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Publication - Professor Patrick Godfrey

    A review of the use of complex systems applied to risk appetite and emerging risks in ERM practice

    Citation

    Godfrey, PS, Allan, N, Yin, Y & Cantle, N, 2013, ‘A review of the use of complex systems applied to risk appetite and emerging risks in ERM practice’. British Actuarial Journal, vol 18 Part 1., pp. 1-72

    Abstract

    Traditional approaches to risk studies and risk management are based upon the paradigm of risk as an event adequately characterised by a single feature. This simplistic conceptualisation of risk leads to the use of analysis tools and models which do not reliably integrate qualitative and quantitative information or model the interconnectivity of the dynamic behaviour of risks. For complex systems, like an economy or financial organisations, a new paradigm or philosophy is required to understand how the constituent parts interact to create behaviours not predictable from the ‘sum of the parts’. Systems theory provides a more robust conceptual framework which views risk as an emerging property arising from the complex and adaptive interactions which occur within companies, sectors and economies.

    Risk appetite is a concept that many practitioners find confusing and hard to implement. The fundamental problem is that there is no common measure for all risks, and it is not always clear how different risk factors should be limited in order to remain within an overall “appetite”. Attempts are generally made to force everything into an impact on profit or capital but this is problematic when businesses and risk decisions become more complex. There is a lack of real understanding about how they would propagate, or indeed how the appetite may shift or evolve to have a preference for specific risks.

    By thinking holistically, risk appetite can be viewed as “our comfort and preference for accepting a series of interconnected uncertainties related to achieving our strategic goals”. By making those uncertainties and the connectivity of the underlying drivers explicit, it is possible for decision makers to define their risk appetite and monitor performance against it more effectively. The ability to link multiple factors back to financial outcomes also makes the challenge of expressing risk appetite in those terms more tractable.

    Similarly, the identification and assessment of emerging risks can become more robust by using a systems approach that enables a clearer understanding of the underlying dynamics that exist between the key factors of the risks themselves. It is possible to identify interactions in a system that may propagate hitherto unseen risks. Emerging risks can be viewed as evolving risks from a complex system. It is also known that such systems exhibit signals in advance of an observable change in overall performance. Knowing how to spot and interpret those signs is the key to building a scientific and robust emerging risk process. Also it is becoming increasingly clear that risk appetite and emerging risks are interconnected in many ways as this research shows.

    Full details in the University publications repository