Applying Innovation Principles to Managing Credit Risk

Recently I had the opportunity to present a webinar as part of the CAS Innovation Council’s Actuarial Innovator Profile Series. I discussed how the credit risk group I work with at Milliman has applied the principles articulated in Amy Wilkinson’s book, The Creator’s Code: The Six Essential Skills of Extraordinary Entrepreneurs. Wilkinson provides a valuable framework for fostering innovative thinking based on “six essential skills,” which are described as:

  1. Find the GapHiRes
  2. Drive for Daylight
  3. Fly the OODA Loop
  4. Fail Wisely
  5. Network Minds
  6. Give Small Gifts

I have been using all the skills Wilkinson describes with excellent results in a global practice focused on managing credit risk, as I explain below.

Mind the Gap

The book describes how innovation starts with “finding the gap”-that is, looking for unaddressed needs in the market. In 2006, when my coauthor and I wrote the Milliman report, “What Happens When Credit Risks Come Home to Roost?,” we had found a gap. We saw that many in the mortgage industry didn’t appreciate two factors that were feeding upon each other to create an enormous risk: loosened underwriting standards on mortgage loans coupled with the exploding pace of housing price increases. Most credit risk models at that time tended to be based on a very short-term history of mortgage experience. We were convinced that that short-term history wasn’t a valid basis on which to build a model for the long-term tail risks.

We built a model from the ground up to analyze credit risk for mortgage guarantee insurers. Our model captured both the granular underwriting risks and the economic contagion risk. As the crisis unfolded, we saw an opportunity to transplant that model into the banking industry’s sudden new requirement to assess repurchase risks, as their portfolios began to unravel with loan repurchase demands.

Work Through the Fine Points

With the second step in the process, “Drive for Daylight,” innovators start to think in broad terms about their ideas. After defining the need, they begin to look for strategic market entry points, seeing openings far ahead. Innovators are oriented toward the future rather than nostalgic conventional wisdom. After the financial crisis hit, we found credit risk manifesting in a wide variety of unexpected places; however, we also found ourselves in a position to put our innovations to practical use. Banks found themselves forced to buy back impaired loans and struggled with valuing the risks posed by such demands. In Sunbird fashion, we were able to respond to many of these unexpected secondary affects by adapting the models we had already developed to help better predict and control for the new risks.

Expecting to Fly and Flopping Sagely

We also got into the third step in the process: “Fly the OODA loop.” OODA stands for “observe, orient, decide and act.” This step emphasizes working out bugs in motion by focusing on the four steps in its name as problems arise. It is an iterative process to identify and dispatch bugs quickly while maintaining the larger focus on the mission objective.

The fourth step, “Fail Wisely”, is closely related. It involves placing small bets on ideas, picking spots to take risks with them, and learning from the results, again within the larger context of meeting a mission objective. In the years of the financial crisis, we were constantly testing and adjusting our models and spinning off limited pilot projects to test new analytical capabilities for new situations. This step might lead innovators to experience and learn from small failures, positioning them to better avoid large catastrophes.

Getting It out to the World

The fifth and sixth steps in the process, “Network Minds” and “Give Small Gifts,” are about bringing the ideas to the world. To network minds is to expose ideas to many disparate points of view for critical consideration, such as we do routinely in our practice.

To get ideas out successfully, it’s essential to build a repertoire of contacts by sharing and collaborating with others, extending innovation into the world by freely demonstrating their benefits. This is something we do directly through relationships with our clients and also in our work with industry groups such as the CAS. We hope that innovation leads to everyone winning in the long run.

That’s the true power of innovation. Have you found yourself employing these six essential skills in your actuarial work? How have they helped spur innovation?

This blog is culled from Applying Innovation Principles to Managing Credit Risk, printed in the March-April issue of the Actuarial Review


About Michael C. Schmitz

Michael C. Schmits, FCAS, is a principal and consulting actuary for Milliman, Inc. in Brookfield, Wisconsin.