Computation and the Strategic Importance of Risk Management

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By Stephen H. Conwill | 05 March 2015

It would be presumptuous of me to claim that the risks we face today are more severe or more difficult to manage than those that were faced by our forebears. Human history has been marked by periods of stability and periods of great turmoil. Each period of turmoil has spawned reflection. We construct narratives to explain the emergence of turmoil; we try to understand the mistakes we have made; we hope that the wisdom we have gained will help inform us as we move towards an uncertain future.

Are we in the middle of a remarkable period of stability or are we about to face great turmoil? No one can answer that question. Even with exceptional resources, we are not clairvoyant. But we are not helpless in the face of uncertainty. Indeed, with the risk management tools available to us today, we can prepare far better than in the past for an uncertain future.

This has been said many times before, but it is worth repeating: our world is changing faster than we can possibly imagine. We are facing change driven by technology. We are facing change driven by cultural and geopolitical conflict. We are facing change driven by the complex interaction of these forces. Change is certain, but the direction of change is not. And the details, of course, are mostly inscrutable.

I very much appreciate your attending our seminar this afternoon. We’ve focused on new directions in financial reporting and new directions in systems and on the emerging importance of the cloud. I’d like to speak briefly about why companies that grasp the importance of these developments will be the market leaders in the years to come. We cannot look into the future with precision; we cannot envision future geopolitical dynamics; we cannot reliably forecast even a relatively simple figure such as Japan’s GDP a few years into the future. Nonetheless, an analysis of the possibilities, of scenarios and sensitivities, is essential to our business planning. Whatever future develops, the companies that survive and prosper will be those that embraced change in their view of systems, embraced change in their view of risk management, and aggressively endorsed efforts to promote human capital development and human capital deployment.

Is Financial Reporting a Strategic Function?

Let me pose a fundamental question: is financial reporting a strategic function? Is it strategic or simply an operational necessity? Before trying to answer that, let’s reflect on the grand sweep of history.

Archeologists have found evidence of bookkeeping dating back 7000 years. That’s a long time ago; a lot has changed since then. As the complexity of society has increased, we’ve progressed from bookkeeping to accounting to financial reporting. And we are now at a very important juncture: we are seeing an integration of financial reporting and risk management functions.

Is financial reporting a strategic function? At times, it seems like merely an obligation; it is necessary, of course, but is perhaps not obviously a lever of strategic differentiation. If you look at history, I think you’ll find that accounting and financial reporting became strategic at times following the introduction of new ideas, ideas such as double entry bookkeeping or public disclosure for stock companies. In these eras, not surprisingly, there was a resistance to new ideas—there always is—but the early adapters gained an important strategic advantage. Fundamental management needs--for understanding and transparency--trumped our innate fear of change; they helped us overcome our fear of scrutiny.

A tremendous amount of effort has been expended over many years in the development of IFRS 4 Phase 2. I must confess that at times I wondered if it was worth the effort; should we have worked harder to simplify, should we have been satisfied with a broader brush approach? But seeing the result of the deliberations and reflecting on the tools that are now available to help us integrate our financial reporting and strategic risk management efforts, I now very much believe it was it was worth the effort.

No company will prosper unless they pursue excellence in financial reporting. Japanese companies understand this well. For the past 20 years, you have been working to enhance the clarity and transparency and effectiveness of financial reporting methods. Not all companies are equal—that is a simple fact of life. Some companies produce better quality information and use that information in an effective way to formulate goals and incentives. They use a variety of metrics to facilitate the design and vetting of operations and strategies. These metrics help us to choose among alternatives and to measure our success.

But until recently, change in financial reporting technologies has been incremental. It no longer is. Technology is facilitating the implementation of reporting and risk management techniques that only a decade ago were impossible. The complexity of our business environment makes the introduction of these techniques essential. We will not survive without them.

Is Risk Management a Strategic Function?

Let’s turn our discussion towards risk management.

Is risk management a strategic function? Yes, of course it is. Many companies would agree, at least in theory. The idea of strategic risk management certainly underlies Solvency 2 in Europe and evolving practice in Japan. But we have not yet truly embraced the idea. It is not internalized throughout our organizations.

Conversations tend to change when a risk manager walks through the door. We talk about embedding a risk culture in our organizations, but it is easier to accomplish in theory than in practice. It can be very hard to avoid an “us versus them” mentality.

A key objective of today’s seminar was to describe very practical tools that will help companies to bridge this gap.

Risk managers must not be viewed as gate keepers, as naysayers, as the scolds who warn of impending doom. They must be viewed as partners, facilitators, as colleagues who help us to identify opportunities and manage the risk that opportunities inevitably entail.

An Era of Risk?

Are we facing an era of unusual risk?

Some of the risks that may have a direct bearing on Japanese business include:

  • Geopolitical risks, including a growth in protectionism, disruptions to trade, or the risk of outright conflict
  • Systemic risk in global finance
  • Uncertainties related to Japanese government debt
  • Uncertainties related to financing of Japan’s social safety net, especially pensions and medical care
  • Uncertainties related to the ultimate unwinding of quantitative easing
  • Uncertainties related to the aging population, birth rates, immigration
  • The possibility of an interest rate spike and the related risk of inflation
  • The impact of disruptive technologies
  • The emergence of new and non-traditional competitors

These risks are scary. They are substantially beyond our control. Instinctively, we want to ignore them; we may want to tell ourselves that they are beyond the realm of our models, that they are beyond the realm of our risk management protocols. If we say that, however, we would be fundamentally wrong.

Emerging Tools

Even when dealing with relatively simple forecasts, we face the following challenge: history provides only a rough guide as to what the future may bring.

All of us are trained to help our companies think about the future. We are trained to use our understanding of the past to construct forecasts well into the future. We undertake stress tests and reverse stress tests; we think stochastically and deterministically; we move forward into a very uncertain world, using the data and the tools available to us.

But we are not clairvoyant.

We are not clairvoyant, but we now have access to tools and techniques that greatly expand the range and credibility of our modeling and risk management activities. They help us build robust and resilient organizations even in the face of a highly uncertain future.

Milliman Integrate is one of these tools.

Implications of Computing Capacity

Because of the growth in computing capacity that has continued unabated over the past several decades, we are at a remarkable juncture. Investment in better financial reporting systems once led to incremental gains. New reporting technologies are now essential for prosperity and survival. We have seen similar imperatives in other aspects of our business. Across a wide spectrum of industries, web-based technology has become essential to support sales and customer service. In the financial services sector, advanced technologies have long been essential in the realm of trading and hedging. For insurers, data analytics is quickly moving towards the mainstream.

And the value added made possible with computing capacity is becoming clearer and clearer in financial reporting and risk management.

  • The products we are offering and the risks we are bearing are complex
  • The behavior of financial markets and customers is complex
  • The demands of regulators and rating agencies are growing, and
  • Competition is increasing

But new reporting and risk management concepts, made possible by vastly increased computing power, are giving us tools to deal with these complexities.

What is the Greatest Challenge that Japanese Companies Face?

What is the greatest challenge that Japan faces as an aging country in an era of globalization? What is the greatest challenge that Japanese companies face? Two things that come to mind are shrinking domestic markets and fierce global competition. But let me suggest a third possibility: the most fundamental challenge to a company operating in an aging society is competition for talent; the ability to hire the talent you need; the ability to build the human capital necessary to leverage new technology and ideas towards competitive success.

Think about our lives. We are being asked to do more things, more quickly, more efficiently than ever before. Our tasks are becoming more complex because the societies and markets in which we operate are becoming more complex.

In this difficult environment, Japanese companies have three choices – shrink because you can’t develop adequate resources to compete effectively, develop a strategy to outsource ever larger parts of your organizations, or greatly enhance the flexibility of systems and processes in order to maintain domestic control.

I believe that the last option is the best for your companies and the best for Japan.

Organizational Change

The introduction of new technologies will inevitably change an organization. But we cannot simply introduce new systems and ideas and wait for the organization to change. We need to be proactive in changing our own organizations. We need to design our organizations with technology in mind, with the constraints caused by a declining workforce in mind, with the rapidly changing needs of our customers in mind, and with the complexity of the global competitive landscape in mind.

We cannot survive without organizational change.

Systems transformation; organizational change; it sounds scary, it may make you think of restructuring; リストラ。

But we are not talking about restructuring, we are talking about redeployment. We are talking about achieving excellence in a very difficult environment with very scarce resources. We are talking about empowering the human element and allowing companies to direct them to where they are most vitally needed.

That is the essence of INTEGRATE.

The Advantage of Being an Early Adapter

Let me challenge you with the following assertion: being an early adapter will be critical. Companies that are content to follow risk being marginalized. We are far beyond the convoy era.

It is tempting to believe that gradual, incremental change can bring about the transformation that is needed. Japan as a nation and Japanese companies are very adept at incremental change. Indeed, following the insurance industry financial crisis of the 1990s, sound regulatory policy coupled with wise company management facilitated the recapitalization of Japan’s insurance industry. The resurgence of Japan’s insurance industry following the crisis of the 1990s marks a remarkable and admirable success.

But there is a danger if we are lulled into complacency. All across the world, all across Japan, there are examples of once prosperous companies that failed not because they took outrageous risks but because they failed to reinvent themselves. They moved too slowly. They tried to adjust incrementally as the world was changing rapidly about them.

But I am confident that you will succeed.

Building Strategic Advantage

What are the advantages bestowed by well-designed risk management systems that are seamlessly embedded in an organization?

  • Lower cost
  • Greater productivity
  • Better understanding of capital needs
  • More appropriate capital allocation
  • Better ability to identify and vet opportunities
  • Increased adaptability
  • Greater resilience in the face of a changing environment

These are all critical advantages.

A Vision for Japan

In Japan’s aging society, in a stable society embedded in an increasingly risky world, the insurance industry will emerge as one of the most vital, essential sectors of the economy.

We should all feel a sense of obligation as we look forward to the future, but also a sense of excitement and shared commitment. With all the talk of bubbles and lost decades and deflation, we may lose sight of one very important fact: the progress made by the Japanese Insurance industry over the past 10 years has been truly remarkable. Japan now has a chance to lead the world in insurance and financial services innovation and risk management. That should be your goal. Japan surprised the world in the 1970s and 1980s, emerging as a leader in quality and innovation in electronics and autos and many other industries. Let me make a prediction this afternoon: this will happen in insurance. Japanese domestic insurers are, in fact, gaining recognition worldwide for the quality of service they offer to customers in Japan. Japanese life and non-life companies are beginning to assume a leadership role among the multinationals of the world. Japan has a tremendous amount to offer.

Certainly Japan shares many challenges with the rest of the world. But this, in fact, is an opportunity—an opportunity to provide leadership. I am confident that over the next decade, Japan will lead the world in developing a vision for security, stability, and efficiency in the challenging circumstances of an aging society.