A short history of risk management

Almost every tool a risk manager uses today was invented to fix a specific problem: a ship that might not come home, a pension that might run out, a bank that failed overnight. Know the problem, and the tool makes sense.

L1.1.10: A short history of financial crises traced five financial crises and the risks behind them. This lesson tells the other side of that story: the ideas and institutions people built to manage risk. Three threads run through it. People learned to share risk (insurance), to measure it (probability, statistics and models) and to govern it (capital rules, independent risk functions and boards).

Step through the eight stages. At each one, say what problem the new idea was meant to solve.

Notice the rhythm. New tools usually follow a failure: Herstatt led to the Basel Committee, derivatives losses in the early 1990s to VaR and independent risk control, Enron to Sarbanes–Oxley, and 2008 to Basel III. Each tool also had blind spots that the next crisis exposed, which is why the next two lessons study failures in detail.

Go back to 1762 and price a one-year life policy as an actuary would: the chance of death times the sum paid, discounted for the interest the premium earns, plus a loading for costs and profit. Move the age and watch the premium climb.

Cover of £100,000, paid at the end of the year if the policyholder dies. Interest 4% a year, loading 20%. Mortality rates from the illustrative curve in the Try it. Amounts in pounds.

Much of this history is regulatory history: the Basel Accords for banks (Basel I in 1988, Basel II in 2004, Basel III from 2010) and the move from Solvency I to Solvency II for EU insurers. M2.7: Introduction to regulation introduces each of them and why they exist; Level 4 covers how the capital is calculated.

• Risk management grew along three threads: sharing risk (insurance), measuring it (probability and models) and governing it (rules, risk functions, boards).
• Marine insurance transferred risk; life tables and actuarial pricing made it measurable.
• Markowitz put a number on portfolio risk; RiskMetrics and the 1996 Market Risk Amendment made VaR the standard for trading risk.
• The Basel Committee (1974) and its Accords (1988, 2004, 2010) set common capital rules; ERM and the CRO joined the risks up.
• Most tools followed a failure, and each had blind spots that a later crisis exposed.

Underwriter

Someone who agrees, for a premium, to bear a loss if it happens.

Life table

A table showing, out of a group of people, how many are still alive at each age.

Actuary

A specialist who uses probability and data to price and reserve for insurance and pensions.

Value at risk (VaR)

Value at risk: a loss that will not be exceeded with a stated confidence over a stated horizon, for example 99% over one day.

Basel Accords

Agreements of the Basel Committee on Banking Supervision that set international minimum standards for bank capital and liquidity.

Enterprise risk management

Enterprise risk management: managing all of a firm's risks together, against one risk appetite, rather than in separate silos.

Chief risk officer

Chief risk officer: the senior executive in charge of a firm's independent risk function.