Three important lessons to be learnt from the current financial crisis

I was listening to a speech by : THARMAN Shanmugaratnam, The Finance Minister of Singapore a few days back and he talked about the three lessons to be learnt from the current financial crisis. Here is how they go.


1. Focus on Core Expertise:
First, insurers should focus on their core areas of expertise. This is perhaps one of the clear lessons from the AIG crisis. AIG's problems came about as a result of its significant venture into credit derivatives and other structured finance activities which were not within its core insurance activities. It earned high returns, but they came with much higher risks than it knew and that it was capable of managing. As we all know, its financial products arm eventually incurred significant losses as a result of these activities, threatening the solvency of the entire group. Fortunately, in Singapore, AIG's insurance arms, AIA and American Home Assurance, have limited exposure to the deterioration in global credit markets and continue to meet all regulatory requirements. The broader lesson is about sticking to what you know, and to manage the risks of your core business. While insurers are in the business of taking risk, their expertise lie in underwriting event risks. They have built up expertise and many years of data to model risks from natural catastrophes, accidents and mortality. Life insurers manage both mortality as well as longevity risks. In addition, they invest in a wide range of assets in order to generate the returns needed to meet the expected payouts from the products they sell. Managing investment risks is therefore a key task in any life insurer's operations. In particular, given the long-term nature of their liabilities, life insurers should ensure that their investment portfolios are sufficiently well diversified with a long-term focus in order to weather short-term market volatilities. It would not be prudent for life insurers to enter into high risk activities that could yield high returns in the short-term but threaten their long-term viability.


2. Reliance on Mathematic Models:
The last few years have seen a tremendous increase in reliance by financial institutions on mathematical models, for making investment decisions. Whether it be options, futures, swaps, no room has been left for basic common sense and analysis to come in and assess the situtation or the deal. The bankers rely on mathematical model predictions and base their decisions on it.
These mathematical models are systems trained on the market trends and scenarios in the last few years and keep upgrading themselves on the basis of the developing market trends. The intelligent onces also have a log of what started the last few financial crisis and can be helpful in preventing those. But what should be realized is that, no matter how well trained and robust these systems are, they can never predict the future accurately or even get close to it when its required the most. Each financial crisis has origniated because of a different reason and has had different consequences. So, the mathematical models cant be a good indicator of a future downturn or what could turn out to be a toxic investment business. It is the human mind which can analyse any situtation best and predict the future, the best anyone/anything can. So, it should be put to judicious use. Rather than going following the predicted flow blindly, we should be stopping and asking questions like "Should this be happening?" "What will this lead to?"


3. Outsorucing risk management and credit rating agencies:
Perhaps outsourcing doesnot work well in all sectors.
Institutions not only outsource the technology management/maintainance, customer helpline but also their risk management and assesment tasks. Insitutions often dont focus much on internal assesment by rely on external credit rating agencies to tell them how good their credit rating is. It goes without saying how important Risk Management is. It should be the foremost focus of any operating business rather than being considered as a back office and a burden on the company.