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Keeping it simple: effective simplicity is the product of careful thought, sound judgment and thorough planning.

HOW does a risk manager, chief risk officer or enterprise risk management overseer make certain that decision-makers throughout the organization appropriately take risk into account and understand the importance of doing so? Part of the answer lies in the oft-heard and self-exemplifying advice--keep it simple.The real trick, though, is knowing when and how to follow this advice and when to ignore it entirely. Here are some principles that can help.

First, translate complex calculations into understandable and useful approximations.At one firm, for example, the interest rate risk exposure of every fixed-income security was translated into the corresponding quantities of two-year, 10-year and 30-year treasuries that, if sold, would offset that exposure. It made sense to use these quantities, which were reported daily, rather than the equivalent but more academically respectable risk measures called duration and convexity, for two important reasons. One was that traders and portfolio managers readily understood them.The other was that our measures directly described what traders needed to know. By contrast, the duration and convexity measures were less intuitive and required traders to make potentially error-prone calculations to identify appropriate trades.

At another firm, as earnings forecasts changed, the tax department would routinely order massive exchanges between taxable and tax-exempt bonds in an attempt to optimize after-tax income. In fact, their recommendations ignored trading costs, which often exceeded the anticipated benefits.The solution consisted of devising and providing to them a very simple rule of thumb for incorporating approximate trading costs in their calculations.

Second, use familiar analogies. Senior managers often find it difficult to understand the basic principles of managing interest rate risk. For example, they often jump to the erroneous conclusion that interest rate risk is minimized when asset and liability durations are equal.To assist them we proposed the analogy of a teeter-totter with weights on each side that are proportional to the economic value of the firm's assets (on the left) and liabilities (on the right).The distances of these weights from the fulcrum are proportional to the durations of those assets and liabilities. Minimizing interest rate risk requires positioning the weights so that the teeter-totter is level and balanced. Since assets exceed liabilities (the difference is net worth), and therefore weigh more in our analogy, balance occurs only when the asset weight is closer to the fulcrum (and therefore has a shorter duration) than the liability weight.

Third, make analogies memorable.The U.S. Department of Defense often summarized its enormously complex budget by saying that it created sufficient military strength for our country to engage in one major war and one minor war at the same time. Consider describing a risk management policy to investors, regulators, and rating agencies as enabling one's firm to simultaneously endure two hurricanes such as Katrina and an equity market drop of 20% (as in 1987) without a threat to its solvency.

Fourth, consider trading perfection for comprehension. One of the current debates in risk management concerns the "best" measure of risk.Value at risk, which is widely used, is measured by selecting a high probability p, such as 99%, and calculating the magnitude of the loss that would be exceeded 1-p percent (in this case 1%) of the time.Although there are solid technical grounds for preferring some alternative risk measures, value at risk is often more readily understood because it is similar to the familiar notion of a worst-case loss, which, since it will never be exceeded, is the 100% value at risk.

Fifth, focus on the big ticket items.There is a temptation in enterprise risk management to aspire to measure and manage every conceivable risk. But most of a firm's risk exposure comes from a handful of major risks. Focusing on these is a powerful simplification.

Finally, don't simplify when doing so gives wrong answers. One firm was embarrassed by being unable to explain why one of its investment portfolios suddenly exhibited stellar performance. It ultimately discovered that a junior programmer had decided that the performance calculation software was too complex, and had deliberately simplified it in ways that produced incorrect results.

Keeping things simple is far from easy. In business, as in art and science, effective simplicity is the product of careful thought, sound judgment and thorough planning.

William H. Panning, a Best's Review columnist, is executive vice president at Willis Re Inc. He can be reached at insight@bestreview.com.
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Author:Panning, William H.
Publication:Best's Review
Article Type:Column
Geographic Code:1USA
Date:Apr 1, 2006
Words:733
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