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
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 OutputInput Input
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
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
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
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”
Illustration for the biology phylogeneticsLamprey SharkSalmonLizard
Illustration for the biology phylogenetics LargeCharacte Rasping Paired fin Jaws dermal Fin rays Lung ristics tongue bonesLamprey ✓ Shark ✓ ✓ ✓Salmon ✓ ✓ ✓ ✓ Lizard ✓ ✓ ✓ ✓
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
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
Animals – Risk Scenario (Ireland)1. Economic Downturn2. 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. …….
Animals – Risk Scenario (UK)1. Fail to recognize and protect portfolios against the effects of larges losses and abnormal weather2. 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 return5. Fraud trends continue to rise …….
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.
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 ClaimsRiskID Risk Fail to recognise and protect portfolios against the effects of larges losses and abnormalUK1 ✓ ✓ ✓ ✓ weather Current review by Lord Chancellor requires reserve strengthening for Ogden lump sumUK2 ✓ awardsUK3 Adverse Bodily Injury trends continue to rise ✓ ✓ ✓ Insufficient rate within Commercial Property portfolios to achieve required risk adjustedUK4 ✓ returnUK5 Fraud trends continue to rise ✓ Focus on top line leads to a failure to maintain underwriting, pricing and controlsUK6 ✓ ✓ ✓ ✓ discipline resulting in negative bottom line impact Inadequate reserves to cover Disease (asbestos, deafness, vibration white finger) andUK7 ✓ ✓ ✓ Abuse claims The European Court of Justice rules against gender based risk pricing in insuranceUK8 ✓ contracts (Achats)UK9 Periodic Payment Orders (PPOs) adversely impact current reserve levels ✓ ✓ Lack of capacity for key initiatives, deals and change programmes resulting in poorUK10 execution and / or poor integration Systemic Credit risk event such that default levels on unsecured credit reach 1991 levelsUK11 or default of a major counterpartyUK12 Poor control of Delegated Authority Schemes business results in a lossUK13 Fail to achieve business case for key initiatives, deals, change programmesUK14 Inflation drives adverse impact on expense base and claims costUK15 Fail to adapt and implement changes to the regulatory architecture, including Solvency II
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 channelTransaction Capture & Maintenance 26, 28, 29, 50, 52 40, 41 All of these relate to Operation
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 controlsPortfolio Risk Selection 2 1. Fail to protect portfolios against larges losses and Portfolio Mngment 5 abnormal weather Reins Arrangements
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?
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.
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.
This presentation has been prepared for illustrative purposes only. The views expressed in this presentation arethose 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.