Emerging Risks in the Actuarial IndustryApril 2023
Emerging risks have been a hot topic, especially given the turbulent environment. The Actuary Canada recently spoke to Max Rudolph, FSA, CFA, CERA, MAAA, principal and founder of Rudolph Financial Consulting, about emerging risks and how individuals and enterprises can learn more about potential ways to mitigate them.
What can you say initially about ever-evolving emerging risks?
An emerging risk is something that is evolving, has not happened recently, or has not happened in the past. Climate change is an example of an emerging risk. Another example is the deadly earthquake that happened in Turkey in February. It has been 100 years since Turkey had an earthquake that was as devastating, so people and governments were not prepared when it happened.
The same goes for the COVID-19 pandemic. Pandemics have happened in history, such as the 1918 influenza pandemic, but we were not prepared for it because it has not happened for a long time. Hurricanes are like that too. Many emerging risks are physical risks. Those are risks that happen through nature. If a climatic event has not happened recently, we are often not prepared for it. Some of those emerging risks are obvious in hindsight, but it was easy for us to ignore them before they happened.
One term that is often used for emerging risk is “black swan.” It is in reference to the fact that Europeans once knew that all swans were white—until explorers in Australia saw black swans. What’s hard is to anticipate and plan for these emerging risks.
In your opinion, what are some of the emerging risks that the actuarial industry is facing?
I am worried about government leverage, which is higher than the level we have seen blow up countries in the past with hyperinflation and currency issues. We have seen institutional investors taking on more private equity investments. Zombie companies are also a concern. Some zombie companies were around a year ago because interest rates were low, which means they were able to make debt payments, but with the current level of higher interest rates, they might not be able to do so.
For some risks, although actuaries have historical data, it is difficult to use that data to predict the future. One example would be wildfires in British Columbia. Some pricing actuaries realize that data on wildfires need to be adjusted due to climate change, but it is difficult to do so.
Another problem we see is that some actuaries are not using cash flow analysis. One example would be the British pension LDI issue. Essentially, they use derivatives to duration match, but they ignore the higher order risks, such as convexity matching, and do not stress test cash flows. Some actuaries are not performing sufficient scenario testing or stress testing to determine impacts on pension plans that reflect the current environment.
Another issue related to life and pension business is related to the COVID-19 pandemic. Mortality significantly increased in 2020, 2021 and 2022. Does that mean future mortality is going to be higher than modeled? Or does that mean fewer people would die because some of the people who were going to die in the next 10 years have died already? This plays out for life and annuity products in different ways. For universal life products, the interaction between interest and mortality margins is not always obvious in terms of which one drives profitability.
There are also two-sided risks like inflation. Now that inflation is coming down, is it going to stay down? Or will high leverage cause inflation to grow again? Or are the current demographic trends (e.g., an aging population) going to cause deflation?
Physical risks that have not happened in several centuries should also be on the emerging risk radar. An example is a large seismic event in the U.S. and Canadian Pacific Northwest.
There is also geopolitical risk that interacts with globalization and de-globalization.
How could aging populations cause deflation?
Think about a world where fertility rates are low. This means that not as many young people are coming into the workforce. People have longer life expectancies in general now. Older people are not GDP growth drivers. Because of the low demand, interest rates would be low, which would then cause deflation tendencies.
What are some ways individuals can learn more about emerging risks?
One avenue is to read magazines like National Geographic. They often address physical risks, which makes me think about how they would interact with other risks I have been thinking about. Consulting firms and regulators also publish reports regarding emerging risks. And, of course, the JRMS publishes the Emerging Risks Survey that I compile.
Also, keep your eyes open, and do not just talk to actuaries if you want to learn more about emerging risks. You could watch a documentary or a continuing education program, for example. Once you start thinking about emerging risks, you will see them more frequently and become open to the search.
What are some potential ways of mitigating emerging risks?
One way is to do a backward projection, reversing recent historical results for a parameter. In an interest rate scenario, for example, year one of the projection would use the rate from a year ago, year two would be the rate from two years ago, etc. You can also look at times with similar circumstances, looking for patterns. It is important to pay attention to the periods right before the especially scary years, for example, the World Wars, the U.S. Civil War, the Depression, high inflation and more.
Another way is to come up with stress tests and identify under what circumstances your company can be solvent and under what circumstances it cannot. Then you can hedge your risks accordingly. It is also important to right-size your response. For some risks it is important—yet difficult—for companies to be prepared. One example could be solar flares. One huge geomagnetic storm caused a northern lights display that went all the way to the Caribbean (1859 Carrington event) and created fires on telegraph lines. With all the technology we have today, it would be disastrous if an event like that happened, but is this something that companies can necessarily prepare for?
It is important to think outside the box and solicit opinions from a wide range of individuals. Insurers may want to specifically exclude coverage for these events. Home office old-timers and agents are great sources. Being a lifelong learner leads to better decision-making.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
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