Risk Management Outsourcing -Why and How Should It Work

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.
by Donald Mumma.

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.

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.

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.

Strategic Reasons to Outsource Risk Measurement

Risk Measurement Should Not Be Confused With Risk Management. 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.

Methods of measuring risk are advancing rapidly. 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 incentive 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.

Many organizations do not possess a modern risk measurement infrastructure or skills. 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.

Outsourced measurement is independent & impartial. 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.

Cost Considerations.
Good risk measurement capability is infrastructure intensive. 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.

The evolution of certain commonly accepted measurement standards are common to all. 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.

The risk of redundancy cost write-off from industry consolidation is reduced. 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.

What are the General Service Requirements?
Reliability and Consistency. 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.

Accurate, Timely and Extensive Market & Historical Data. The outsourcing service should be capable of supplying external information sources for measuring risk that meets the customers requirements.

The Technology Infrastructure covers people and the system. 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.

The system software architecture is dynamic and robust. 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.

The system must also be able to allow for flexible business rules. 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 data marts in each subscriber’s data warehouse.

Output distribution and storage should be subscriber driven. 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).

Multiple risk methodologies and broad instrument coverage. 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 data sets (e.g. S&P, Moody’s, CreditMetrics, etc.).All these standards should be superior to a comparable internally conducted function.

Flexible and Responsive to Individual Customer Needs. 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.

Connectable to Customer Systems. 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.

Conflicts of Interest, Confidentiality and Security. 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.

Auditable. 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.

Cost Competitive. 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.

What should the Service Features include?
Risk Measurement Flexibility and Testing. 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 counter parties and portfolios defined by the customer.

Counter party Credit Scoring Flexibility. The service should provide for multiple rating bands with applicable default probabilities defined by the customer or a continuum default probabilities defined for each counter party. Multiple levels of losses upon default should be accommodated to reflect different deal structures.

Multiple Limit Setting and Monitoring Capability. 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.

Real Time Mark to Market. This feature may be of limited value unless the customer defines price translation definitions for all instruments for which there are no live market feeds from instruments that have live market feeds.

Historical Data Bases. 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.

Customer Flexibility Features. 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.

SERVICE & PRICE STRUCTURE
An Outsourcing Service should be priced on a scale to the customer’s unique requirements. 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 instruments and counter parties, 2)number of portfolios and sub books, 3) number and geography of offices, 4) number of measurement methods and 5) 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.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.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?

REPRINTED WITH THE PERMISSION FROM COMMODITIES NOW, JUNE 1998.