Low likelihood, high impact risks

Introduction to Low Likelihood, High Impact Risks

Welcome to one of the most critical topics in the CP1 syllabus! In our previous chapters, we looked at how to manage risks that happen regularly. But what happens when we face a risk that is extremely rare but could potentially bankrupt an entire organisation? These are known as low likelihood, high impact (LLHI) risks.

Often referred to as "tail risks" because they sit at the extreme ends of a probability distribution, these events are the ones that keep actuaries and Chief Risk Officers awake at night. Understanding how to identify and manage them is the difference between an organisation surviving a crisis or failing completely.

What are Low Likelihood, High Impact Risks?

In simple terms, these are events that have a very small probability of occurring, but if they do occur, the consequences are severe or even catastrophic.

Examples include:

• A global pandemic causing a massive spike in benefits payable on contingent events (like life insurance claims).
• A massive earthquake or hurricane hitting a major city.
• A total collapse of the global financial markets (systemic risk).
• A major data breach or technological failure that halts business operations.

Don't worry if this seems daunting! The goal isn't to predict exactly when these will happen, but to ensure the provider of financial products is resilient enough to survive them.

The Challenge of Managing LLHI Risks

LLHI risks are notoriously difficult to manage for two main reasons:

1. Lack of Data

As we learned in the section on data requirements, actuarial models usually rely on large amounts of historical data to predict the future. Because LLHI events happen so rarely, there is very little "ideal data" available. This makes it hard to use standard stochastic modelling with high confidence.

2. Human Perception and Risk Appetite

Stakeholders often suffer from "it won't happen to me" syndrome. If a provider hasn't seen a major disaster in 50 years, they may become complacent, reducing their risk appetite for protection and potentially underestimating the capital requirements needed.

Key Takeaway: Because historical data is sparse, we must use scenario analysis and stress-testing to "invent" possible disasters and see if our business survives them.

Tools for Managing LLHI Risks

When dealing with these "black swan" events, providers of financial products use a combination of risk responses. You can remember these using the framework of risk acceptance, rejection, transfer, and control.

1. Risk Transfer (The most common response)

Since the impact is too high for one organisation to handle alone, they often pay someone else to take the risk.

• Reinsurance: An insurance company buys insurance from a larger global reinsurer to cover massive claims.
• Securitisation: Transferring risk to the capital markets (e.g., catastrophe bonds).

2. Risk Control and Mitigation

This involves taking steps to reduce the impact if the event occurs.

• Diversification: Spreading risks across different geographic regions or different types of financial products so that one single event doesn't impact everything at once.
• Limit Setting: Putting a cap on the maximum amount of business written in a specific high-risk area.

3. Risk Acceptance (Holding Capital)

Sometimes, a risk cannot be fully transferred. In this case, the organisation must accept it and hold enough economic and regulatory capital to remain solvent. We use internal models to determine how much capital is needed to survive a "1 in 200 year" event (a common regulatory standard).

Quick Review: Which tool is best? It depends on the risk appetite of the stakeholders and the cost of the protection versus the cost of holding capital.

Assessment Techniques: Stress Testing and Scenario Analysis

Since we can't rely solely on past data, we use these two vital techniques (as mentioned in syllabus objective 3.4):

• Stress-testing: Changing one specific variable to an extreme degree (e.g., "What happens to our surplus/profit if the stock market falls by \(40\%\)?").
• Scenario analysis: Looking at a "story" of events that happen together (e.g., "What happens if there is a massive earthquake AND the local stock market crashes AND we cannot access our offices?").

These techniques help providers understand their risk efficiency—finding the right balance between taking risks for profit and staying safe from ruin.

Stakeholder Perspectives

Different stakeholders view LLHI risks differently:

• Regulators: Their primary concern is prudential regulation. They want to ensure the organisation has enough capital to pay benefits even in a disaster. They want to ensure the provider can treat a customer fairly even when under financial strain.
• Shareholders: They want profit. They might find it frustrating to hold large amounts of "idle" capital for a risk that might never happen.
• Management: They must balance these views, using Enterprise Risk Management (ERM) to add value by managing these risks holistically rather than in silos.

Common Mistakes to Avoid

Mistake 1: Thinking "Low Likelihood" means "Zero Likelihood." In the exam, always assume that if a risk is possible, it must be planned for.

Mistake 2: Forgetting the interrelationship between risk and capital. If you identify a high-impact risk, your response should almost always mention capital requirements or provisions.

Key Summary Table

Final Thought: Managing LLHI risks is about Living with the Solution. It requires constant monitoring and reporting of the financial condition to ensure that the organisation remains robust against the unexpected.