insights into the real world of CEO advancement, selection and firing.

Firstly, and quite logically, as in many other areas of business and finance, there is an inherent survivorship bias, particularly when it comes to assessing and hiring external candidates. After all, if one has failed in a previous role, one is unlikely to be top of the candidate selection list! Conversely, confident and apparently successful individuals have a distinct advantage. In fact, the paper posits that over-confidence in one’s abilities is actually an advantage at that stage, because a Board or selection committee will not have had the opportunity to observe an individual’s true nature, as it would have done with an internal candidate. It is also well understood (and not just at the CEO level!) that hiring managers have the tendency to hire those with whom they identify, and whom they believe they “understand”.

Secondly, and this would apply to internal candidates as well, the need to be seen to perform can lead to a willingness to take on more risk to try to create leverage to the upside (which is often also influenced by the structure of compensation packages), thus actually increasing the risk of failure in adverse circumstances. Of course, by definition, in the absence of a monopolistic advantage, a business has to accept an element of risk in order to grow and prosper. However, there is the  question of whether the risk-taking is proportionate, or might expose the business to a material risk of ruin. The selection process and its own in-built “skew” may inadvertently increase the risk of future failure, or, at best, underperformance when truly tested. Ironically, it is the individuals who are more self-aware and more humble who may perform better long term.

And finally, when it comes to the firing of an unsuccessful CEO (who is still likely disproportionately to be male- just look at the (re)insurance industry!), the authors find evidence that the more “male” a Board is in terms of its composition, the greater its reluctance to fire “one of its own”.

None of the above is particularly surprising. However, it is useful to see the issues examined in a more rigorous and less anecdotal way. It suggests the need, as always, to distinguish between the truly capable and the clever “bluffers”; and to look at a business’s past performance in context and on a risk-adjusted basis, trying to assess how much it reflects the skills of the CEO.

At Awbury, our whole business model and operational approach is built around deploying a cohesive team, which believes fundamentally in measured, incremental growth. Aiming to “shoot the lights out” is most certainly not of any interest, because, particularly in the (re)insurance business, it is axiomatic that excessive risk taking is, frankly, stupid.

The Awbury Team