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In my career as an asset manager, and as a manager of financial risk, I have learned that all good risk management is done upfront, before the first purchase is made or product is sold. Secondarily, good risk management relies on the concept of feedback, i. e., are the results expected at inception happening? If not, are they happening in a way that makes us doubt the margin of safety that we thought we had?

I’ll give you some examples:

1) There are two ways to offer disability insurance (this applies to high-end P&C products for the wealthy, and other financial products):

  • Rigorous underwriting that does not cover groups & individuals that could be high risk.
  • Underwrite freely, and then attempt to deny claims that happen with higher than expected frequency.

2) After designing a living benefit for an annuity, you notice that one option is being chosen by policyholders, and the rest not. Do you:

  • Retest the option being chosen, to see that you are not giving away the store?
  • Do nothing. After all, it’s the only product of its class selling, and marketing is off your back for now. Why spoil the party?

3) You discover that you are the only company willing to offer a certain type of reinsurance, or a certain type of coverage. Do you:

  • Try to analyze why your competitors don’t do it. If there’s no special and durable barrier to entry that you possess, make the pricing jump through harder hoops.
  • Congratulate yourself for your unique perspective, and willing to take risks that others won’t.

4) On your new insurance product, the claims area sends you early claims data, showing you reasons for the claims. They reasons aren’t what you would have expected from the quality of the clientele that you thought you were marketing to. Do you:

  • Begin analyzing marketing data, to see if the product is being offered more to those less intended. Analyze what agencies are doing who sell a disproportionate amount of the product.
  • Attribute the claims to the “Law of Small Numbers.” Hey, it’s a weird world, and odd stuff happens.

5) You’re part of a team of value investors. A news event hits, showing that the company will be less profitable than expected by a wide margin. Do you:

  • Analyze what the company is worth presently. If it is no longer safe or cheap, sell. If the market has over-reacted, buy. Oh, and feed back the lessons from this episode into the process for evaluating new investments.
  • Automatically sell, because it has breached your loss limits.
  • Just hang on, because we have more than enough capital versus investable ideas.
  • Complain about the event, the potential dishonesty of management, and the analyst that recommended purchase. Ask why we didn’t sell this last week. Decide to go activist on the company, because it obviously the assets would be managed better in hands that you select.

6) The credit cycle has gotten long in the tooth, and securities that offer a decent yield versus risks undertaken have become few. You manage money for income seeking investors. Do you:

  • Edge away from risky bonds, slowly upgrade quality, and pare yields. Communicate to clients why you are doing this, even if it means you might see assets walk.
  • Stay fully invested in the best quality bonds you can find, subject to a given yield hurdle.
  • Just facilitate the demands of clients, and invest as if you faced normal yield tradeoffs for risks undertaken. After all, they want you to take risks. If clients lose, that is their problem.

7) As a value manager, you have been underperforming for clients. Though you have tested and re-tested your processes, you can’t find anything wrong. You think there is a speculative mania going on. Several other managers that do things your way have been fired. Do you:

  • Stick to your guns. Safe and cheap will eventually win out. Communicate that to clients.
  • Tweak your portfolios to make them more index-like.
  • Switch to growth or momentum investing. If you can’t beat them, join them.

There will be a part 2 to this piece. I will finish up and summarize there.

Source: Risk Control Up Front