ASSURATECH Applications of Advanced Science in the New Era of Risk Management Lee Smith, FCAS, MAAA Co-author, Presenter Lilli Segre Tossani, MA, BA Co-author “What If” Simulations Demand Forecasting Predictive Modeling

ASSURATECH Rapidly Changing Global Risk Landscape Unimagined new sources of risk Unimagined new sources of risk Unimagined risk correlations Unimagined risk correlations Unimagined emergent vulnerabilities Unimagined emergent vulnerabilities Consolidations within the insurance industry Consolidations within the insurance industry Consolidations within insured industries Consolidations within insured industries

ASSURATECH Limitations of Traditional Models Standard linear statistical models inadequate to new world of risk Standard linear statistical models inadequate to new world of risk l Increasing emergence of fat tails in data patterns l Extreme events cut across products, coverage, policyholders & financial statement categories l Traditional linear Financial Risk Management models lack needed flexibility l Stochastic methods cannot accommodate interactions between multiple marketplace forces

ASSURATECH Models from Outside the Industry Catastrophe modeling using meteorological, seismological data Catastrophe modeling using meteorological, seismological data Financial models Financial models l Portfolio Theory l Capital Asset Pricing Model l Value at Risk Questions remain Questions remain l What risks to measure l How to expand the perspective to include & evaluate multiple & cascading risks

ASSURATECH Enterprise Models – ERM Characterizes ERM risk as threats to organization Characterizes ERM risk as threats to organization Reveals interconnectedness of operational, event, asset, liability, information & strategic risk Reveals interconnectedness of operational, event, asset, liability, information & strategic risk Cannot accurately value the effects of multiple & non-linear correlations, cascading risks or positive feedback loops Cannot accurately value the effects of multiple & non-linear correlations, cascading risks or positive feedback loops

ASSURATECH Enterprise Models – DFA Projects financial results under a variety of possible scenarios Projects financial results under a variety of possible scenarios Incorporates feedback loops & management intervention decisions Incorporates feedback loops & management intervention decisions Combines underwriting & investment activities to get an overall company view Combines underwriting & investment activities to get an overall company view Traditional linear statistical analysis of aggregate data + multiple iterations Traditional linear statistical analysis of aggregate data + multiple iterations Slow & ponderous to use Slow & ponderous to use

ASSURATECH New Tools for Complex Systems Need: model simultaneous changes to multiple variables in complex environments Need: model simultaneous changes to multiple variables in complex environments l Today all risks are potentially cascading risks l Traditional tools never intended to work with this expanded risk l Statistical modeling cannot meet the challenge of today’s non-linear dynamics

ASSURATECH Complexity Science: The Key to Understanding Complex systems Technology: Technology: l Agent-based simulation l Bottom-up pattern recognition l Precision forecasting Applications: Applications: l Risk management l Economic systems l Ecosystems l Investment markets Santa Fe Institute

ASSURATECH Traditional Systems and Products Dynamic Financial Analysis (DFA) Dynamic Financial Analysis (DFA) l Ranges of values rather than expected values l Better informed decision making Enterprise Risk Management (ERM) Enterprise Risk Management (ERM) l Identifies, categorizes, prioritizes, quantifies all risks l Enables better risk & return assessment l Hedging & diversification strategies to optimize results Capital Allocation Capital Allocation l Assess profit potential for investment alternatives l Enables allocation by level of risk

ASSURATECH Traditional Systems and Products, cont’d Rate models Rate models l Standard pricing models l Includes risk-profit load Catastrophe models Catastrophe models l Use meteorological and seismological data rather than historical data to estimate costs

ASSURATECH Informatics — The Tools of Complexity Data Mining Data Mining l Extract very complicated patterns, correlations, etc. from databases l Can mine non-normalized, disparate databases Data Visualization Data Visualization l Visual representation thru charts, graphs, 3D animation, etc. l Allows visual orientation to patterns and trends l Allows visual orientation to patterns and trends Genetic Algorithms Genetic Algorithms l Algorithms mimic Darwinian evolution l Reproduce by random combination to make new programs l Best problem-solvers survive, continue to evolve

ASSURATECH The Tools of Complexity, cont’d Neural Networks Neural Networks l Simulate the operation of the human brain l Receive data as input, produce behavior as output l Learn and adapt Agent-based Simulation Agent-based Simulation l Lower-level agents interact according to simple rules l Behavior of the entire system emerges from the interactions of the agents l Agents can be non-homogenous, highly interactive l Reveals non-linear, non-intuitive results

ASSURATECH Comparison of Tools very high performance medium performance low performance not possible Level of Analysis Level of Competency Product Enterprise Global Industry Cascading Risk Extreme Events Disparate Data Mining Non-Linear Results Data Visualization DFA ERM Rate Models Capital Allocation Catastrophe Models iw 3

ASSURATECH Knowledge Capture / Strategic Intelligence The complexity advantage: The complexity advantage: l Citibank uncovered $200M in hidden credit risk l Proctor and Gamble saved 22% in distribution expense l Dupont saved $500M annually in manufacturing expense

ASSURATECH Agent-Based Simulator: A Scenario Generator Bench test ideas before committing resources Bench test ideas before committing resources l Corporate strategies l Market strategies l Pricing options l Capital allocation l Effects of extreme events l Hidden risks

ASSURATECH Data Mining: Key to Predictive Modeling Precisely segment markets Precisely segment markets Test multi-channel, multi-product offerings Test multi-channel, multi-product offerings Optimize marketing budgets Optimize marketing budgets Optimize Customer Relationship Management (CRM) budgets Optimize Customer Relationship Management (CRM) budgets

ASSURATECH Demand Forecasting Business systems follow physical laws well-known in physics Business systems follow physical laws well-known in physics l Phase transitions, hysteresis, etc. l Simple changes in the system can dramatically impact the bottom line Uncertainty works to the advantage of those with knowledge Uncertainty works to the advantage of those with knowledge

ASSURATECH InsuranceWorld© Enterprise Simulation win survive collapse Equity Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11 Jan-12 Quarter Equity ($M) Lee Smith Co. Tom & Dick XYZ Co. Harry & Sons ABC, Inc.

ASSURATECH Complexity Science Today’s Toolkit for Understanding Emergent Risk in Complex Systems