ASSURATECH Applications of Advanced Science in the New Era of Risk Management Lee Smith, FCAS, MAAA Presenter Presenter Information Science Quantum Mechanics Complexity and Chaos

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 Perspectives on the New Science The SFI, formed in 1987, brought together experts from a variety of areas to address common interests. The SFI, formed in 1987, brought together experts from a variety of areas to address common interests. The technology had emerged from attempts to solve equations for nonlinear systems of particles from the A-Bomb chain reaction. The technology had emerged from attempts to solve equations for nonlinear systems of particles from the A-Bomb chain reaction. A fusion of statistical mechanics and nonlinear dynamics along with advances in topology, set and group theory, algebraic geometry, and perturbation theory had created a new mathematical framework. A fusion of statistical mechanics and nonlinear dynamics along with advances in topology, set and group theory, algebraic geometry, and perturbation theory had created a new mathematical framework.

ASSURATECH Elements of Complexity Science Complexity science is a name which emerged from techniques developed by thinkers in many venues. Complexity science is a name which emerged from techniques developed by thinkers in many venues. In studying the subatomic world, scientists had been required to develop computer and math structures to deal with multidimensional, non-local, fuzzy, virtual, probabilistic entities which seemed fundamental. In studying the subatomic world, scientists had been required to develop computer and math structures to deal with multidimensional, non-local, fuzzy, virtual, probabilistic entities which seemed fundamental. At the classical level, scientists found chaotic and fractal structures which required interplay between mathematics and computer science. At the classical level, scientists found chaotic and fractal structures which required interplay between mathematics and computer science. Topological features (power laws, fat tails,…) influenced the collective dynamics of networks. Topological features (power laws, fat tails,…) influenced the collective dynamics of networks. Data mining and visualization techniques became critical to unraveling underlying patterns. Data mining and visualization techniques became critical to unraveling underlying patterns.

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 Perspectives from the Physical Sciences Information may be as fundamental an element of the physical universe as matter, energy, space and time. Information may be as fundamental an element of the physical universe as matter, energy, space and time. The Standard Model of the Atom, encompassed in Quantum Field theory, consists of mathematical “particles” which exist in a state of probabilistic superposition. The Standard Model of the Atom, encompassed in Quantum Field theory, consists of mathematical “particles” which exist in a state of probabilistic superposition. Our world is a “wedding cake” of layers from the virtual in the core of the atom through the subatomic, classical, social, institutional and cosmic. Our world is a “wedding cake” of layers from the virtual in the core of the atom through the subatomic, classical, social, institutional and cosmic.

ASSURATECH Perspectives from the Physical Sciences, cont’d String theory would reconcile macro relativity with micro quantum, but the physics is ahead of the math. String theory would reconcile macro relativity with micro quantum, but the physics is ahead of the math. Complexity and chaos theories allow the physical world to create its own categories, and develop the math around that. Complexity and chaos theories allow the physical world to create its own categories, and develop the math around that. The Info Mesa was developed to provide a forum for reducing reality to data and data to information. The Info Mesa was developed to provide a forum for reducing reality to data and data to information.

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 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 InsuranceWorld© Enterprise Simulation win survive collapse Equity Jan-03Jan-04Jan-05 Jan-06 Jan-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