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<title>Risk Management Outsourcing - Why and How It Should Work</title>
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<td width="75%" valign="top"><p ALIGN="left"><font face="Arial" size="6"><b><strong>Risk
Management Outsourcing: Why And How It Should Work</strong></b></font></p>
<p><strong><font face="Arial" size="4">BY Donald Mumma<br>
</font><font face="Arial" size="3"><em>Commodities Now</em></font></strong><font face="Arial" size="4"><br>
</font><font face="Arial" size="3">(<em>originally published by PMA OnLine Magazine: 11/98</em>)</font><font size="4"></p>
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<td width="50%"><font FACE="Futura Lt BT"><p ALIGN="JUSTIFY"><big><font face="Arial">The
rapid changes in the energy industry have forced many companies to scramble to put
together new business strategies, corporate and management structures and systems to cope
with a new reality of customer competition. With these new strategies, structures and
systems comes the realization that coping with new and changing risks has put significant
stress on human, financial and technical resources. </font></big></p>
</font><p ALIGN="right"><font face="Arial" COLOR="#008000"><em><strong>-- Donald Mumma</strong></em></font></td>
<td width="50%"><p align="center"><img src="../images/mumma.gif" alt="mumma.gif (24948 bytes)" WIDTH="304" HEIGHT="268"></td>
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</center></div><p ALIGN="JUSTIFY"><font face="Arial">These new threats have also given
birth to new opportunities and new market participants with their own ideas on how to win
customers and manage risks. Some will get it very right and some will get it very wrong.
Time will tell who the winners and losers are. Who would have thought that PANAM or
Continental Illinois would go out of business because they could not manage the risks of
their business. Nevertheless, history is littered with example after example of financial
failures that happened because risks were either not seen or measured incorrectly.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Today, many energy companies are spending
extraordinary amounts of human energy, financial and technical resources and management
attention on managing price and credit risk. Some have decided that it is too hard and
have outsourced to others. But what have they outsourced? One major gas distribution
company recently announced a decision to outsource all of their price risk management to a
potential future competitor. Some may see this as giving away a major competency that will
be necessary to win new and preserve old customers. Outsourcing is generally considered
for functions that are not seen as a strategic core competency of an organization.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">When it comes to outsourcing risk management it is
very important to distinguish between risk measurement and risk management. There is a
case for outsourcing the measurement part of risk management. The issues are presented for
your thought and consideration.</font></p>
<b><font FACE="Futura Lt BT" SIZE="4" COLOR="#008000"><p ALIGN="JUSTIFY"></font><font face="Arial" size="4" color="#008000">Strategic Reasons to Outsource Risk Measurement</font><i></p>
<p ALIGN="JUSTIFY"><font face="Arial">Risk <u>Measurement</u> Should Not Be Confused With
Risk <u>Management</u></i></b>. Risk Measurement is an administration process that
involves considerable human and technical resources to produce risk measures and reports
for various parts of the organization. The value added in Risk Management is the decision
making on such things as customer choices, deal structure, pricing and portfolio
management.</font></p>
<i><b><p ALIGN="JUSTIFY"><font face="Arial">Methods of measuring risk are advancing
rapidly</b></i>. Consequently, risk measurement infrastructure obsolescence risk is high.
If a market pricing model changes or new concepts of management emerge, the measurement
infrastructure is often the thing that must be fixed first before the organization can
confidently and prudently move forward. When the technical and administrative part of the
organization considers itself as overhead, it may not be incented to keep up or be
responsive. When risk measurement is a business, its livelihood depends on being modern
and responsive. This should be considered very differently from the business of risk
decision making. Here the risk decision-maker is the profit center. </font></p>
<i><b><p ALIGN="JUSTIFY"><font face="Arial">Many oganizations do not possess a modern risk
measurement infrastructure or skills</b></i>. Because it has not been required in the
past, for many organizations it is not a core competency. Although there is a growing
talent pool of people who know how to manage risk, the same cannot be said for
measurement. Many risk managers are increasingly frustrated by the lack of understanding
and commitment of organizations to meet the risk measurement technical infrastructure
requirements. Yet without this capability, some companies may find themselves taking risks
they do not properly measure or not take manageable risks because they lack the capability
to measure it. </font></p>
<i><b><p ALIGN="JUSTIFY"><font face="Arial">Outsourced measurement is independent &
impartial.</b></i> One of the organizational challenges for an energy company is where to
put risk measurement. Because risk measurement is an every day requirement it is an
operating administration function. Because of many organizational issues, most risk
measurement is conducted within the management structures of the business units taking the
risks. The lessons of Barings, Orange County and others suggests that this is an operating
control risk waiting to explode. The most honest people in the world are put in a very
compromising position if they are responsible for both managing and reporting risk and
later measured and paid on their risk/return performance. </font></p>
<b><font FACE="Futura Lt BT" SIZE="4" COLOR="#008000"><p ALIGN="JUSTIFY"></font><font face="Arial" size="4" color="#008000">Cost Considerations</font><i></p>
<p ALIGN="JUSTIFY"><font face="Arial">Good risk measurement capability is infrastructure
intensive</i></b>. It requires a minimum level of hardware, software and staff that may be
very different from the current business infrastructure. The cost of this capability may
be beyond the profit potential of the business. Two possible consequences are either a
decision to have sub-optimal risk measurement or an avoidance of profitable opportunities.
Economies of scale in this area has led a few to form so-called strategic alliances. This
is usually a company without good risk measurement joining with one that does. Outsourcing
risk measurement may be a viable alternative.</font></p>
<i><b><p ALIGN="JUSTIFY"><font face="Arial">The evolution of certain commonly accepted
measurement standards are common to all</b></i>. The cost of implementing these changes is
multiplied by the number of different systems in use. Alternatively, it is a fraction of
the cost for users of the same system.</font></p>
<i><b><p ALIGN="JUSTIFY"><font face="Arial">The risk of redundancy cost write-off from
industry consolidation is reduced.</b></i> One of the primary reasons for industry
consolidation is to reduce costs of administration. By outsourcing this function, the
choice of risk measurement for the combined organization going forward may not require a
write off of imbedded investments in assets and people.</font></p>
<p ALIGN="JUSTIFY"> </p>
<b><font FACE="Futura Lt BT" SIZE="4" COLOR="#008000"><p ALIGN="JUSTIFY"></font><font face="Arial" color="#008000" size="5">What are the General Service Requirements?</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Reliability and Consistency.</b> The outsourcing
service must meet the same standards of reliability and consistency as are required to
meet internal operating risk requirements. Quite often an outsourcing service exceeds the
experience of internally conducted activities because of its business focus.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Accurate, Timely and Extensive Market &
Historical Data.</b> The outsourcing service should be capable of supplying external
information sources for measuring risk that meets the customers requirements.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">The Technology Infrastructure covers people and
the system</b>. The Outsourcing Service company should have several types of personnel;
Financial Engineers, Operations, Customer Service and Consultants. They should have a good
knowledge base of the customer’s business and be tightly connected to a technology
development team which keeps a leading edge in software and hardware platforms.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">The system software architecture is dynamic and
robust. </b>A dynamic data warehouse should be used to handle multiple databases of
subscribers data, consisting of transactional, market and subscriber legacy information.
It should interface with various sources, usually within the enterprise, for storage and
for risk processing. </font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">The system must also be able to allow for
flexible business rules</b>. These should drive risk measurement processes within the
system’s risk processing engines. Results of risk execution processes are then
aggregated and stored into specific datamarts in each subscriber’s data warehouse.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Output distribution and storage should be
subscriber driven</b>. Different methods of service delivery should be available, ranging
from hard copy report production and delivery, to online access. On-line access to reports
and underlying data should be accessible through either direct communication link or a
Secure Internet service. Information processing and access frequencies should also be
specified, e.g. daily, weekly or on demand (close to real-time).</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Multiple risk methodologies and broad instrument
coverage</b>. The risk engine should be flexible to support various methodologies to
assess individual and consolidated risks. These should include Monte-Carlo simulation,
historical simulation, Variance/Covariance analysis or a subscriber’s own proprietary
methodologies. In addition full instrument coverage should include not only standard
products, but also instruments measured with proprietary or plug-in third parties
analytics as well as commercially available datasets (e.g. S&P, Moody’s,
CreditMetrics, etc.).</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">All these standards should be superior to a
comparable internally conducted function.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Flexible and Responsive to Individual Customer
Needs</b>. The 70% solution applies here. Most systems and processes are common to all. An
Outsourcing service must be able to meet the last 30% requirements that are unique to
individual customers, without extensive system modifications.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Connectable to Customer Systems</b>. The
outsourcing service should be virtually transparent to the customer. The display,
reporting and inquiry capability of the service should look no different than if it was
coming from "inside" the organization.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Conflicts of Interest, Confidentiality and
Security.</b> These are very important considerations. The business of the outsourcing
company and its affiliations should be examined very carefully to assure that the
potentially sensitive measures are not exposed to falling into undesirable hands.
Additionally the system security itself should provide protection to access by only
authorized people at different levels for different purposes.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Auditable.</b> The outsourcing service’s
system and processes should be open to outside audit to assure that company standards of
controls are being met. Quite often there can be considerable cost savings from audit
requirements if a single audit is performed for all customers.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Cost Competitive.</b> The standard for cost
competitiveness should be that the net present value of the cost for the level of service
required by the customer stays below the cost to perform the same function internally.</font></p>
<p ALIGN="JUSTIFY"> </p>
<font FACE="Futura Lt BT" SIZE="4" COLOR="#008000"><p ALIGN="JUSTIFY"></font><font face="Arial" color="#008000" size="5">What should the Service Features include?</font><b></p>
<p ALIGN="JUSTIFY"><font face="Arial">Risk Measurement Flexibility and Testing</b>. The
service provider should be able to accommodate multiple methods of risk measurement,
including closed form models, historical data, Monte Carlo, simulations and stress
testing. The service should also provide a capability to test different models against
historical information. Credit risks should be able to calculate expected, unexpected and
worst case losses for counterparties and portfolios defined by the customer. </font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Counterparty Credit Scoring Flexibility.</b> The
service should provide for multiple rating bands with applicable default probabilities
defined by the customer or continuous default probabilities defined for each counterparty.
Multiple levels of losses upon default should be accommodated to reflect different deal
structures.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Multiple Limit Setting and Monitoring Capability.
</b>The service should accommodate multiple levels of market and credit limits defined by
the customer, with the ability to provide on line review and exception reporting for limit
violations and sources. </font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Real Time Mark to Market.</b> This feature may be
of limited value unless the customer defines price models for transactions that do not
have live market feeds from instruments that have live market feeds. </font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Historical Data Bases.</b> The service should be
able to accommodate either customer or service provided price data bases covering the
instruments used by the customer including equities, credit, interest rates (both domestic
and foreign), currencies and commodities: precious metals, oil, gas, electricity.</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">Customer Flexibility Features.</b> The basic
flexibility features of the service should include 1) establishing business rules, 2)
portfolio definition and aggregation structure, 3) data base definitions, 4) customer
hook-up and host linkage and 5) direct customer driven report generation.</font></p>
<p ALIGN="JUSTIFY"><font FACE="Futura Lt BT" SIZE="4" COLOR="#008000"> </p>
</font><p ALIGN="JUSTIFY"><font face="Arial" color="#008000" size="5">SERVICE & PRICE
STRUCTURE</font></p>
<b><p ALIGN="JUSTIFY"><font face="Arial">An Outsourcing Service should be priced on a
scale to the customer’s unique requirements.</b> It should be remembered that the
ability of an outsourcing service to be profitable is its superior economies of scale. The
same drivers of the service companies costs will drive its pricing. For each customer the
drivers of cost and, thus price will be based on 1) number of different data sources and
destinations, 2) number of instruments and counterparties, 3)number of portfolios and sub
books, 4) number and geography of offices, 5) number of measurement methods and 6)
frequency of risk measurements. Much of the cost is in set-up, with ongoing costs
significantly leveraged by the critical mass savings on technology and staffing.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">The term structure of outsourcing may range from one
to as many as five years. The dynamics of the industry, technology and credit issues will
be important variables. Other provisions may be individually structured up front or as
requirements change.</font></p>
<p><font face="Arial">What is most important to a decision on outsourcing is a confidence
by both parties that they see the relationship as a long term mutually beneficial business
partnership that is capable of accommodating change.</font></p>
<hr>
<p align="center"><strong><font size="3">About the Author</font></strong></p>
<p><font size="2">Don Mumma is Managing Director, Axiom Software Laboratories, where his
responsibilities include the risk management consulting and masurement outsourcing
services of the company. His 20+ years of professional and management experience spans a
multitude of financial and energy risk management disciplines. Axiom Software Laboratories
is located at 63 Wall Street, New York, NY 10005. Tel: 1-212-248-4188 Fax: 1-212-248-4354
Web Site: <a href="http://www.axiomsl.com">http://www.axiomsl.com</a> | E-mail <a href="mailto:[email protected]">[email protected]</a></font></p>
<hr>
<font SIZE="1"><p ALIGN="JUSTIFY"></font><font size="2">Reprinted with permission from <strong>COMMODITIES
NOW, JUNE 1998</strong>. <a href="http://www.commodities-now.com">http://www.commodities-now.com</a></font></td>
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