New or evolving risks are usually not backed with extensive historical data for estimating their future impact. These can be termed emerging risks. They are difficult to manage due to limited data and unfamiliarity with their nature, and they can impact all industries and entities. The length of time before emerging risks occur can be quite long -- 10 years or more -- which can lead to unintended consequences if the risks are not acted upon sooner.

Managing these newer or emerging risks can be a tightrope walk for insurance companies. When a risk manager recognizes a risk much earlier than competitors, the insurance company acts upon it by pricing the risk into a product, thus increasing its premium.

If clients do not consider the probability of the risk high enough to pay the premium, the company can experience reduced sales. If the risk does not occur for a long time, this can even cause the firm to be forced out of that market entirely, irrespective of the correctness of the risk manager's assessment.

However, if the risk manager assesses the risk correctly, and if the risk plays out quickly, the firm can be considered far-sighted and can gain a leadership position in the industry.

Unpredictability lies at the heart of identifying risks, with the end result always being elusive. Companies that ignore a risk may enjoy many years of outsized results, as opposed to those that plan for it, before finally succumbing to the downside of the cycle.

Those who recognized the bubble building in the subprime mortgage market initially had trouble finding ways to trade on their knowledge. Even after derivative instruments had been developed, the bubble continued to grow. Some investors had to close on these positions before they paid off.

In 2003, following the SARS (severe acute respiratory syndrome) pandemic, many in the life insurance industry recognized that the risk of infectious disease such as influenza was only minimally priced into their products. Knowing that higher mortality assumptions would price their products out of the market, they discussed the risk at various actuarial and risk management conferences in an attempt to engage the industry. By the time a minor influenza pandemic arose in 2009, steps were in place to consider this risk when calculating capital requirements and assessing a company's own risk. Reinsurers also adjusted their claims assumptions to accept this risk.

Assessing and Prioritizing

Assessment and prioritization of emerging risks depends on a number of factors, including global events recent trends.

The Fourth Survey of Emerging Risks (sponsored by the Joint Risk Management Section, a collaborative effort of the Society of Actuaries, Casualty Actuarial Society, and the Canadian Institute of Actuaries), covered a variety of issues related to emerging risks. From a list of 23 risks compiled by the World Economic Forum, these respondents, who were mostly from the insurance industry, were asked to identify their top five emerging risks and their overall No. 1 risk, and to answer a series of other risk management questions.

The survey categorized risks as economic, environmental, geopolitical, societal and technological. The initial survey was completed early in 2008 as the financial crisis was getting under way. Economic risks have historically scored highest in this survey. These include concerns about spikes in the price of oil, a Chinese economic hard landing and demographic shifts.

Geopolitical risks have consistently been strong in the survey results, representative of the "human anchoring" bias. This bias reflects a tendency to let recent events dominate thinking about future events. For example, in the fall 2008 survey, most of the responses were received before the Mumbai terrorism attacks, so very few had listed terrorism as one of their top five emerging risks. In responses afterwards, all participants listed terrorism in their top five, and for some it was the No. 1 emerging risk. Understanding this bias helps risk managers manage risks in the context of recent events.

The reverse of this bias can be observed as we get farther from the economic crisis of 2008. Risk managers in late 2010 were able to think about non-financial risks to a greater degree than was seen in earlier surveys.

In the survey conducted in 2010, a number of recent events influenced the results. Earthquakes impacted Haiti, Chile and New Zealand, while Iceland experienced a volcano eruption that impacted air travel for weeks. The oil spill in the Gulf of Mexico highlighted the fragility of oil supply. Other natural disasters occurred, the European debt crisis widened and tensions erupted on the Korean peninsula.

In the 2010 survey, the top five results continued to come primarily from the economic category. Allowing for multiple responses, fall in value of the U.S. dollar came in first, with 49%. It was followed by:  international terrorism (43%), Chinese economic hard landing (41%), oil price shock (40%) and failed and failing states (38%).

The voting for overall No. 1 emerging risk had Chinese economic hard landing on top, at 14%, ahead of fall in value of the dollar (11%), blow-up in asset prices (10%), breakdown of critical information infrastructure (9%) and oil-price shock (9%).

Leading Indicators

Key risk indicators (KRIs) can be a measure of risk exposures. When data on KRIs is collected after an event, they are called lagging indicators, reflective of historical measures. These include items from the income statement and balance sheet, along with metrics like sales levels and counterparty exposures. Trending macroeconomic data can provide KRIs, as can revenue and liabilities specific to a firm.

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