Presented in Open Discussion Forum at Dec. 07, 2012 sponsored by Institute Actuaries of Japan (Modified to logo-free version)

1. A New Approach to Predict Emerging
Risks Using Risk DNA Model
Motoharu Dei, FIAJ, Consultant
Milliman Inc.
IAJ, Open Discussion Forum ERM Section
December 7th, 2012

2. Introduction

3. Reference Material for Today’s Presentation
 Management Board of the UK Actuarial
Profession invited proposals for a
funded external research, and this
report was awarded.
 “A review of the use of complex systems
applied to risk appetite and emerging risks
in ERM practice”
 Authors (from Milliman, the Universities of
Bristol and Bath Systems Centre)
 N. ALLAN
 N. CANTLE
 P. GODFREY
 Y.YIN http://www.actuaries.org.uk/research-and-
resources/documents/review-use-complex-systems-
applied-risk-appetite-and-emerging-risks

4. System Thinking
 The methods discussed in the report are based on “System
Thinking”.
 “Concept Mapping”, “Systems Dynamics Modelling”, “Chaos
Theory”, “Fuzzy Theory”, “Neural Networks”, “Genetic
Algorithms”, “Phylogenetic Analysis”, Bayesian Network”,
“Cellular Automata”, “Agent Based Modelling”, ”Network
Theory”
Output
Output Input
Output
Input
Input

5. System Thinking
 The methods discussed in the report are based on “System
Thinking”.
 “Concept Mapping”, “Systems Dynamics Modelling”, “Chaos
Theory”, “Fuzzy Theory”, “Neural Networks”, “Genetic
Algorithms”, “Phylogenetic Analysis”, Bayesian Network”,
“Cellular Automata”, “Agent Based Modelling”, ”Network
Theory”
Output
Input
Output
Input

6. System Thinking
 The biology, phylogenetics (/faɪlɵdʒɪˈnɛtɪks/) isare study ofon “System
In methods discussed in the report the based
Thinking”. relation among groups of organisms (e.g. species,
evolutionary
populations), which is discovered through molecular
 sequencingMapping”, “Systems Dynamics Modelling”, “Chaos
“Concept data and morphological data matrices. (Wikipedia)
Theory”, “Fuzzy Theory”, “Neural Networks”, “Genetic
Algorithms”, “Phylogenetic Analysis”, Bayesian Network”,
“Cellular Automata”, “Agent Based Modelling”, ”Network
Theory”
Output
Input
Output
Input

7. Phylogenetic Approach

8. Emerging Risk
 We should not guess in advance what we expect to see in
identifying the emerging risk
 Many attempts to monitor risk registers throw that away at outset
 Need a “model-free” approach to see emergence
Allow people to “mix”
colours

9. Phylogenetic Approach
 This approach was also presented in the SOA annual meeting in
this October (Session 99 – Emerging Risk) by Neil Cantle.
 The core idea is to adapt the same analysis which researchers
use to analyse the “biological evolution” into the “risk evolution”.
 Which risk scenarios are “similar”
 How the risk characteristics “evolve”?
 Future potential risk “mutation”

10. Illustration for the biology phylogenetics
Lamprey
Shark
Salmon
Lizard

11. Illustration for the biology phylogenetics
Large
Characte Rasping
Paired fin Jaws dermal Fin rays Lung
ristics tongue
bones
Lamprey
✓
Shark
✓ ✓ ✓
Salmon
✓ ✓ ✓ ✓
Lizard
✓ ✓ ✓ ✓

12. Illustration for the biology phylogenetics
 By application of phylogenetic analysis (parsimony algorithm), the
evolution process can be revealed using the tree-like
“cladogram”:
 First, assume that the species evolve from nothing to existence and
one of the two branches shall be occupied by the species with the
least characters, i.e., the lamprey
 Second and later, repeat the selection method to find the organism
that owns the least changes to the lamprey and last species.
(a) paired fins, (b) jaws, (c) large dermal
bones, (d) fin rays, (e) lungs, and (f) rasping
tongue

13. Illustration for the biology phylogenetics
 Now we can dig into the evolution analysis:
 The shape of lamprey is stable and not likely to have changes soon.
 Salmon and lizard must share the same ancestor which shark does not
have relations to.
 ……
 We can do the same thing for risk analysis!
(a) paired fins, (b) jaws, (c) large dermal
bones, (d) fin rays, (e) lungs, and (f) rasping
tongue

14. Risk Phylogenetics illustration

15. Data Preparation
Biological Characteristics
✓
Animals ✓ ✓
✓

16. Data Preparation
Risk
Characteristics
Biological Characteristics
✓
Risk
Scenarios
Animals ✓ ✓
✓

17. Characteristics - Risk Characteristics
Risk Characteristic Code 5.05 Employment Practices / Employee Relations 30
1.1 Portfolio risk selection 1 5.06 Employment Practices / Safe Environment 31
1.2 Portfolio Management 2 5.07 Employment Practices / Diversity & Discrim. 32
1.3 Claims management 3 5.08 Improper Business or Market Practices 33
1.4 Technical Reserving 4 5.09 Published Financial Statements 34
1.5 Reinsurance arrangements 5 5.10 Advisory activities 35
1.6 Longevity risk (Pension) 6 5.11 Damage to Physical Assets 36
1.7 Pricing 7 5.12 Bus disruption & sys failures / Systems 37
2.1 Reinsurance Credit Risk 8 5.13 Transaction Capture & Maintenance 38
2.2 Insurance products credit risk+A23 9 5.14 Monitoring & Reporting 39
2.3 Insurance operations credit risk 10 5.15 Customer Intake and Documentation 40
2.4 Invested assets credit risk 11 5.16 Customer & Client Account Management 41
3.1 Asset and liability matching 12 5.17 Trade counterparties 42
3.2 Investment default 13 5.18 Vendors & Suppliers 43
3.3 Currency risk 14 5.19 Compliance with existing regulation 44
3.4 Basis risk 15 5.20 Increase in regulatory costs 45
3.5 Property price depreciation 16 5.21 Failure to implement Solvency II 46
3.6 Equity risk 17 5.22 Cross sector funding FSCF 47
3.7 Interest rate risk 18 5.23 Product Flaws 48
3.8 Commodity risk 19 5.24 Expenses overruns 49
3.9 Spread risk 20 6.1 Regulators 50
4.1 Assets liquidity 21 6.2 Corporate responsibility 51
4.2 Funding liquidity 22 6.3 Investors / JV Partners 52
4.3 Liability liquidity 23 6.4 Media 53
4.4 FX liquidity 24 7.1 Legal, Public Affairs & Regulatory 54
4.5 Intra-day liquidity 25 7.2 Macro-Economic 55
5.01 Internal fraud / Unauthorised Transactions 26 7.3 Changing Claims Patterns 56
5.02 Internal fraud / Theft and Fraud 27 8.1 Internal 57
5.03 External Fraud / Theft and Fraud 28 8.2 External 58
5.04 External Fraud / System Security 29 8.3 General 59

18. Characteristics - Risk Characteristics
Risk Characteristic Code 5.05 Employment Practices / Employee Relations 30
1.1 Portfolio risk selection 1 5.06 Employment Practices / Safe Environment 31
1.2 Portfolio Management 2 5.07 Employment Practices / Diversity & Discrim. 32
1.3 Claims management 3 5.08 Improper Business or Market Practices 33
1.4 Technical Reserving 4 5.09 Published Financial Statements 34
Risk Characteristic
1.5 Reinsurance arrangements
1.6 Longevity risk (Pension)
5
6
5.10 Advisory activities
5.11 Damage to Physical Assets
Code 35
36
1.7 Pricing
1.1 Portfolio risk selection
2.1 Reinsurance Credit Risk
7
8 5.13 Transaction Capture & Maintenance
1
5.12 Bus disruption & sys failures / Systems 37
38
2.2 Insurance products credit risk+A23 9 5.14 Monitoring & Reporting 39
1.2 Portfolio Management
2.3 Insurance operations credit risk 10 5.15 Customer Intake and Documentation
2 40
2.4 Invested assets credit risk 11 5.16 Customer & Client Account Management 41
1.3 Claims management
3.1 Asset and liability matching 12 5.17 Trade counterparties
3 42
3.2 Investment default 13 5.18 Vendors & Suppliers 43
1.4 Technical Reserving
3.3 Currency risk 14 5.19 Compliance with existing regulation4 44
3.4 Basis risk 15 5.20 Increase in regulatory costs 45
1.5 Reinsurance arrangements
3.5 Property price depreciation 16 5.21 Failure to implement Solvency II 5 46
3.6 Equity risk 17 5.22 Cross sector funding FSCF 47
1.6 Longevity risk (Pension)
3.7 Interest rate risk 18 5.23 Product Flaws 6 48
3.8 Commodity risk 19 5.24 Expenses overruns 49
1.7 Pricing
3.9 Spread risk 20 6.1 Regulators 7 50
4.1 Assets liquidity 21 6.2 Corporate responsibility 51
2.1 Reinsurance Credit Risk
4.2 Funding liquidity 22 6.3 Investors / JV Partners 8 52
4.3 Liability liquidity 23 6.4 Media 53
2.2 Insurance products credit risk+A23
4.4 FX liquidity 24 7.1 Legal, Public Affairs & Regulatory 9 54
4.5 Intra-day liquidity 25 7.2 Macro-Economic 55
2.3 Insurance operations credit risk
5.01 Internal fraud / Unauthorised Transactions 26 7.3 Changing Claims Patterns 10 56
5.02 Internal fraud / Theft and Fraud 27 8.1 Internal 57
5.03 External Fraud / Theft and Fraud 28 8.2 External 58
5.04 External Fraud / System Security 29 8.3 General 59

19. Animals – Risk Scenario (Ireland)
1. Economic Downturn
2. Failure to deliver the required scale and breadth of
improvement plan benefits leading to under delivery of
projected 2011 UW result.
3. Business does not achieve planned growth.
4. ABC integration / alignment.
5. Loss of key intermediary / corporate account through
failure of intermediary or transfer of business to
competitor.
…….

20. Animals – Risk Scenario (UK)
1. Fail to recognize and protect portfolios against the
effects of larges losses and abnormal weather
2. Current review by Lord Chancellor requires reserve
strengthening for Ogden lump sum awards delivery of
projected 2011 UW result.
3. Adverse Bodily Injury trends continue to rise.
4. Insufficient rate within Commercial Property portfolios
to achieve required risk adjusted return
5. Fraud trends continue to rise
…….

21. Data prepared (Ireland)
“Characteristics”
1 Portfolio 2 Portfolio 3 Claims 4 Technical 5 Reinsurance
Risk ID Risk Risk Selection Management Management Reserving Arraignments
IRE1 Economic Downturn. ✓
Failure to deliver the required scale and breadth of improvement
IRE2 ✓
plan benefits leading to under delivery of projected 2011 UW result.
IRE3 Business does not achieve planned growth.
IRE4 ABC integration / alignment.
Loss of key intermediary / corporate account through failure of
IRE5
intermediary or transfer of business to competitor.
“Animals”
IRE6 Non-compliance with regulatory requirements, including subsidiaries.
IRE7 Inadequate Data Privacy procedures.
IRE8 Risk of adverse development of Prior Year claims on X Book.
IRE9 Repeat of catastrophic weather events. ✓ ✓ ✓
IRE10 Implementation of Periodic Payment Orders. ✓ ✓
IRE11 Failure of Software House.
IRE12 Immature capability re direct and on-line channel.
IRE13 XXX Insurance Ireland S&P downgrade.
IRE14 Outcome of test Achats by ECJ – EU gender directive decision.

22. Data prepared (UK)
1 Underwriting Risk
6 Longevity risk
1 Portfolio risk
arrangements
5 Reinsurance
management
Management
4 Technical
2 Portfolio
Reserving
(Pension)
selection
7 Pricing
3 Claims
Risk
ID Risk
Fail to recognise and protect portfolios against the effects of larges losses and abnormal
UK1 ✓ ✓ ✓ ✓
weather
Current review by Lord Chancellor requires reserve strengthening for Ogden lump sum
UK2 ✓
awards
UK3 Adverse Bodily Injury trends continue to rise ✓ ✓ ✓
Insufficient rate within Commercial Property portfolios to achieve required risk adjusted
UK4 ✓
return
UK5 Fraud trends continue to rise ✓
Focus on top line leads to a failure to maintain underwriting, pricing and controls
UK6 ✓ ✓ ✓ ✓
discipline resulting in negative bottom line impact
Inadequate reserves to cover Disease (asbestos, deafness, vibration white finger) and
UK7 ✓ ✓ ✓
Abuse claims
The European Court of Justice rules against gender based risk pricing in insurance
UK8 ✓
contracts (Achats)
UK9 Periodic Payment Orders (PPOs) adversely impact current reserve levels ✓ ✓
Lack of capacity for key initiatives, deals and change programmes resulting in poor
UK10
execution and / or poor integration
Systemic Credit risk event such that default levels on unsecured credit reach 1991 levels
UK11
or default of a major counterparty
UK12 Poor control of Delegated Authority Schemes business results in a loss
UK13 Fail to achieve business case for key initiatives, deals, change programmes
UK14 Inflation drives adverse impact on expense base and claims cost
UK15 Fail to adapt and implement changes to the regulatory architecture, including Solvency II

23. Risk Evolution Cladgram (Ireland)
Lots of evolution from “7 Pricing” and “38 Trans”
1. Economic Downturn
# = Code of Risk 3, 8, 9, 10, 11, 13, 16, 17, 18, 19, 20, 21, 24, 55
characteristics 49 2. Under delivery of projected UW result
Portfolio Mngment
2
9. Repeat of catastrophic weather events
Pricing 4, 56
7 10. Implementation Periodic Payments
1
7
Portfolio Risk Selection
14. Outcome - EU gender directive
45, 54
8. Prior Year claims on X Book
56
52, 53
44, 46, 50
All of these related to Pricing
10, 58
Vendors & Suppliers
43 3. Buss doesn’t achieve planned growth
37
38
4. ABC integration / alignment
57
7. Inadequate Data Privacy procedures
Internal
38
12. Immature capability re on-line channel
Transaction Capture & Maintenance 26, 28, 29, 50, 52
40, 41
All of these relate to Operation

24. Risk Evolution Cladgram (UK)
8, 9, 10, 11
37
38, 40, 41
5. Fraud trends continue to rise
49, 56
27, 28, 29
7. Inadequate reserves to cover Disease and Abuse
Claims Mngment claims
3 9. (PPOs) adversely impact current reserve levels
5, 56
4
Technical Reserving
46, 54, 57
8. The European Court of Justice rules against
54Legal, Public Affairs & Regulatory
(Achats)
2. Review by Lord Chancellor requires reserves rise
Pricing 4. Insufficient rate within Commercial Property
7 portfolios
3. Adverse Bodily Injury trends continue to rise
3, 56
6. Failure to maintain underwriting, pricing and
1
3, 26, 39 controls
Portfolio Risk Selection 2 1. Fail to protect portfolios against larges losses and
Portfolio Mngment
5 abnormal weather
Reins Arrangements

25. Key Observations and Questions
 For Ireland and UK, ‘Pricing‘(7) is the most important risk
character since it defines a biggest clade.
 The risk ‘Economic Downturn’(IRE1) is quite distinct due to its
large number of characters:
 Economic downturn is a complex risk and covers many areas
 and this could also be argued that it is too high level and should be
split into more defined areas (like ‘housing crises‘ or ‘euro crises‘).
 Branches with the most characters indicate there has been
significant evolution and we are likely to see more cascading
evolution, like a warm jungle is host to more forms of life than
the cold tundra.
 If the risk ‘Inadequate Data Privacy Procedures‘(IRE7) (3 branches
and 5 characters) were to combine with ‘Immature Capability on
On-line Channel‘(IRE12), what does the emerging risk look like?

26. Key Observations and Questions
 In the UK, there are 3 risks which show no relation to any
others ‘Systematic credit risk event’ (UK11), ‘Inflation derives
adverse impact on expense and claim cost’ (UK14) and ‘Fail to
adapt changes to the regulatory architecture such as SII’
(UK15).
 Risks that have not changed significantly are likely to be stable.
 Or this should be checked against whether the risks have not been
described in sufficient detail.
 We can presume “co-evolution”, which means that characters
or risks have a tendency to evolve in each other‘s presence.
 Like a bird that develops a long beak and a flower holding nectar that
continues to extend the long shape.
 For example, ‘Media‘(53) only evolves in the presence of ‘Investors/JV
Partners‘(52). So we can investigate risks that have character (52),
but not yet (53) and presume some new risk events occurring.

27. Summary

28. Summary
 Modern risk management is complex and ERM requires a
holistic approach to make sense of the layers, interconnections
and non-quantitative measures.
 Using the phylogenetic analysis as the means of constructing
model-free evolutionary risk trees and their interpretation
enabled us to reveal the possible emerging risks.
 The visualization of the risks and characters in a tree format
enables a lot of fruitful observations to be quickly spotted that
would be difficult and tiresome in a spreadsheet.
 It also could be a good news that new and free software
programs and algorithms allow easy access for actuaries to be
able to construct their own risk trees.

29. This presentation has been prepared for illustrative purposes only. The views expressed in this presentation are
those of the speaker and do not necessarily represent the views of Milliman as a firm.
No reliance or inference should be placed on the statements presented herein.
Actual experience and developments may differ than those presented in this presentation.