Lloyds - cognition and how human factors affect risk perception

While the Solvency II world will be as grateful for as they are familiar with Lloyds of London's work in the Sol II sphere, they pushed out an intriguing paper for all risk practitioners this week around cognition, the impact of human behaviour, and our interaction with models when identifying and assessing risks.

This is a piece of academic research very much needed at this point in time, where the regulatory obligations around internal model challenge have yet to formally land, let alone be adequately road-tested, while at the same time the UK is continuing with its ICAS+ regime, where entrants will no doubt receive running commentary on their progress in upscaling both assumption/parameter challenge as well as model use.

Anyone involved in the 200-ish pre-applications for internal model use prior to Solvency II go-live in Europe would therefore benefit from a read of this, particularly if you are on the validation-side. I picked out the following;

Fundamentals which impact on modelling choices (data sets, interpolation/extrapolation, correlations, tail dependencies etc)

• "We are not equally aware of all risks...people make decisions based on a subset of the available evidence"
• "Expectations are strongly influenced by personal experience and current events"
• Tendency to "...lose sight of infrequent losses" in the face of more frequent visible events
• Tendency to procrastinate around risks which are difficult to assess
• "Some may query the relevance of human factors, given the prevalence of quantitative risk models - the suggestion being.modelling rules out biases"

Risk appetite

• "Low risk appetite can increase false alarms, and a high risk appetite increases misses"
• "The greater risk appetite of powerful individuals can stem from a tendency to focus more on rewards and successes, while people who are lacking in power are often more cautious and attentive to threats and potential obstacles" - is it this dichotomy which makes the role of the CRO ultimus inter pares in the boardroom?

Aide-memoire lists for risk practitioners

• How to counteract risk perceptions - p11
• Separating risk perceptions from immediate context - p13
• Awareness of bias linked to power - p16
• Risks in perspective - p20
• Behavioural principles which can create added value - p22

Towers Watson paper on Extreme Risks - useful for Reverse Stress Testing

For anyone who has reverse stress testing on their agenda, this release from Towers Watson should help you on the "unlikely but extreme" events front.

They categorise these events into three types - Financial, Economic and "Other" (being environmental and political), and provide 15 solid risk events, some ideas on ranking, hedging and parameterising impact and likelihood., all of which are valid in the face of a lack of guidance from EIOPA on the subject at this juncture (remember ORSA requirements!).

Certainly worth using in your next FSA-driven reverse stress testing exercise if you are UK-based, and considering in the context of the forthcoming public consultation on ORSA for the rest of you Euro-landers.