David Wright Notes
Creating and Destroying Risk
Quotes
Dinos Iordanou, Not Unreasonable
What is the insurance business? What do you manufacture? I asked that question to a lot of people, “What do you manufacture?” You manufacture decisions. It’s no different than the investment business. The investment business, what do you do? You don’t make widgets, you don’t make cars, you don’t make chairs. You make decisions. You analyze a company, you analyze the strategy. You do the same thing with underwriting. You look at the company, you look at the risk that they’re facing, etc. And you make a decision as to what is an appropriate price for you to take that risk and give them the protection that they need.
[I]n underwriting the two principles you must have are discipline and crisp execution.
[DW] So Warren Buffett, and Hank Greenberg, in my conception of it radically, radically different people. Is there anything in common? What do they share?
[DI] They, the thing that they share that is common is they make decisions based on a lot of analysis and a lot of knowledge. Both of them. Warren reads, enormous volume of information. And he has a sixth sense. That is what I’m thinking logical counting happened yet. And Hank always made decision based on at least my interaction with him, when you went to see him, you better have all the facts in order, yeah, don’t go by guessing, go by having the appropriate information. …both of them, there were tremendous focus on detail. And they liked the detail, different minds, different attitudes, etc. But if I had to say, what, what was both a secret ingredient to both in their decision making, if they will base it on a lot of facts and knowledge.
Kevin O’Donnell, RNR, Q4-2021
The market trend in 2021, was to move away from property cat risk due to fears of climate change, social and monetary inflation, as well as a lack of confidence in cat modeling. However, our expertise and experience gave us the confidence to know when we were being paid adequately to assume this risk, which we are uniquely positioned to understand in price due to our strong underwriting bench, with many of our underwriters having experience over multiple market cycles, are scientists, engineers, and risk modelers at RenaissanceReRisk Sciences and our integrated system.
I think investor skepticism is extremely high. … Investors are flocking to CAT bonds, and if you look at the spectrum of transparency and simplicity to enter a CAT market, to take diversifying risk, CAT bonds are a good place to do that. As you move through the spectrum of reinsurance and then all the way to retro, the [
lack of] transparency and understanding diminishes materially.
And I think there’ll be continued skepticism at the more risky end of the risk
perspective[spectrum] from ILS Investors.
Winston Churchill, speech before Commons, June 4, 1940
We shall not flag nor fail. We shall go on to the end. We shall fight in France and on the seas and oceans; we shall fight with growing confidence and growing strength in the air. We shall defend our island whatever the cost may be; we shall fight on beaches, landing grounds, in fields, in streets and on the hills. We shall never surrender and even if, which I do not for the moment believe, this island or a large part of it were subjugated and starving, then our empire beyond the seas, armed and guarded by the British Fleet, will carry on the struggle until in God’s good time the New World with all its power and might, sets forth to the liberation and rescue of the Old.
Consequences of Risk / “Volatility”
Risk = volatility = outcome
- Appropriate? For attritional risks: yes. Cat, more problematic. [Clear, objective, comparable, inescapable.]
- Non-cat: close connection between process and outcome…won’t be far off mean for long…
| Corporate (public, shared) | Individual (private) risk |
|---|---|
| Miss targets | Low/no bonus |
| Low earnings | No promotion |
| Erode capital | Low/no long-term comp |
| Impairment | Fired/terminated |
| Insolvency |
| Risk emitter/creator | Risk absorber/destroyer |
|---|---|
| Assumed by corporate balance sheet | Assumed onto personal balance sheet |
| Socialized | Individual |
| Decision impeding | Decision enhancing/enabling/facilitating |
| Financial risk | Career and reputation risk |
| Public disclosure |
| Espoused Theory | Theory in Use |
|---|---|
| Point estimate, “reserve”, “loss pick” | Actual outcome |
| VaR, loss potential | Actual outcome, “volatility” |
| “Confidence in pricing”, technical expertise | Personal credibility |
| Acting rationally… | |
Public (organizational) risk vs. private (individual) risk
Organizations aggregate financial and reputational risk
Financial risk capacity and reputational risk capacity
- Financing follows reputation
- Deploy reputation bearing risks
- Reputational risk capacity
- Reputational risk management
- Financial risk capacity is a function of reputational risk capacity
Action Outcome Matrix
| Best Action | Create / Emit | Destroy / Absorb |
|---|---|---|
| Actual Action | ||
| Create / Emit | Decision based on all the facts | FUD |
| Avoid big mistakes | Analysis paralysis | |
| Confused, delayed, ineffective decision making | ||
| Destroy / Absorb | Surprise loss, events “blow up” | Crisp decision making, based on relevant considerations |
| Change in strategy | Confidence in decision | |
| Investor skepticism, higher cost of capital | ||
| Loss of prestige, bonus, employment |
Productive and Destructive Risk Disclosures
| Productive | Destructive |
|---|---|
| Confidence building | Confidence eroding, “FUD” |
| Technically correct | |
| Accurate | |
| Relevant | |
| Timely | |
| Clearly communicated, digestible | |
| Understood | |
| Validated (data-based, back-tested) | Speculative, “What-if”, “Ah, but…” |
| Clarify | Obfuscate |
| Enable decision | Delay, confound decision “need more data” |
Risk Management
| Action | Corporate | Personal |
|---|---|---|
| Theory | Espoused | In-Use |
| Risk limits, uw guidelines | Control, consistency, rouge uw | |
| Purchase reinsurance | ||
| Quota share | ||
| Cat | ||
| Casualty XOL, property risk excess | ||
| Reinsurance as capital | ||
| Reinsurance as credential |
Actuarial Disclosures
- Range of methods for reasonable range
- Stigler story of averages, don’t pollute “best method” with low credibility estimates (from foreign astronomers)
- SE mean, confidence
- High/low range of \(n\) random samples contains the true median with probability \(1-2^{n-1}\), (when \(n=5\) with probability 0.9375 [Hubbard]).
- Range of outcomes
- SE of outcome
- PML, VaR, TVaR
- Bootstrap
- Bayesian, prior and posterior distributions of parameter; predictive distribution of outcome
- Multiple priors
Actuarial training increases your personal risk bearing capacity: you leverage the confidence others have in actuarial methods.
Are the different risk nomenclatures useful?
- Risk
- Uncertainty
- Systematic
- Systemic
- Prudence
- Temperance
So What?
Advising often involves emitting risk and leading absorbing it. But good advisors and good leaders perform both functions. Functioning as an actuarial leader (not manager of actuaries) entails knowing which risks to absorb and which to emit. The same function that the CEO performs for the entire organization.
[Primer on Decision Making]: information constraints
Decision:
- Alternatives
- Consequences, and uncertainty about consequences
- Preferences
- Decision rule (DR)
Decision making problems
- Attention: time and attention are limited
- Memory: and record keeping
- Comprehension
- Communication: specialties are not good at communicating with one-another
Coping with info constraints
- Edit/simplify problem
- Decompose problem
- Heuristics
- Framing