October 15th, 2014

The Categories Of Emerging Risk

Posted at 1:00 AM ET

For purposes of this analysis we have developed three categories of emerging risk:

  • Technological
  • Crystalizing
  • Aggravating

Technological

Technological change has always presented a challenge, but when addressed correctly it has also presented an opportunity - think of satellites and offshore rigs. The response here is to develop technological competence and construct policy forms that are fit-for-purpose, rather than an untidy amalgam of outmoded and inappropriate wordings. Above all there is a need to build credible models of potentially accumulating incidents so that risk appetites can be aligned with the exposures being faced. Ultimately, greater knowledge will mean these are, by definition, no longer emerging risks, any more than aviation risks.

Crystalizing

Crystalizing risks, by contrast, will by their nature always operate to a large extent outside the bounds of current knowledge. The only response is therefore to establish business practices that aim to detect “weak signals” and monitor them in case they become “clear tendencies with a high potential for danger” (1). Most reinsurers have groups of experts who have been assigned to the task of building early-warning systems that identify lead-indicators.

Once such indicators are identified it is important that their financial implications are recognized promptly and correctly. In this respect a key task of regulators is to enforce a prudent risk management methodology that preserves a sustainable and level playing-field for responsible competition. Failure to address crystalizing risks should not provide competitive advantage. On the other hand regulators need to ensure that structural inflexibility does not in fact create further instability.

Aggravating

Aggravating risks are by their nature fairly well understood. The difficulty arises from misestimating their scope and extent. The response is very similar to that for technological change in terms of building expertise and knowledge. However, globalization gives these risks a dimension that makes them very difficult to quantify. Emerging risks do not observe boundaries, territorial or otherwise.

In fact the World Economic Forum makes the point that globalization creates systemic risk. This point is made strikingly clear by John Gray in Al Qaeda and What it Means to be Modern (2), which argues that modern-day terrorism can only be properly understood within the context of the benefits of globalization and the internet. These benefits have actually enabled asymmetric warfare.

Whatever the category of emerging risk the main challenge lies in modeling and quantifying their potential impacts. Only in this way can insurers leverage their key capability, which is the creation of value by risk management. The challenges are described in the report section on modeling. In this connection it is worthwhile once again to quote from the World Economic Forum. “Systemic risks include elements that cannot be easily quantified using traditional tools and formulas from probability theory and mathematics, or made to fit the classical distinction between risk and uncertainty” (3).

Following the “Modeling” Section this report looks at reinsurance responses to the threat of emerging risks and their impact on loss reserving cycles. It is clear that insurers’ risk management initiatives need to take note of the trend, identified by the World Economic Forum, “away from technical planning for individual risks and towards holistic planning for a range of unspecified risks” (4).

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Note:

1. Dr. Andreas Tacke, Hannover Re, Hannover Re on Emerging Risks, February 2013.

2. John Gray, Al Qaeda and What it Means to be Modern, Faber, 2003.

3. World Economic Forum, Global Risks 2014, Page 27.

4. World Economic Forum, Global Risks 2014, Page 42.

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