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The Actuary The magazine of the Institute & Faculty of Actuaries

Letter of the month: Kent Sandom

The invitation to submit thoughts on ‘the end of risk management’ (Jan/Feb 2008, p23) could hardly be ignored following my last letter (Actuaries’ need for investment strategy, December 2007). Not wishing to labour the point, I stressed that risk management could only be applied with due consideration of economic/market circumstances.
Indeed, I fear that the term ‘risk management’ in the hands of many actuaries leads them into mathematics, asset/liability modelling and obscure derivative theories. A full understanding of the potential risks (and rewards with equities) is needed at all times, which is often more subjective than hypothetical mathematical theory. To quote examples:
1 The ignored consequences of falling interest rates and increasing longevity — coupled with inadequate reserving for guaranteed annuity rates — caused the collapse of Equitable Life.
2 The strange assumption that aggregating sub-prime mortgages in the US, and selling such mortgage packages, somehow reduced the risks followed by the subsequent contagion of the credit crunch.
3 Northern Rock seemed to forget that its business was borrowing short and lending long. Rather than relying on loyal retail deposits, short wholesale funding dried up in the money market with inevitable consequences.
4 Competition among banks and building societies led to collateral debt obligations, and structured financial instruments with reduced collateral backing exacerbated these situations.
5 The removal of cheap finance has caused large losses in several major hedge funds. Many try to develop parallel switches from A to B, like contracts for difference, but the prospect of major gains in single transactions of selling short or buying increases risks dramatically.
6 The UK has not provided the only example of rogue traders causing major calamities (comparable with some hedge funds’ performance). Independent and continuous auditing is vital.
In summary, risk must be managed but it is not primarily a mathematical problem. It is an organisational, management challenge with the need for an awareness of the possible consequences of one’s decisions. Experience, flair and common sense are particularly important in selecting business models and investment strategy.
Kent Sandom
30 January 2008

The writer of the Letter of the month receives a Venecia fountain pen kindly supplied by HBOS

The editorial team welcomes readers’ letters but reserves the right to edit them for publication. Please e-mail letters@the-actuary.org.uk