March 2nd, 2009

Risk Modeling Part I: Overview

Posted at 1:00 AM ET

Ryan Ogaard, Global Head of Instrat®

The global financial crisis has increased the world’s focus on risk modeling, and for some it has called the very validity of the practice into question. Common themes resonating throughout the popular press include the difficulty of modeling human behavior and the complexity of the intricate webs of financial hedging that imploded to create the current crisis. In-depth investigations into the mechanics of subprime have revealed the existence of known blind spots in the models. Management considered these blind spots either unimportant or unlikely to have an impact on results, but they point to the real culprits in most modeling mishaps - a lack of holistic risk awareness, or what the 9/11 Commission’s report called “a failure of the imagination.”

Risk assessment is, at its heart, a creative endeavor - an exercise in visualizing and testing the unknown. A task like this cannot be summed up in a single tool, such as a “risk model,” nor can it be dismissed because reliance on such tools was one of the many proximate causes of the recent financial crisis. Indeed, risk modeling is robust and yields valuable information to decision-makers. This is particularly true in the property and casualty (P&C) insurance sector, where risk is the basic fabric of the business. P&C lines of business have experienced decades of investment, failure, investigation, and improvement in the methods, tools, and processes that produce credible risk information. Much of the progress in risk management has been facilitated by advances in technology, and recently, a consensus on risk management best practices has been emerging.

A range of sophisticated risk management practices is now required by stakeholders in P&C companies. Such practices are meant to prove that an insurer is managing risk and to provide transparency into a company’s balance of risk and supporting capital. Management has generally embraced advanced risk-assessment methods and tools, seeing them not only as requirements, but also as creators of competitive advantage. Insightful analysis of risk can show a company where to deploy capital, where unexploited opportunities lay, and where exposures might be dangerous, or at least unprofitable. But in spite of widespread adoption within the industry, risk assessment is still developing and all too often is not seen as holistic.

Originally published in MMC Viewpoint

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