April 02, 2013 at 04:09 AM EDT
The Education of an Investment Risk Manager, Part IV
One day, when I was least expecting it, the Spanish Inquisition arrived, otherwise known as internal audit. IA: You run the GIC business. Me: Yes. IA: What functions do you control here? Me: I market, price, cashflow test, and reserve the GICs. I also direct hedging and investment policy. IA: Isn’t that too large of [...]

One day, when I was least expecting it, the Spanish Inquisition arrived, otherwise known as internal audit.

IA: You run the GIC business.

Me: Yes.

IA: What functions do you control here?

Me: I market, price, cashflow test, and reserve the GICs.  I also direct hedging and investment policy.

IA: Isn’t that too large of a concentration of power in your hands?  You do everything.  There are no checks and balances.

Me: It allows us to run a better operation, because we feed back our results into our underwriting.  Besides, my boss reviews my work regularly.  I am not the only one analyzing my work.

IA: But leaving reserving and pricing in the hands of the same person is wrong.

Me: In many cases I would agree with you, but these are GICs; I have little freedom in setting reserves for them, the answers are formulaic, I can’t vary them.  Besides, take a look at our cash flow testing opinion.

IA: Huh?

Me: after reading this, you will see all the controls we put on the process.  We run far more rigorous tests than other insurers do to ascertain the profitability of our business.  Have a read.  Beyond that, our financials are reconciled to the penny every night.  It would be very difficult to have fraud here.

IA: You really seem to have too much power…

Me: We are not a large division.  We have four actuaries total.  We have different functions, and we can’t spare the effort to split pricing and reserving.  The boss watches over us; go ask him for his view of what  we do.

IA: I have, and he sounds like you.

Me: And he is the best.  He built this place, and it runs more smoothly than any other division of the company.

IA: Your division is funny.  You do things that we recommend against, but we can’t find anything wrong.

Me: We’re just doing our jobs.

IA: (Sigh) Okay, thanks, but our objections will be in the report to management.

Me: That’s fine; if the boss says to change things we will do it.

One of the most important aspects of insurance is to let the results of underwriting flow back into reserving and pricing.  You want to try to change your pricing of new business such that it reflects the true risks undertaken.

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Then there was the minor panic that happened in late 1993, early 1994.  Rates had been low for a long time, and the investment department decided to buy some 10- and 30-year Treasuries, because they couldn’t find anything with enough yield.  Thus my conversation with the manager of my portfolio:

Me: Why are we holding 10- and 30-year bonds?  The duration of my longest liability is five years.

IM: Well we couldn’t find anything you buy.  These are just placeholder assets.

Me: You could hold cash, or 3-year Treasuries.

IM: But we wouldn’t get the yield we need.

Me: I am less concerned about our income than that we cover our risks.  You have made my interest rate risk higher by a factor of two.

IM: That much?

Me: This is a leveraged operation.  We ordinarily run at a duration of 2.5.  You can’t give me assets with durations near 7 or 14.

IM: Don’t worry, assets that fit your need should show up soon, just give us time.

Me: I would rather wait in cash, but okay.

+++++++ Two months later +++++++++++

Me: We’re sitting on 10% losses on the long Treasuries now.  You are killing my year.  What are you going to do?

IM: (makes a gesture of praying)

Me: that’s not good enough!  You said you would find something soon and now the Fed is tightening.

IM: We’re looking, we’re looking.

Me: (sigh) I know, but put yourself in my shoes.  We control risk first and then seek yield.  This reverses our priorities.

IM: I know, but relative yield is hard to find these days

Me: I know, but absolute yields are rising, and we are losing in the process.

+++++++++++++++++++++++++++++++

We closed out the position two months later for a loss of 18%.  Had the bonds been held longer, it would have been worse.  As it was, once we cleared that out, I started selling GICs rapidly, and did not hedge the sales, because I had figured out that rates would keep rising for a while, as I wrote about here.

As noted in the article just cited, 1994 eventually ended up being a winner of a year, but it started with that inauspicious event.  Who could tell?  My main point is this: don’t give up your risk control discipline to make a few measly bucks.  In tough situations, focus on the risks, and ignore the yields.

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