Turning risk into value

Among asset managers, MEAG may well be the envy of its peers. It manages more than EUR 256 billion of assets, yet suffered no direct damage in the financial crisis. This is almost certainly due to the risk management culture at the firm and its heritage as part of Munich Re.

Only a small portion of the assets under its management are from Munich Re companies and, as Dr. Peter Schenk explains, insurance companies do things differently. “The assets of insurance companies have to behave differently than assets belonging to other types of investors. The assets must back the liabilities of the insurance company. What is more, life insurance company assets have to be structured completely differently than those of a composite insurer or firms that reinsure storm risks. The risk content and asset behavior mean that they have to match, or approximately match, this liability structure. Any deviation has to be deliberate. This means that when you manage assets for insurance companies, you have to talk about risk. The liabilities are risks. Insurance companies deal with risk. Munich Re’s mission statement is ‘We turn risk into value’. So that’s where we start from. We have to understand the investor’s risk concept.”

Primary focus on risk

While many other fund managers may be under greater pressure to focus on return, MEAG’s primary focus is on risk. More particularly, it has to understand very clearly the ‘riskless position’ of the investor. But what is ‘risklessness’? “For a private individual it may mean cash in a drawer to pay for tomorrow’s pizza,” says Dr. Schenk. “For an insurance company that knows, or expects from its models, that it will have to be able to pay certain claims in a year’s time, or, in life insurance, in 10 or 15 years’ time, your riskless position will not be cash, because relative to the liabilities, the return is quite different.

To arrive at this riskless position you have to do certain calculations; you need to look at the asset and liability values at risk. You need processes that will meet the liability structure when it changes. Insured events may or may not occur. Claims may emerge or not emerge.” Modelling but also preparedness for the unexpected are key ingredients of the process. As Dr. Schenk adds without any hint of complacency, “A financial crisis is just another event that makes you think about your risk profile.”

It follows, then, that understanding and calculating risk at MEAG starts at the top of the firm. As well as heading the risk management function at MEAG, Dr. Schenk also plays a role in the integrated risk management function of Munich Re as a whole, where he reports directly to its chief risk officer. Any new investment decision that is taken involves the full participation of the risk management function; it has to pass the risk management test.

“It is very important to remember that there always are two perspectives in our decision processes: the front office perspective and the risk perspective, which are taken equally into account,” explains Dr. Schenk. “In order to come to a well-balanced decision, the people with an allocation idea must know that they will be confronted with risk perspectives. An example where we see this working in practice is our ‘New Product Process’. When an attractive new investment idea comes out in the market, the front office may be thrilled with it. The investor may be thrilled as well, because it may be a good instrument to reflect its liability profile. But we will only take up on it if we on the risk management side agree. We have to be able to understand the product. We have to be able to adequately model it in our systems. We have be able to access the data we need to feed our models, so that the output they give us is in the form of useful information.”

Business enablers

However, it would be a mistake to paint the risk management function only as an obstacle to doing business. The risk management culture has evolved much further than that and according to Dr. Schenk, “There are conflicts, but we have found ways to deal with them as a routine. What is necessary is intense communication and mutual respect. We work together in one building. We meet at lunch. Whenever issues arise, we sit down together and talk about them. We regard our role explicitly as business enablers. We supply the front office with tools that they can use for their allocation and try to assist in finding solutions when dealing with narrow risk limits and other restrictions. It helps if they see that we really do not want to hinder them and that we are not always risk averse, but that we also try to find ways for them to take on risk.”

Dr. Schenk sets out the first principles of MEAG’s risk management operation. The internal data has to be up to date and complete. It has to be stored correctly and securely so that all holdings are known at any time. The details of holdings must be transparent. The methods and processes for handling the data have to be able to transform it into information that is useful and can flow into the decision-making process. To achieve these things MEAG uses a centralized data backbone that includes SimCorp Dimension. These features are the basic building blocks, but it is dealing with the unusual situations that defines the risk culture at MEAG and tests how effective it is.

As Dr. Schenk elaborates, “When special situations emerge, when there is a crisis or new business opportunities – something unusual, you have to have all this data, and the processes and governance rules must be set up perfectly. And you need a risk culture that is able to change to another gear; to move into crisis mode, if you like. Then, when you do, the culture of the firm ensures that everybody really likes to work with each other. Everybody keeps a close eye on the risk system, but the gap between it and the special situation can only be bridged with communication and action, with everybody really doing not only what is in their job description, but whatever is necessary at that moment.” Dr. Schenk adds that, “This is a ‘top-down issue’ because everyone appreciates that understanding, managing and controlling risk is vital to our business and our decision-making process.”

Multi-disciplinary team

It is also key to the process that the risk management function is staffed in a way that matches the demands of the business in all its complexity. For example, Dr. Schenk himself has a background in mathematics and computer science and holds a doctorate in economics. He notes that his colleagues in the Risk Management department are an interdisciplinary team. There are economists, people with technical computer science backgrounds, but also physicists. In addition, the company sponsors them to gain Professional Risk Managers’ International Association (PRMIA) qualifications. Intellectual rigor and professional competence are essential prerequisites.

However, part of MEAG’s success in the financial crisis is owed to the 2000-2003 equity bubble, which sharpened the firm’s resolve to enhance its risk culture. As Dr. Schenk explains, “We looked at everything: at what worked and what didn’t work so well. The problem is always interfaces between different departments; between the asset manager and the investor. And there we learned some lessons. One was that we really intensified communication. We introduced a mandate management concept which ensures that the tactical asset allocation not only fits MEAG’s view of the market, but also the investor’s overall situation. One example of what this concept entails are the regular asset/liability management meetings now held between investors and MEAG. Another is the elaborate risk management process with well-documented tasks and areas of responsibility. Every objective that an investor has is quantified and corresponding risk triggers are defined. When a risk trigger is activated, a predetermined process starts. This process always has to do with distributing and exchanging information, meeting together and deciding. Our processes now encourage people to make decisions.”

Today, for example, risk modelling, stress testing and reviewing and revisiting the stress tests and models on a regular basis are vital processes. And transparency is the sine qua non. It is one of the chief reasons that MEAG avoided the worst of the crisis, as Dr. Schenk points out: “If you have transparency, you can quickly manage an asset’s risk. You can sell it or hedge it faster than your competitors perhaps. Nobody could ever understand what a CDO of CDOs was, because you couldn’t drill into the data that really exposed the risk. If we were to buy these products and somebody asked us, “What is your exposure to US real estate, or to British credit cards?” we couldn’t see the answer. We wouldn’t have the data. So we either wouldn’t permit such instruments at all, or would at least classify them as ‘nonstandard’, which leads to strict limitation in volumes and special pricing and reporting rules.”

Global prospects

So in the bigger picture, considering the raft of new controls and measures currently under discussion, and in light of MEAG’s experience, is Dr. Schenk optimistic that products that are not sufficiently transparent will be banned or sufficiently de-risked in the future, so as to not pose a threat?

“It is not black and white, but altogether I’m not optimistic. Buy-side needs and sell-side creativity will always lead to interesting constructions that somehow manage to comply with existing regulation. So it will always be the task of individual companies’ risk management to make a judgment about the degree of transparency,” he says. “The other thing is systemic risk. To prevent this we would need a global risk management system. A global risk management system means global data pools, a global early warning concept and global risk management processes linked to these warnings. This is now being thought about and discussed in all kinds of forums, but the challenges are huge. I think the desire is there, as well as the basic willingness to collaborate, but it will be cumbersome to arrive at concrete decisions and to accept jointly shouldering the pains risk management brings with it. I think the train is moving in the right direction, but if it is to reach its destination, many components have to interlock, and many parties who have not worked together so far will have to do so in the future. It is complicated, global, and there are lessons to be learned along the way. It might take a long time.”

Dr. Schenk concludes by saying that while the world has probably learned how to avoid another sub-prime crisis, it is the unexpected we have to prepare for. “To deal with the unexpected you need global risk management systems, a global risk culture and global risk governance, so that the relevant key persons will sit down together and make decisions, fast.” This, he says, will be very difficult to achieve on a global scale, but for MEAG’s own business, with the highly evolved risk management capability that Dr. Schenk describes, there is plenty of cause for optimism.