Category Archives: capital

Allocating capital to insurance products

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A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.

Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.

The question:

What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?

My brief answer (this is a huge topic!):

There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product

Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).

Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives. Continue reading →

Mumbling in the dark

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Are you outraged at the proposed increase in electricity prices from Eskom?

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Creative Commons License photo credit: Näystin

If you are, you’re not alone. 88% of readers polled in a News24 poll were “outraged” at the increase. The problem is that all this outrage is irrelevant at best, and dangerously distracting at worst.

Why price is the wrong thing to worry about

Eskom produces electricity for the country and makes a profit or a loss doing so. This profit or loss goes back into treasury, which, inefficiencies aside, belongs collectively to the citizens of South Africa.

If prices are too low and Eskom makes a loss, this shortfall must be made up through higher taxes or lower government spending. If Eskom is not given additional capital, it will have to stop buying coal and stop investing in new infrastructure.

Those who complain about the inflationary effects of electricity prices are considering the issue too narrowly. Electricity prices may be easier to see than broader macro-economic issues about budget deficits, growth-disincentives from higher taxes and other implications of funding electricity generation from general taxes, but that doesn’t mean it is the right way to look at the problem.

Expensive electricity is better than no electricity. Complaining about higher electricity prices, while understandable, is not useful since the money must come from somewhere.

The real 5 issues we should be discussing

  1. Is Eskom generating electricity efficiently, and at an appropriate cost (compared  to international benchmarks, adjusted for our local fuel costs and other differences)? If Eskom is not producing power as cheaply as they should, let’s focus on fixing the operational and industrial design problems to fundamentally lower the costs of production. More efficiency benefits entire country. Continue reading →

69th bank failure in the US for 2009

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The US Federal Deposit Insurance Corporation closed the 69th bank of 2009 recently. The rate of closures has increased recently, leading some analysts to believe that well over 100 banks could be closed this year.

The Savings and Loan crisis of the 1980s in the US started at about the same pace, with 100 closures per year. However, the number of closures increased to a peak of 534 in 1989 – fully 9 years after the start of the uptick in closures in 1980.

The South African banking environment is different – very much fewer banks and arguably tighter regulation give the lack of deposit insurance. However, the pain that US banks are feeling informs views that our banking sector still has pain to live through before turning around.

Lack of faith in ABSA house price index

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ABSA appears to be restricting the access of equity in home loan accounts that were specifically sold with this feature in mind.  Moneyweb’s article on the real estate shocker has already totally nearly 70 comments.

What this says about ABSA’s house price index

What’s interesting is that ABSA’s house price index has remained positive throughout the interest rate increases, decreased consumer confidence, massively decreased property market activity and general feelings of gloom around the local property market.  Steadily increasing prices sharply reduce the risk of borrowers accessing the equity in their home loans up to the original agreed loan amount.

For most borrowers, their property would have had several years of price increases (on average) since the loan amount was granted. ABSA’s reluctance in this regard seems to suggest that they aren’t confident in their own property price index.

The second sentence of their announcement [hosted by moneyweb while I look for original] is:

Absa took the decision to amend the facility due to the decline in property values over the past six months

Decrease? ABSA still has property prices increasing!

Hints of the real reasons?

Another sentence:

This is also due to the substantial increase in the cost of holding capital to support all unutilised facilities

Tough times for all financial institutions. I can imagine tense meetings where managers of different divisions are instructed to find ways to reduce capital requirements. This is a tangible sign of the impact of the financial crisis on our banks and the tightening of pressures on the real economy.

Variation in property returns around the mean

It is true that individual properties could experience significantly different price appreciation or depreciation compared with the overall average. However, those with significant equity in their home loans are:

  • Those who have been paying off the capital for several years, and would thus have been exposed to several years of positive house price appreciation. It seems unlikely that fluctuations in this groups property returns will put their current house price less than the original loan amount. Unless of course ABSA granted home loans  irresponsibly in the past, offering 100% or greater loans on overvalued properties. It seems unfair to change their approach on their FlexiReserve Comprehensive loan product now.
  • Those who have made additional payments into their home loans over and above the required minimum payment. These borrowers only have equity in their home loans because they paid more than they were required to pay. Usually, this was one of the reasons they used this product – they were doing the financially prudent thing by paying off their debt as quickly as possible and maximising the effective return they could earn on their cash. These borrowers may end up worse off than if they had simply made the minimum payment required in the first place!

A primary sentence from their marketing material on the loan product (taken as at 15/10/2008):

Access equity in your home loan and withdraw from it whenever you need additional funds.

That sounds surprisingly like what many borrowers have done. It continues:

You have immediate access to available funds via the Internet, Telephone Banking, ATMs or any Absa branch, provided you have an Absa transactional account

Interesting, eh?

An element of truth

ABSA’s announcement makes a big deal about this being for the protection of borrowers and ABSA. There is truth to this. Borrowing against equity that “doesn’t exist” is not a good idea. In fact, in these unstable financial times, one should be trying to pay down debt as quickly as possible, not add to it.

This doesn’t change that many individuals and families would have stashed their special-event savings into the high-yielding comfort and safety of their home loan. Now is also a time when some may need those savings. I don’t think it’s up to ABSA to unilaterally decide to change the rules of the game.

Packing for Prague

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Heading off to a Solvency II conference in Prague this evening. QIS 4 is hot news at the moment, and the conference is going to cover many of the details and requirements of the exercise.
Large European multinationals have spent enormous effort on the 4 QIS exercises. The data requirements alone are huge. Somehow CEIOPS has managed to keep the project more or less on track – the same can’t be said for the IFRS4 Phase 2 project. Given the intended consistency between IFRS and Sol2, I wonder whether this means IFRS will by default be more heavily influenced by Sol2 (and the recently published MCEV principles fomr the CFO Forum) than previously thought.
Will have some specifics from the course to blog about over the next week.

Confidence and capital – Nationwide has neither

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Nationwide Airlines is on the ground. A series of business and operational problems met the global economy of skyrocketing avgas prices and left them insolvent by R172m (assets of R46m less liabilities of R218m). They’ve also left friends of mine stranded in South Africa after a trip from Ireland for another friend’s wedding (congratulations Kay and Brennan!).

Simplistic overview of causes

  • High fuel costs – avgas has increased significantly recently.  However, this affects all airlines.
  • High fuel costs combined with fuel inefficient planes.  Nationwide’s older aircraft are less fuel efficient. Fuel costs per flight are thus higher than some competitors. An increase in fuel prices hits them harder.
  • Small capital base (now negative), high fixed costs and challenging break-even targets. Nationwide needed 75% capacity on its flights to break even. This reflects the high fixed costs per flight, and high fixed costs overall. A small capital base means that there was limited time to trade through difficult conditions and preserve the franchise / brand value of the operation.
  • Loss of confidence due to safety concerns, regulatory intervention. Since one of Nationwide’s planes “lost and engine” in flight confidence from the flying public has plummeted.  It has since emerged that the engine was in fact designed to free itself from the plane under certain circumstances. Combined with the pilot’s successful landing shows that the outcome was pretty good compared with other possibilities. However, a large portion of the market was not prepared to fly Nationwide anymore. Combined with the chaos preceding and succeding the operational and safety crisis, I stopped flying Nationwide simply because we had concerns about their ability to get us to our destinations on time. This may not have been based on a thorough analysis, but was based on several specific events. I’m sure I wasn’t the only one to reach this conclusion.
  • Price competition – pretty much the only customers prepared to fly Nationwide were those looking for the cheapest flight at any cost (safety, timeliness etc.). Thus, Nationwide’s pricing power diminished to virtually nothing. This exacerbated the need to fill planes to meet fixed costs.

Lessons for other organisations

Decreased capital bases have become a popular path to increased Return on Equity. Now, theory suggests that decreased equity will boost financial leverage if debt is involved (debt here including debt-like obligations such as fixed equipment leases). On a more practical level, decreased capital provides a smaller buffer against adverse trading conditions (default experience for banks, claims experience for general insurers, equity market declines for life insurers, interest rate shocks for most business). Assuming Nationwide had a viable business, a larger capital base would have allowed them to continue trading through the difficult times and emerge at the end of the tunnel a profitable business.

One of the standard counters to this is that if new capital were needed it could be raised from the efficient, deep, liquid, transparent, costless capital markets. Needless to say, those don’t exist. The practicalities of a bail-out package in sufficient time to keep an airline running make it especially challenging. Incidentally, it’s not unlikely that someone will take over Nationwide’s planes and staff – if our market does need those flights and employees that should find a home somewhere. If there was sufficient slack in the market for the other airlines to mop up the increased relative demand, then a company “exiting” the market is exactly what microeconomics would predict. Pity Mango has our tax money to shield them from a similar fate.

Financial services companies would do well not to dismiss Nationwide’s fate as ”nothing to do with me”. Northern Rock’s catastrophic loss of confidence might have been a little closer to home, but shares the same message of significant gearing, illiquid assets and a loss of confidence. Capital strength provides more leeway to ride out tough times, but also adds confidence to customers (deposit holders, policyholders) which is most critical in tough times. The costs of financial distress rise as companies’ capital positions worsen. Low probability events can be catastrophic when they hit, and there is plenty of evidence to show how human beings chronically underestimate the probability of low probability events.

Hedging. Again.

Fuel price skyrocketed. Margins destroyed. Airline no longer profitable. Now, if an increase in fuel price really would be that deadly to an organisation, surely hedging of this otherwise uncontrollable risk should have been sensible? As it turned out, Nationwide was partially taking a bet on fuel prices declining or staying constant. Lose the bet lose your business. If they had hedged, even partially, and fuel prices had declined, they would have still been in a sticky mess, but presumably better than they are now. If the competitive position they would have been in with locked-in higher fuel prices would have meant that they would also have gone out of business, then I’m afraid this sounds more like a wild speculative fling than a sustainable business. Rolling dice on that scale doesn’t inspire confidence.

Three conclusions

  1. High gearing and a small capital base has definite costs they aren’t completely factored into a naive RoE analysis.
  2. Customer confidence is critical to a sustainable business and should be nurtured.
  3. Hedging of major, uncontrollable and potentially fatal risks must be included in an organisations risk and strategic management.

1Time down 11.4% today. Comair up nearly 9%.  Market taking bets on which company is better positioned for the new competitive landscape?

Nick & Jerome

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Jérôme Kerviel, a 31 year-old banker at Soc Gen is blamed for losses of €4.9 billion incurred through rogue trades spanning over a period of some months.

The story has a remarkable similarity to Nick Leeson, the Original Rogue Trader who is blamed for the demise of Barings Bank in 1995. Unfortunately for Soc Gen, it seems the comparison extends as well to the general failure of controls and systemic failure of risk management processes. In Nick Leeson’s book (a very worthwhile read) he outlines the astonishing story of how easy it was to do the unthinkable and crater an unfillable hole in Barings’ balance sheet from a trading operation in Singapore without troubling internal controls and external auditors.

Conspiracy

Jérôme was trading vanilla equity derivatives – the sort of things that haven’t been complicated for a long while now. Very similar (again) to the instruments used by Nick Leeson. Jérôme’s positions were supposed to be externally hedged. Soc Gen should not have been exposed to overall delta risk of the markets moving either way. The fact that this was possible, went on for several months, and managed to grow to a hole this size leads some to simply disbelieve the story. One regularly repeated story is that Soc Gen may have incurred higher than tolerable losses (Sub Prime is often the assumed cause here) and needed a scapegoat (answering to the name of Jérôme) to divert blame from senior management.

I have no information as to whether this is true or not and do not want to express an opinion on such a flammable topic!

Stand Up, Internal Audit & Risk Management

Internal Audit and Risk Management areas are often the poor second cousins of the fiancial services world. They have little of the glamour and large bonuses of traders and investment bankers. The “people who make the money” alternate between complaining about the restrictions placed upon them by risk management, and generally feeling superior in every way to the internal auditors.

However, there are many more stories (on all different scales) of internal audit and risk management functions not being strong enough, or following process too rigorously at the expense of truly searching for risks. In fairness to process, I can think of plenty of examples I’ve seen myself where the problems arose from not following process. Businesses need to find a way to ensure adequate protections and controls are in place, without stifling the busines goals of the company. This post is not a comprehensive treatment of what could have fixed the Soc Gen problems, and I’m fully aware of how much easier it is to find the solutions to past problems. Having said that, three general rules for risk management and internal audit that seem not to have been applied here:

  1. It seems that Jérôme’s verbal skills may have sidetracked earlier attempts to catch his unauthorised trades. Some hard-and-fast rules are required. No negotiation. You hit this limit, perform this action, make this error and the wheels turn. NASA’s shuttle tragedies have been partially blamed on management’s gung-ho attitude of ignoring engineering warnings. These rules must be made before specific circumstances arise. No exceptions. No special cases.
  2. Follow the cash. Jérôme had seemingly faked hedging positions. As he was needing to place variation margin (cash) up for his losses, there should have been hard cash coming on from the offsetting contract. Barings was flushing cash at Nick Leeson’s Singapore operation when half a thought would have raised alarm bells.
  3. Reluctance to take leave. Jérôme apparently hadn’t taken leave in 8 months and didn’t let other traders cover his positions. I know a story about a claims processor at an insurance company who hadn’t taken a day of leave in several years. Until he was so sick he was admitted to hospital. That was the day his colleagues figured out he had been paying fraudlent claims to himself for years. There are thousands examples like this. All internal auditors should have read case studies such as these.

Operational Risk

The real story here extends far beyond Soc Gen’s borders, beyond Frances and beyond the investment banking world. Companies of every size are exposed to a range of risks, some identified and measured, others Black Swans waiting to make a first entrance.

Operational Risk, defined by the Basel committee as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”. These losses are an excellent (although extreme) example of op risk. Operational risk is more difficult to measure than many other types of risk. The actual events that give rise to the biggest risks are often unique. Past experience at Soc Gen would not have indicated that a risk of this type and magnitude were possible.

Before the Barings disaster, few would have imagined that such an event were possible. It would have been excluded from “reasonable” risk management discussions and measurements as too unlikely. After 1995, when many banks realised that there previous understanding of how badly things could go was wrong, better risk management systems and controls were implemented. From the responses of many in the industry, it appears as if everyone was again under the impression that this magnitude of risk couldn’t happen. Now, in a little over ten years, we’ve had two events of similar style and broadly comparable scale.

The real question isn’t when will something like this happen again. The question is what will be the next completely unexpected op risk event be?

Solvency II makes another milestone – QIS3 out

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Apparently the results for QIS3 are now available.  QIS3 (“Quiz 3″) is the third Quantitative Impact Study along the path to rolling out Sovlency II for insurance companies between 2010 and 2012. It provides further light on what capital requirements will actually be when Sovlency II comes into effect.

Perhaps a warning is required for the overally optimistic. Basel II required 5 QISs before maturing to be ready for roll-out. Many acknowledge that Solvency II is more complicated, with a greater number of complex risks to consider so it could arguably take much longer. Also, Basel II had the framework of Basel I to start with, where many European insurers have had very simplistic capital requirements to date. Watch this space!

I’ll provide some more feedback on the actual results of Solvency II when I’ve had a look through the material.