Risk Management Reports

March, 1998
Volume 25, No. 3

Virtual Publication
Since 1996, Risk Management Reports has been available in full text at our web site, http://www.riskinfo.com. RiskInfo provides access to several other publications as well as a discussion area. With the explosion of Internet use in the past few years, I want to explore a new idea that might make RMR more valuable to its readers.

Tom Peters argues that information technology permits "instant feedback" to writers commenting on today's events. In the past, few wrote letters to the editor and the process of response and modification of opinion could take months. Today we can do this instantly. With more than 30% of its subscribers outside the United States, RMR could take advantage of this technology to provide globally the kind of discussion that is found now in face-to-face meetings.

What I'm proposing is the addition of all subscribers with email addresses to our website for an on-going discussion group on global strategic risk management topics. You would have the option of receiving RMR monthly via email, by hard copy, or both.

You could provide instant comment, derisive or otherwise, on anything that I write to both me and your fellow groupies around the world. I'd receive more ideas for articles. RMR would become an on-going, global discussion group on strategic and holistic risk management, merging ideas from the different RM sectors: financial/market; public policy; environmental safety and health; regulatory and legal liability; and operational and insurance.

This new delivery method would also permit the use of on-line subscriptions and payment through credit cards.

What are your reactions? Would you read and use RMR as readily via a monthly electronic posting as in hard copy? Would you want to continue both, or just one or the other? Please check the web site (www.riskinfo.com) and email me with your reactions (fkloman@aol.com).

If Doonesbury and Dilbert can do this, why shouldn't Risk Management Reports?

 

What is wrong with me, that I want to leave a trace, by scribbling these disjunct and jumpy notes concerning my idle existence? Spoiling paper . . . .

John Updike, Toward the End of Time, Alfred A. Knopf,
New York, 1997

 
 
Letter from Australia
Oz and its neighboring New Zealand were the first countries to adopt a formal risk management Standard (see RMR February 1996), so I have been listening carefully to risk managers from Down Under to gauge the effect of this guideline. It suggested that all risks be addressed together, although few managers now have such a span on responsibility. Chuck Marshall, the Group Manager Risk for BHP Petroleum, in Melbourne, recently posted a thoughtful response on developments in Australia.

He wrote, "I think we've lost the plot. Every position in a company has some degree of risk management (avoiding/reducing exposure to mistakes and loss). People with the title and the professional organization do not have an exclusive right to the term, and I for one certainly do not let some textbook definition put me in a box that is inconsistent with or limiting to my function.

Any risk management function is as broad or as limited as you and your management define it . I agree that probably no one is qualified in every area of expertise necessary to every task of risk management, just as there is no one person qualified in all areas of Safety, Health, Environment, Finance or Engineering. However, that does not mean that we cannot assign to one person the responsibility to see and/or oversee the conduct of proper risk management to meet the needs of the organization. The CEO may be the ultimate risk manager, but he relies on expert advice.

How can anyone say that those of us called risk managers, whether the more traditional insurance-buyer, or the rocket scientist, derivatives/options designer, should be concerned only with the downside. Our input is needed in every commercial (upside) decision to invent, invest, build, produce, sell, buy, hedge, insure, retain, etc., etc. We must inform those making the "potential-for-gain" decisions of what the downside risks are so that they can build into their decisions the cost to mitigate the risk and potential failure-mode losses.

Statistically, every oil well drilled is potentially a dry hole, about six out of seven. Maybe one in a thousand catches fire, and/or may pollute. If oil or gas is found, the cost to develop and profitably produce it may be too great to proceed. Most projects take three to four years to complete, twenty to thirty years to pump dry, and the rate of return can be ruined by any unexpected delay or interruption.

I have input every step of the way advising the decision makers at various points and making my own decisions as to coverage, retention, unique risk financing proposals to meet specific circumstances, etc. You cannot separate the upside from the downside.

I have a new assignment to attempt to understand all of the risk identification, analysis and management processes and mechanisms at work in our company. From this we hope to identify gaps and overlaps and provide an audit map of the entire risk management process. I will perform only a small portion of the actual risk identification and decisions, but I will provide a template to highlight all of the major, quantified risks faced at various stages, lists all of the separate processes performed by engineering, marketing, treasury, risk management, etc., and produce the risk management plan and responsibilities as the project progresses.

Ambitious? Yes. Difficult? Definitely. Necessary? Somehow, it does or should get done, in various departments, formally or informally, adequately or not. We would accomplish little if we did not try to manage the difficult and sometimes the seemingly impossible."

In a later note, Chuck emphasized the fluidity of risk amid ever-changing data, making risk decisions more difficult and requiring their continuing overview. This flux is one of the challenges of the process. As Chuck said, "Management has grasped the myth but not yet the limitations of the concept."

While he agreed that a risk decision should consider both gain and harm, he suggested that "performance beyond what you expect is lagniappe, not an unwanted outcome." True, when "performance beyond" is not excessive. But what if you sell ten times as many widgets as you projected? Isn't there a potentially disruptive element to that seemingly favorable outcome, especially if your manufacturing capacity is limited and your competitors then jump in and corral your market? Excessive up-side results may be as detrimental as heavy down-side costs.

According to Australian Company Secretary (November 1997), the Australian Stock Exchange, like its counterparts in Toronto and London, now requires all listed companies to "provide information about how significant risks are identified and managed, in their annual reports." Some of the pertinent risks are identified in a new Trade Practices Act in Australia: cost of litigation, damages and compensation, disruption to management, impairment of staff morale, adverse publicity and public relations, failure to disclose, and governmental supervision.

The new Standard is generating changes in risk management in Australia!

 
Risk analyses are not so linear, nor project risks so straightforward and static, as to permit the simple application of systematic techniques. The (Australian/New Zealand) Standard is a great teaching tool and mind-jogger, but it is not very practical for revealing the literal risks of complex, evolving projects and operations most in need of risk insight.

Chuck Marshall, in email to Editor, December 29, 1997

 
 
Risk and the Business Plan
Chuck Marshall's comments reminded me of an article from the July-August 1997 Harvard Business Review. In it William Sahlman, a Business School professor, describes "How to Write a Great Business Plan." He echoes Chuck's comments about the multitude of unknowns when trying to predict both revenues and profits, suggesting that most plans are "wildly optimistic." Sahlman sees four "interdependent factors" that are critical to a new venture: the people, the opportunity, the context, and the "risk and reward." He defines this last factor as "an assessment of everything that can go wrong and right, and a discussion of how the entrepreneurial team can respond." Isn't this really risk management in a nutshell: all the risks, good and bad, and a contingency plan?

Sahlman concurs with Chuck Marshall that all of these factors are "moving targets," moving in different directions and at different rates of speed, thoroughly complicating the process unless flexibility is built into it from the outset. Sahlman's article concludes with the admonition that any business plan "must unflinchingly confront the risks ahead - in terms of people, opportunity and context."

 
"The business plan for your start-up is idiotic but I'm going to provide the venture capital funding anyway. We'll generate lots of media hype, go public and make millions by shafting greedy and ignorant investors. The Latin word for 'close your eyes and open your mouth' is 'prospectus'."

Scott Adams, Dilbert, as reprinted in Harvard Business Review,
July-August 1997

 
 
The Risk Spectrum
What uncertainties affect an organization? Too often our personal experiences and perspective dictate our risk views. In 1992 I tried to break free of this limitation of personal experience and perspective, and the overwhelming nausea created by those voluminous "checklists" through the construction of a simple diagram summarizing all major areas of risk. It was published that year by The Geneva Papers in my article, "Rethinking Risk Management" and, in a revised version, by Risk Management Reports in January 1994. It's time for further revision.

Risk, like Sir Winston Churchill's description of Russia, is "a riddle wrapped in a mystery inside an enigma." The Russian nesting dolls that probably stimulated his remark are an apt simile: whenever we peel away one layer of risk, we find another. A risk response inevitably creatres a new one. We can never know a "risk" completely. Nonetheless a working diagram, like the Spectrum above, can help us begin the process of analysis with simple visualization. Any intangible begs for this. I remember a bumper sticker on my sister's car: "Visualize Whirled Peas." Whenever I think of "world peace" I now think of a pot of lumpy pea soup! When you next think of "risk," will you remember nesting circles?

The "organization" sits, like the dolls, within encircling risks and responses. The outer layer is "global." It describes uncertainties that are seldom "manageable" but which have significant strategic effects. They cannot be disregarded. Pandemics affect employees, customers and infrastructures. Tuberculosis is increasing even while AIDS is declining, at least in the more developed countries. New strains of flu tax antibiotics to which they are immune. Religious fundamentalism, anticipating the millennium, causes turmoil from Sri Lanka to Northern Ireland, from Waco to the Middle East. The demise of the Soviet Union increases the risk of a nuclear mistake. The expansion of powers armed with nuclear weapons raises the threat of a terrorist bomb. With the end of the bi-polar world, people are inclined to create their own mini-states. Global warming is still a theory, not an established fact, but the signs are ominous. World population continues to rise, even as a few countries move toward zero growth. An older population leads to an "accretion of special interest groups," in the words of Charles Kindleberger, in The Aging Economy, which can be "especially pernicious in aging societies because they embody the collective memories and institutional framework of a past that may well be archaic."

These global risks surround the "organizational risks" that are more susceptible to our control.

Internal specialists have attacked these risks for years, but separately, not together. Hedgers and credit managers address financial and market risks. Lawyers and compliance officers treat regulatory and political risks. Insurance buyers finance operational and liability risks. Security specialists, occupational safety and health advisors, environmental engineers and contingency and crisis management planners all work individually toward balancing risks and rewards. Each looks at a specific segment, not at the whole. Risks do not take kindly to discrete boxes, rudely slopping over into one another. An employee mistake results in injury to other employees, damage to property, owned and others, liability lawsuits, crackdowns from regulators and inspectors, and possible reductions in liquidity and the creditworthiness of commercial paper. All risks are interconnected. The process of analysis and response, including mitigating controls and financing, needs a simple overview of the entire environment. The Risk Spectrum is a quick and intuitive glimpse of the total pluses and minuses that affect an organization.

 
Intuition is an abused word, but if we define it as the power to apprehend things without the intervention of a reasoning or logical process, we are talking about something which is not intelligence in the accepted sense of the word.

Robertson Davies, The Merry Heart, Viking, New York 1997

 
 
F.I.A.S.C.O.
For a thoroughly chilling view of the world of derivatives traders, read Frank Partnoy's new book, F.I.A.S.C.O., published by W.W.Norton & Company late last year. Billed as an "insider's diary, a shocking education in the jungle of high finance," the book chronicles the author's two years of selling derivatives on Wall Street, for First Boston and Morgan Stanley. Partnoy's world comes across as a vicious gambling pit where traders play with other people's money and take great delight in "ripping off their faces," to use one of their favorite terms. The immaturity, the addiction to the lure of the "bet," the outright greed, supported by an out-of-control bonus system, and the failure to honor even a modicum of concern for the customer, are all part of his picture. He describes the Mexican peso and the Orange County crises in detail. In every case the avariciousness of the sellers was matched by the greed of the buyers: "For a fund manager (a buyer - ed.) an extra one-half-percent return is pure gold. A couple of extra basis points alone would put you in the upper echelon of managers. . . . The managers of these funds seemed to be willing to chance buying risky derivatives, even if it meant that they might be fired. These managers were like the contestants playing Let's Make a Deal, choosing either what was behind door number one or door number two. Behind one door was a modest, above-market return; behind the other, a financial time-bomb."

Many bought derivatives disguised as other instruments in order to hide their manipulations: "A buyer was like an underage kid who pays the local bum to buy booze for him, then pours the booze in a Coke can so his parents won't notice."

Partnoy's conclusion is disillusioning: "I believe that derivatives are the most recent example of a basic theme in the history of finance: Wall Street bilks Main Street. Since the introduction of money thousands of years ago, financial intermediaries with more information have been taking advantage of lenders and borrowers with less."

Does this book paint an accurate picture? I don't know, but it has the ring of authenticity. I checked with several friends in the business and they confirmed some of the allegations, though they denied that their firms acted improperly.

This is an example of pure counterparty risk. How do we deal with it? I have three suggestions. The first is adoption of rigorous global accounting standards, at least as tight as those in the US, supported by audit organizations that are independent of other financial connections to their clients. This change is beginning to occur. The second is increased transparency in reporting all aspects of transactions, to the public, to regulators and to shareholders, including the remuneration, direct and indirect, of involved traders. The third suggestion is advanced by Lev Borodovsky, one of the leaders of GARP, the Global Association of Risk Professionals. The remuneration system should become "risk-based," eliminating the enormous annual bonuses that seem to be the major contirbuting factor for this excess. Each year's bonus should be amortized for as many years as the corresponding risk, to either counterparty. The first bonus payment should also be withheld for twelve months. This third suggestion makes sense to me, but, given the driven world of investment banking, I doubt that it will happen!

The problems of Procter & Gamble, Gibson Greeting Cards, Barings Bank, Daiwa Bank and Orange County have not disappeared. Within the past two months, the Union Bank of Switzerland announced a potential derivatives trading loss of from US$ 300 million to as much as US$ 689 million, a loss that may have led to its merger with smaller Swiss Bank Corporation. Is Frank Partnoy's parting summary correct?

 
It's never been easy, I suppose, up close, deciding whether you're dealing with staggering originality or someone who's hanging onto their sanity by their eyeballs.

Tibor Fischer, The Thought Gang, Scribner, New York 1994

 
 
Fiduciary Diversion
Since 1971, when I first wrote about it, I've been concerned about the system under which insurance agents and brokers hold premiums collected from insureds for extended periods before remitting them to insurers. The first problem is that the intermediaries earn investment income on these fiduciary funds, income that is not generally reported to customers. It is income that should accrue to either the insured or the insurance company. Sophisticated buyers try and remit to brokers and agents at the end of any grace period, thus reducing intermediary investment income on float, but it is impossible to eliminate it entirely.

That brings up the second problem: potential diversion of these fiduciary funds from the rightful recipient to the intermediary. Mark Druskoff and Bud Griffin, both of the California consulting firm of Warren, McVeigh & Griffin, wrote an article in a recent issue of The Risk Management Letter (Volume 18, Number 9) on "Avoiding the Risk of Fiduciary Diversion by Agents and Brokers."

They went on at length about considering the size of the broker, checking its financial statements, looking for warning signs and obtaining a non-cancelable surety bond, before coming to what is the only logical conclusion: pay the insurance company directly! The authors say that this is not always "possible or practical," because insurers may object or when a placement is made up of numerous carriers. The buyer using insurance for risk financing should insist on direct payment and move business elsewhere if a company will not accommodate. The buyer should insist on as few participants as possible in a placement: in many cases this complication is a means for assuring the continued need of an intermediary.

Go direct; pay direct!

 
Optimists are the ultimate realists. The reason that optimism makes the difference is that human beings and all our creations are perfectible.

William Safire, "Holiday Message," The New York Times,
December 24, 1997

Copyright 1998, by H. Felix Kloman and Seawrack Press, Inc.