Systemic Risk - It's the nightmare of actuaries, the elusive type of risk that causes actuaries to throw their hands up in despair, and cry out "I can't analyse it!". Precisely. Which is why we should synthesise it instead.
Wait, wait..what is systemic risk, why is it a nightmare, and why should we synthesise? I thought you were going to talk about systems thinking??
Let's go over these step by step.
1) Firstly, systemic risk - it is best illustrated by an example that is very real to us now, the Covid-19 pandemic.
What we know is, a single person in a distant city in a country, in an (extremely) unfortunate event somehow contracted this virus from a bat presumably in a seafood/animal market, and in less than a year, global economies have been brought to their knees, millions have lost jobs and their lives, the healthcare segment in virtually every country is staggering to cope, mental health issues have escalated, domestic abuse has worsened, we have become acutely aware of the impact of human activity on the environment, the impact of overcrowding in prisons, the impact of conspiracy theories in derailing containment efforts, etc etc etc.
All from a single bat to a single person (presumably). And this is what we call a systemic risk, a single event sparking a domino effect to cause the failure of entire systems of economies, livelihoods, health etc.
Most of us have seen many instances of systemic risks - eg natural disasters, the dotcom bubble crash, the Asian financial crisis, the 2008 financial crisis triggered by failures in mortgage-backed securities. And unfortunately, the reality is that we will see many more in our lifetimes.
2) Next, why is it a nightmare for actuaries? Well, by our training, actuaries tend to analyse. To "analyse" means to break a complex problem into small parts (reductionism), and proceed to understand the whole as a sum of the small parts.
In this process, it is necessary to assume a degree of independence between the parts in order to build mathematical models and analyse the risk. Then we may introduce some form of dependence, either mathematically (using copulas, multiple decrements, multi-variate models etc) and/or through scenario testing, varying some assumptions together.
Naturally, the relationships and linkages between the components may be downplayed.
This process is important, and it is how we go about pricing and valuing most insurance and financial contracts. However, we know that these models can break under certain circumstances - and systemic risks are a central part of the circumstances that break models.
3) Why synthesise, and what is systems thinking?
Synthesis can be seen as the opposite of analysis, but I prefer to think of it as a complementary way of thinking.
To "synthesise" is to combine each individual component into a connected whole. "Systems thinking" is an approach that employs synthesis in understanding problems, viewing a system as a whole. The system is understood by examining the linkages and interactions between the components.
Emphasis is placed on inter-relationships, perspectives and boundaries. Changing one part of the system will impact other parts and the entire system.
Employing this approach can help us better understand and prepare for systemic risks. Admittedly I don't think this will enable us to quantify systemic risk ahead of time, but we will be better placed to design processes, systems and policies that can help us withstand or at least soften the impact of systemic risks.
Actuaries are seen as experts in risk management, so it is crucial for us to develop this skill of systems thinking to enable our clients, employers, and society to weather the storms of systemic risks.
Comments