EMERGING RISKS MANAGEMENT - Casualty Actuarial Society

EMERGING RISKS MANAGEMENTFOR INSURERS

HumanityThe real problem with humanity is the following: We have Paleolithic emo:ons; medieval ins:tu:ons; and god like technology. 2009 Dr. E.O. Wilson, Harvard University Source: The Watchman s RaJle, Thinking Our Way Out of Ex:nc:on, Rebecca D. Costa, 2009 Vanguard Press, Kindle Edi:on 2

DefinitionEmerging risks are risks which may develop or whichalready exist that are difficult to quantify and may have a highloss potential. Further, emerging risks are marked by a highdegree of uncertainty; even basic information, which wouldhelp adequately assess the frequency and severity of a givenrisk, is often lacking.Examples of such risks include climate change, asbestosliabilities, genetic engineering and nanotechnology.From CRO Forum (2005)3

Unknown Unknowns“ [T]here are known knowns; there arethings we know we know. We also knowthere are known unknowns; that is to saywe know there are some things we donot know. But there are also unknownunknowns – there are things we do notknow we don't know. ”Former United States Secretary of DefenseDonald Rumsfeld4

Black SwanNassim Taleb"What we call here a Black Swan (andcapitalize it) is an event with the followingthree attributes. First, it is an outlier, as it lies outsidethe realm of regular expectations,because nothing in the past canconvincingly point to its possibility. Second, it carries an extreme 'impact'.Third, in spite of its outlier status,human nature makes us concoctexplanations for its occurrence afterthe fact, making it explainable andpredictable."5

EMERGING RISKS MANAGEMENTFOR INSURERSHOW TO FINDEMERGING RISKS

Expert Predictionsabout the Future"Stocks have reached whatlooks like a permanently highplateau.""I think there is a worldmarket for maybe fivecomputers."Irving Fisher, economics professor at YaleUniversity, 1929.Thomas Watson, chairman of IBM,1943."It will be gone by June."Variety, passing judgment on rock'n roll in 1955."It will be years - not in mytime - before a woman willbecome Prime Minister."Margaret Thatcher, future Prime Minister,October 26th, 1969."We will bury you."Nikita Krushchev, Soviet Premier,predicting Soviet communism will winover U.S. capitalism, 1958."Reagan doesn't have thatpresidential look."United Artists Executive, rejectingReagan as lead in 1964 film The BestMan.7

Low frequency / High SeverityEarthquake Tsunami Nuclear8

50 PossibleEmerging Risks Business model changeCompetitor activityCorruption & fraudCurrency warsFree market obstructionsHigh unemployment/underemploymentHousing bubbleHyperinflationIncreased moral hazard (following contracts, etc.)Low interest ratesManagement cultureMarket complexityMarket crashMassive international bond defaultsMeltdown of derivatives markets with counterparty failuresMeltdown of reinsurance markets with counterparty failuresNew distribution channels / methods of distributionNew market entrants with drastically different objectives andmethodsNo-growth (or negative growth) economic scenarioProlonged very low interest ratesRestructure/default of U.S. National DebtRisk of radical changes in workplace expectations/norms foreither employers or employeesSovereign DefaultStrategically Important Financial Institutions Systemic risk of collapseTax Policy changesTrade WarsUS debt crisisUS Fiscal and Monetary PolicyRising financial inequalityRegime changeUnemploymentUnfunded Social ProgramsUnsustainable Medicare BenefitsUS entering war like in IraqUS loses world dominanceUS severe loss of credit standingWorld war IIICollapse of EuroConsistently low investment returnsDeflationDeleveragingEmployee engagementExcessive private debtFinancial security system breakdownGlobal depressionImpact of unfunded entitlement programsSocial Security breakdownBedbugsCell phone radiation9

Another 50 PossibleEmerging Risks Climate changeFood additives (growth hormones)Food production's impact on freshwater and general foodsupply.Fracking risksFragility of electrical power grid (US and Canada)Implementation of carbon tariffs, taxes, or similarAntibiotics lose effectivenessNatural Catastrophe: DroughtNatural Catastrophe: ALL Storms, not just tropicalNatural resource depletionOverpopulationSharp rise in middle class (India & China)PandemicSoil degradation/permanent loss of food growing capacitySpace DebrisSpace WeatherVolcanic ashFamineChanges in regulatory and legal regimesContinued growth in government powerDerivative limitationsRise of Narco StatesDirectors and Officers liability expansionFreeze of political processGovernment debts & overspendingMedical advances Impacts of government regulation (ex: Health CareReform)Ineffective governmental response to crisesLoss of trust in government/institutions ("occupymovement")Political climate changesPolitical riskRegulatory load increasesRegulatory ComplexityShifting world economic power to ChinaThreat of widespread adoption of socialism/communismAccelerating governmental costsAffordability and access to basic and higher educationCivil UnrestClass shiftConsumer personal DNA/genome accessLoss of confidence/motivation in the 1st world countriesLoss of freedomSocial networking misuseStress-related diseasesTerrorismAdequate training to meet technological needsCyber hactivism - the use of cyber terrorism a aninstrument of political influence and/or controlHacker attacks / cyber crimeNanotechnology10New combination of smaller events

What do these five citieshave in common?SingaporeTaipeiTorontoHong KongGuangdong11

SARS (2002 – 2003)SingaporeTaipeiTorontoHong KongGuangdong12

Awareness of potentialEmerging Risks Changing trends – the difference between regressionto mean and continuation to failure Very infrequent events – historical record may not beuseful Cascading failure – small adverse event creates otherproblems until there is a major crisis Slow macro trends- some problems, like demographicissues, develop over a generation Tipping points – like the sudden movement incongress regarding immigration and gay marriage.Suddenly the river changes direction.13

Systems Analysis Feedback Loops–Positive Feedback Loop –Negative Feedback Loop – Slide into failureBalancing Feedback Loop Usually massive growth of one or severalelementsFactors will bring system back to “normal” stateSystem Constraints–Limits of sub systemsComplex Adaptive Systems–System is difficult to analyze as it is alwayschanging in response to prior experiences–Most systems involving humans are ComplexAdaptive Systems14

SummaryIdentifying Emerging Risks1. Be careful of experts2. Consider combinations of events3. Think outside the box4. Consider lots and lots of possibilities5. Things may be hidden by accounting model6. Look at things happening far away7. Use Systems Thinking15

EMERGING RISKS MANAGEMENTFOR INSURERSEVALUATINGEMERGING RISKS

Emerging RiskEvaluation Likelihood – often very difficultbecause emerging risk have rarely ornever happened before Impact – most common – use stressand scenario tests to evaluate Velocity – how fast will potentialchange into actual? How much timewill you have to react? Can everyonefit into the lifeboats if they all leavetheir bunks at the same time?17

Picture of aStress Test1818

Examples of Stress TestsAM Best SRQ Market Risk:– Stocks: Losses equal to peak to trough of 2008 crash– Interest rates shift by 2.0% which has happened once every 8 years over the past 50 years.Underwriting Risk– Catastrophe: Experience a catastrophic loss at 1/100 level per cat model– Reserves: Experience excess loss development equal to worst one year loss development inpast years– Pricing: Experience underwriting loss equal to worst combined ratio for past years for twolargest lines of business at the same time.Credit Risks A reinsurer fails and it was the largest unsecured reinsurer.Operational Risk– Fraud by investment manager resulting in loss of 10% of funds under management.– IT data security breach which results in release of sensitive customer data for all personal linesclients and costs from fines and remedies for individuals– Employee class action lawsuit– Misplace the largest claims resulting in unexpected jump in claims as well as penalties for latepaymentsLiquidity Risk Experience Underwriting and Operational losses described above and must pay outwhile interest rates move by 2% and must raise any funds needed by selling bonds that have droppedin valueStrategic Risk New competitor takes away 50% of sales with new and innovative product and/or salesstrategy. Company is unable to cut fixed expenses immediately.19

Lloyd’s RDS Florida WindstormGulf of Mexico WindstormEuropean WindstormJapanese WindstormCalifornia EarthquakeNew Madrid Earthquake MarineLoss of Major ComplexAviation CollisionSatellite RisksLiability RisksPolitical RisksJapanese EarthquakeUK FloodTerrorismMixture of Historic and SyntheticSingle Event Scenarios20

Lloyd’s RDSTerrorism Scenario21

SummaryEvaluating Emerging Risks Only evaluate emerging risks with either:– high impact, high velocity, or some frequency knowledge Don’t stress over Frequency Evaluate Severity with Stress and Scenario Tests– Use mostly Bottom up Synthetic Scenario Tests Be careful not to over generalize from stress test results Use Systems Thinking to assess Risk Velocity22

EMERGING RISKS MANAGEMENTFOR INSURERSMONITORINGEMERGING RISKS

Selecting Risks forMonitoring Based upon assessments, which risks are – Potentially disruptive to company plans– Potentially disastrous to earnings expectations– Potentially ruinous to company continuation If you do anticipate these risks– Will that give you an advantage over your competitors? If you do not anticipate these risks– Will your competitors have an advantage over you?24

Risk Velocity Emerging Risks with expectedhigh velocity––Monitoring may be less effectiveMay want to concentrate on ActionPlans Emerging Risks with lowervelocity–May be able to identify KRIs thatgive good warning–Allow time to recognize emergenceand adapt or develop action plansbased upon specific circumstances25

Key Risk Indicators When able, measure the risk to track exposure When unable to measure – track KRIs– Forwards, Backwards, Inwards, Outwards26

Key Risk IndicatorsPandemic RiskFORWARDBACKWARDTrend current experienceforward to projectpossible situation in 6monthsCompare recentexperience with historicalat different stages ofprogression of Pandemic.INWARDOUTWARDCount of infections fromown claim andunderwriting experience.Count of infections fromall territories, even whereyou don’t do business.27

Key Risk IndicatorsPandemic RiskProjection April 3SARS declared over.Actual June28Source: Milliman

What Happened toSARS? Hong Kong health authorities tookaction.– Instituted quarantine of infectedindividuals and their families SARS was 1/1000th as bad as the earlymodel said that it could be. Key Risk Indicators were effective inhelping the health authorities to makethe right call.29

SummaryMonitoring Emerging Risks Be selective to choose risks to monitor Select Key Risk Indicators– May not be able to directly monitor risk– Looking for indications of increasing likelihood– Look Forward, Backward, Inward, Outward forKRI’s30

EMERGING RISKS MANAGEMENTFOR INSURERSPLANNING ACTIONS