Looking Forward With Clarity

The Survey of Emerging Risks helps actuaries improve forward-looking projections Max J. Rudolph December 2017/January 2018

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Actuaries often are accused of creating a process where we drive a car using only the rearview mirror to observe our surroundings. Jokes about driverless cars notwithstanding, one of the hardest parts of projecting the future is figuring out when historical data is no longer predictive. While unknown unknowns (thanks to Donald Rumsfeld) have led to the study of Black Swans (Nassim Taleb¹) and Gray Rhinos (Michele Wucker²), unknown knowns typically become a battleground where politics and forward thinkers skirmish. Awareness of emerging risks, and anticipating their positive and negative effects, gives risk managers a head start in developing mitigation strategies.

Some risks evolve slowly over time, requiring statistical techniques to extrapolate based on recent trends. This might include flood risk due to climate change, or auto insurance as seat belt usage became prevalent. Some risks occur infrequently, allowing practitioners to make a bet to ignore tail events like pandemics and extreme earthquakes. When risks shift, prior data is harmful if used to describe the future. Insurance risks related to driverless cars, cyberattacks, severe hurricanes and opioid use fall in this category. While evolving risks sometimes occur slow enough for adaptation, those that move quickly increase solvency risk and could be systemic. Risk managers who seek emerging risks and develop contingency plans increase firm resiliency.

The 10^th Survey

The Survey of Emerging Risks³ tracks the trends of thoughts of risk managers across time. The results presented in this article are from the 10th survey.⁴ Responses were received primarily from North American actuaries involved with risk management, although some responses were from risk managers working in government and other industries across the globe. Trends are as important as absolute responses, helping risk managers contemplate individual risks, combinations of risks and unintended consequences of actions and inactions.

Past highlights of the surveys include recency bias, the increasing importance of cyber risks, and the prominence of risk culture in long-term results. This year is no different. The rise of populism in developed countries resulted in the Brexit vote, where U.K. voters expressed a desire to leave the European Union, and the election of Donald Trump as president of the United States. The survey’s timing, just weeks after the 2016 American national election, reflects this as seen by increases in the retrenchment from globalization risk across questions about current and emerging risks. One trend recognized this year is the prevalence for geopolitical risks to have higher responses in even-numbered years corresponding to the American election cycle.

Risk management practices continue to evolve. The year 2016 saw limited geopolitical risk breakouts, but the Middle East, Venezuela, Ukraine and North Korea all remain hot zones. Hackers have become a constant threat, but the public quickly is lulled into complacency until a shock occurs. A lack of natural disasters in the United States had lulled some into complacency prior to Hurricanes Harvey, Irma, Maria and Nate. This year’s Survey of Emerging Risks, the 10th in the series, attempts to capture these trends.

In addition to the top five and top emerging risks, the survey also looks at the top current risks and risk combinations.

Top Five Emerging Risks

The survey combines 23 individual risks into five categories—economic, environmental, geopolitical, societal and technological. (See the “Background” sidebar for more details.) In the primary survey question, respondents were asked to choose up to five emerging risks. The geopolitical category of risks gained ground (Figure 1 shows percentages from the current survey for each category), reclaiming the top category, as the economic and societal categories dropped from the previous survey. The economic category has trended lower as we move further from the global financial crisis, and the technological category has grown as cyber risks and other technologies receive more attention from risk managers.

Cyber continued in its position at the top of the list of emerging risks. But for the first time since its entry as a risk in 2009, it did not rise, falling from 65 percent to 53 percent of respondents selecting it.

The uppermost choices (in the top five) in the geopolitical category were terrorism (40 percent of respondents choosing it in their top five) and retrenchment from globalization (up from 6 percent to 31 percent). Risks with new highs across the survey history were climate change, natural catastrophe: earthquakes, retrenchment from globalization and technology. A new low was recorded by the Chinese economic hard landing risk for the sixth consecutive year. Risk managers must adapt rapidly in this quickly changing environment.

The evolution of the top five risks provides evidence that trends can be relied on in this survey, and the general continuity between survey iterations adds credibility. In this survey, financial volatility has overtaken cyber as the top current risk, but cyber remains the top emerging risk both when choosing five or the single top risk. (See Figure 2.)

Three risks increased materially from the previous survey when respondents were asked to choose their top five emerging risks. Transnational crime and corruption doubled from 5 percent to 10 percent. Retrenchment from globalization and technology each rose by double digits. Quite a few risks were materially lower, led by those in the economic category. The individual risks included Chinese economic hard landing, asset price collapse, liability regimes/regulatory framework and cyber.

Figure 3 shows results for the top five emerging risks from the most recent two surveys, showing how risks can move materially between iterations.

Top Emerging Risk

When asked for a single emerging risk from the respondents’ top five, the results are similar.

The results for the top emerging risk were recorded as follows:

1. Cyber
2. Financial volatility
3. Asset price collapse
4. Retrenchment from globalization
5. Technology

Chinese economic hard landing, terrorism and liability regimes/regulatory framework dropped out of the top five. Interestingly, asset price collapse and retrenchment from globalization both had much higher responses when considering the top emerging risk.

Risk Combinations

This year’s survey again asked about concerns due to combinations of emerging risks. The top risks chosen include financial volatility, cyber, terrorism, asset price collapse, retrenchment from globalization and regional instability.

The top five combinations of two risks were:

• Terrorism and cyber
• Cyber and technology
• Financial volatility and retrenchment from globalization
• Asset price collapse and financial volatility
• Chinese economic hard landing and asset price collapse

Retrenchment From Globalization

Each year it seems that at least one risk has a breakout response. This survey reflected concerns about uncertainty due to populist topics in the United States and Europe. This was reflected in the survey, with higher responses being recorded for retrenchment from globalization in each of the surveyed categories: current risk, top five emerging risks, top emerging risk and risk combinations. Together with financial volatility, this risk was ranked third among combinations. While impossible to determine exactly why a specific risk goes up and down, for this risk it is notable that it had gone down in the previous survey before it skyrocketed. Figure 4 shows the progression of this risk since 2009 across all metrics.

Conclusion

Emerging risks are a great challenge for management teams. How do you manage risks with lengthy time horizons, some of which are not yet on the radar for many, while incentives are set over much shorter spans? How can a CEO keep the focus on intermediate and long-term decisions when short-term fires are so distracting?

Environmental scans are a key component as risk managers attempt to embrace emerging risks. Several consulting firms and magazines share their knowledge, and the World Economic Forum annually releases its Global Risks survey. The collection of surveys described in this article is unique in that it attempts to trend the same risks over time, leaving it to the readers to incorporate this information into their risk framework.

How can modelers incorporate emerging risks when historical data may not be similar to future results? Unknown unknowns will affect everyone in unique ways, and stress scenarios are hard to develop. Unknown knowns, where past historical data fails to be predictive, should be tested as thoroughly as possible.

Emerging risks are a key component of an Own Risk Solvency Assessment (ORSA) filing for an insurer, describing how they are considered and acted on. These can be built into stress tests through specific scenarios like a pandemic or Category 5 hurricane, or through stochastic modeling by adding risks like cyber or driverless cars to the operational risk model.

Those who look inward for risk management will fall short of goals and be surprised by discontinuities. Those who look outward will not anticipate every emerging risk, but they will turn the odds in their favor. This will clarify their vision and improve forward-looking projections.

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