COVID19 and Complexity: The Need of the Hour in Risk Management
By Syed Danish Ali
Risk Management, December 2020
Editor’s note: Our newsletter issues from the second half of 2020 have inevitably focused on COVID-19. In July the topic of systemic risk was addressed, while in September our readers learned about an ongoing effort that attempts to understand potential COVID mitigation measures. In line with this trend, we are wrapping up the year by sharing a thought-provoking article by Syed Danish Ali that can be interpreted as a "lessons learned" for risk management practitioners.
COVID-19 highlights the need for greater complexity science expertise in risk management and in the actuarial field. Crises like the current COVID-19 pandemic, the 2008 financial meltdown and others help us to turn our focus inward for introspection on how we can better manage our resources and provide a deeper understanding of what our objectives should be and how we can achieve them.
In other words, we can say that in times of crisis, systematic risks are brought to the front. In normal times, businesses sweep specific risks under the rug due to leadership’s keen focus on profitability and cost minimization. This leads to pent-up specific risks turning into systematic risks. Risk management can then be described as a way to “deconstruct” the current business practices so that we can “reconstruct” them into something better. Consider this brief example of deconstruction:
- Average life spans for corporation lives have been decreasing over time in an accelerating manner. Today it is 18 years, in 1958 it was 61 years and, per McKinsey research, in 2027, 75 percent quoted on the S&P 500 will have disappeared. The result has been attributed to a wide number of factors generally clubbed as “creative destruction” as described by Joseph Schumpeter. Tech companies have generally led this charge, (1) by changing business models and products and (2) through meeting and altering customers’ expectations. Schumpeter adopted this line of thought by following Karl Marx, who first pointed out that capitalism cannot exist without continuously altering the forces of production and that relentless change was the only constant here.
- This led to a reaction from many businesses that is reactionary rather than visionary and is shortsighted. The long term doesn’t matter anymore and structural considerations are up to the government policy makers and not the businesses to handle. Only the quarterly results matter, the day-to-day operations matter. Strategy is seen as a theoretical aloof blob that never materializes anyway because it gets eaten away by culture, and the sole focus is on the bare necessary infrastructure. All other considerations are relegated to externalities. The result is that as long as everything is going fine, it stays fine, but when losses begin to accrue, investors pull out. Soon afterward another company sprouts up or companies are sold. Everyone works according to the role prescribed to her by her job description and no one gets to think outside of her role. This stifles independent creative thinking and leads to group think to the extent that when asked to improve, current roles add more complexities (more procedures, more bureaucracy) instead of simplifying and looking at the bigger picture. A tangible example is that of middle-tier insurers across many geographies that are mostly acting as clones of one another with strikingly similar products, operations, business management and strategies.
- Areas of top focus are sales, profitability, growth, cost minimization and short-term results. Although this is fine in times of economic booms and when the past is a good indicator of the future under normal business environment, in times of crisis it shows how businesses traded efficiency for resilience. Fragile, vulnerable, leveraged growth replaced sustainable long-term growth. Resilience looks like something that is unimportant and uncomfortable because it is bubble-breaking to the way corporate managers and investors usually think. Therefore, it is up to the risk manager to highlight preparing for worst-case scenarios without sounding like a doomsday prepper. Their role is to believe in optimism. Any exercise where their business goes bankrupt feels emotionally very taxing as they attempt to make it work or die trying. The risk manager must start by acknowledging this optimism but then remind senior management that preparing for the worst, as the Stoics say, can help avoid the worst case from happening in the first place.
The reconstruction of business practices can mean:
- More focus is given to resilience than currently, and mechanisms are made to adapt in times of crisis. In good times, building resilience seems to be increasing costs unnecessarily, but vision should prevail over shortsightedness. This resilience can mean increase in costs but it also means that the systems/operations in place will be more responsive in times of crisis and not unfold like a house of cards when the going gets tough.
- Risk managers must focus more on structure and complexity as a way of understanding vulnerabilities and building anti-fragility, however limited, in the company. The risk management way of thinking should apply to all important decision making. Risk managers are themselves susceptible to trying to fit in with the crowd and may start filling the stomachs of file cabinets by increasing compliance and standards to the point that very little meaningful decision making can be achieved. This should be avoided.
- Stable, consistent growth must be given more preference than currently. But this doesn’t mean that a company morphs into a frozen-in-time bureaucracy, because creative destruction will very quickly demolish it. A relentless focus on innovation has to follow despite knowing that most innovations will fail.
- The risk manager needs a two-pronged focus, on the qualitative side, such as behavioral psychology, and on the quantitative side. The current trend is to hire risk managers from internal audit segments. While internal audit is a field in itself, it usually leads toward trend where more and more forms and compliance standards are adhered to. The quantitative side of risk management (capital modeling, implemented Monte Carlo simulations to decision making, scenario testing, stress testing) gets ignored as well as the qualitative side of behavioral psychology and focus on complexity and structural thinking (which can be both qualitative and quantitative). Actuaries are ideally suited to handle both of these qualitative and quantitative sides but there is a need for them to delve in more detail in complexity models and apply them to the business case in point. There are plenty of researches done by the SOA, CAS, IFoA on complexity modeling for actuaries to get started.
WE ARE PRODUCTS OF OUR SOCIAL CONSTRUCTS
Elaborating further on behavioral psychology, over the past decade or so, there has been increasing interest in behavioral economics/behavioral psychology/behavioral economics to decode what goes on in our minds when we make financial decisions. How do numbers impact us? How do we decide what to do? After years of research, it has come out that we are consistently irrational and prone to a number of cognitive biases when making decisions. We cannot escape from these cognitive biases—there are too many biases and they are part of how we have evolved over millennia as human beings—but we can be aware of them and “de-fang” them, as Nassim Nicholas Taleb put it. We use many mental shortcuts (called heuristics) to make decisions and make sense of the explosion of information that we receive with our limited time and mental resources.
We are social beings and create our own social constructs. These social constructs are invisible and not readily understood by us. Take finance, for example; modern banking and shareholder-led business and insurance may seem to be worth trillions and be very pervasive, but it took 200 years by the powerful to make us used to them. Modern capitalist insurance is not natural, a way of life, but is a social construct with its own historical context. Finance in the 1800s was ridiculed by many as people obsessed with material wealth who don’t ponder on the meaning of life or on the sciences. Finance developed its own set of rituals, like the stock market ticker, banks as temples and protocols to gain prestige amongst the masses by showing it as a separate scientific field. Similarly, life insurance was rejected by the Western world in the 1800s, as people did not want to buy from those who were trying to profit from death. The life insurance agents aggressively became a modern type of priest in being upright and convinced people (virtue signaling) that in event of death of the sole breadwinner, the family can avoid destitution and poverty and becoming criminals by simply buying a life insurance policy. The peer-to-peer business in insurance (like lemonade and Islamic takaful) were historically known as mutual companies where people used to pool together to protect one another. Hence, we should not take for granted the all-powerful state of reality that surrounds us.
While describing these reconstructions and deconstructions I do not wish to imply that all businesses are necessarily evil or that reconstructions will lead to a utopia. Humans, as much as their systems are imperfect and fractal requiring changes; but expecting extreme binary outcomes of a gray reality should be avoided. To paraphrase the theory of Schrödinger’s cat, there is a superposition of two mutually contradictive states (good and bad exists at the same time) to any of our actions (e.g., introducing a new product in the market), but we will never know the actual decoherent outcome (it can be either good or bad) unless we take action.
The situation is highly uncertain and evolving on a daily basis. Hence, it is impossible to accurately forecast the actual impacts. Nevertheless, we can stay alert and seek understanding so that we can proactively manage crises like the COVID-19 pandemic. There is a higher need for actuaries and risk managers to focus on complexity, structural thinking and behavioral psychology so that they can act as agents of change to build better systems. Also, all the latest technology cannot be a replacement for deep erudite thinking because fundamentally we remain the same and have similar aspirations, fears and hopes.
Although it might be tempting to view this phenomenon as temporary and that it will be overcome and the mean reversion will put insurers back on their usual underwriting cycles, this is not likely to be the case. Even previously, those insurers who had hoped for the mean reversion to kick in the 1990s ended up going bankrupt. COVID-19 is a paradigm shift in how insurers do business and there is certainly no going back.
The views reflected in this article are solely of the author and do not reflect his employer’s position.
Syed Danish Ali is deputy manager, Actuarial, at PKF Al Bassam. He can be reached at firstname.lastname@example.org.