Evolution of Risk Knowledge and Insurance ERM
Changes in the Risk Society Forces Enhanced Insurance ERM(July, 2015)
We should expand our knowledge of risk for enhancing Insurance ERM.
Risk society has always been changing
Risk and Uncertainty should be distinguished in insurance ERM
We face various changes such as sudden movement of Earth’s crust caused by on-going energy accumulation, an unexpected turn of global economy imbalances and bubble bursts, and newly born risk arising from the technological development (e.g. Climate changes).
These changes mean the deviation from the pre-set assumptions and scenarios, which force the company to revise its strategy and business plan influenced by the technological innovation, regulatory changes and legal liability reforms, geo-political risk changes, financial crisis, and natural catastrophes.
Risk management is treated as the core part of management tools. Especially, it is vital for insurance companies since they absorb various risks from the assured, and must manage them.
The risk portfolio of insurers has always been changing. Therefore, an insurer should distinguish the “uncertainty” from “risk”.
Uncertain factors are built in insurance risk
“Risk repeats “ or “Risk is changing”
No one can predict the future exactly. Therefore, we cannot make it completely risk-free. However, we can come close to the rational risk management by appropriately assessing the risks.
In general, the uncertainty means the situation of unknown future. In economics, one is regarded to make decisions under the rational expected hypothesis. Therefore, the probability of the event’s occurrence is calculated as we call it “risk” for the measurable of uncertainties , which distinguished from the term “uncertainty” of the unmeasurable uncertainties.
An insurable risk is so-called “risk” ,not “uncertainty. However, we do recognize that there are uncertain factors in risks.
Sometimes it is said that risk repeats, on the other hand it is said that risk is changing. The Great East Japan Earthquake (occurred on 11 March 2011 with 9.0-magnitude) turned out to vastly exceed pre-disaster assumptions of Center Disaster Management Council Committee in Japan.
Hence, this fact tells us that insurers should recognize the existence of uncertain factors in their underwriting risks.
Limitation of identifying and assessing risk
Reflection on the reality of decision making
However the survey of earthquake and tsunami deposit would suggest the possible occurrence of such a large scale earthquake like the Great East Japan Earthquake. If so, this earthquake is not “beyond our expectation(or risk is changing) but regarded as repeating the same type of risk”.
There is a very difficult issue to be confronted. We usually make a decision under a certain time horizon subject to the current social values, the technological standard, and the economical environment and so on. We should bear in mind the fact where our decision is usually made under such a general framework.
In our evolving insurance ERM, we should pay attention to the limitation of the availability of current information & data, and should continue to enhance our risk knowledge.
Risk measurement model crystallizes the current knowledge
The probabilistic approaches are taken in the risk measurement model. Let’s look at the natural catastrophe model.
The natural catastrophe model treats the complicated physical phenomenon. Its reliability depends on the level of understanding with regards to what extent the earthquake and typhoon’s mechanism is clarified and how much impact to the properties such as damages to buildings. We do not always have enough data to underpin modeling. But the model has been developed by the combination of progress in observation techniques and computer technology.
The model consists of the three parts. First is the hazard module which evaluates the strength of a natural hazard. The second is a vulnerability module which evaluates the damageability on site. And the third is a financial module which evaluates the financial losses under the insurance terms and conditions.
As the model can estimate the losses under the specific assumptions, also can estimate the impact in the case of deviation from the current typhoon route, which is useful for Insurance companies, rating agencies, and regulators for their consideration.
risk appropriately considering the limitation of models
It is one of the core parts of the modern ERM to secure and manage the financial soundness by quantifying risk within the internal model and comparing it with the holding capital.
However, it is difficult to evaluate all the risk faced by companies, since we do not have enough data for calculation of risk. Moreover, it is difficult to consider all the risk factors even in the case of the quantifiable risk. Furthermore, there are uncertain factors somewhere in its structure and even in our recognition process.
Therefore, it is vital to conduct the validation of models periodically in order to incorporate the newly available information and data.
In addition, we should complement the weakness of quantitative approach by utilizing the qualitative approach such as scenario stress testing.
Insurance ERM is a never ending story for evolution of risk knowledge
“Risk Management” is the connective term with “Risk” and “Management”.
Risk knowledge has been cultivated within the continuous process of P(Planning）, D（Do）, C（Check）, and A（Action）, which is all the same loop as the other management tools.
As hazard is always changing we should bear in mind that the uncertain factors embedded in the risk would emerge.
We have a tendency to rely on our insight based on our past experience when we face uncertainties. Generally speaking, we are not willing to look straight on the embarrassing facts that tells us the defect of our judgment.
We could not enhance our risk knowledge without recognizing the limitation of our current knowledge and the latent risk in our decision making process.
That is why insurance ERM needs our eternal efforts.