Risk and Risk Underwriting

In writing about the importance of promoting private enterprise, as well as in many other sections of my work, I suggested an almost near certainty that the risk management industry eventually will facilitate resilience and structural adaptivity in our built environment.  In my larger draft, I included a short section about this, which I am posting below (somewhat revised).  I believe it is beneficial to share this section now in order to explain my optimism for resilience. (I also wrote short sections on Time, Rapid Change, Optimism, A Futurist Perspective, and The Human Factor but do not necessarily intend to post them here.)

The future will be all about risk and trying to find protection from the rapidly increasing threats to our world as we advance in population size, social/cultural/economic complexity, and cutting-edge science and technology.  Risk underwriting will play a big role in how well or how poorly we adapt to accelerating change. 

Underwriting, as I understand it, is the process in which a person, organization or company stands behind, or safeguards, a different company, person, investment, or venture under certain stated conditions.  Underwriting is a process when issuing insurance policies, municipal bonds, initial public offerings of stock by a corporation, business loans for start-up or expansion, mortgages on houses, or other similar financial instruments.  In addition, it normally includes an analysis and rating of the probability of the safety and success of the company, person, investment, or venture.   Risk is a major component of this analysis. 

Of course, there are many aspects of risk transfer strategies and transactions throughout the financial system that tend to offset some of the location issue observations I am making here.  These include hedging, arbitrage, derivatives, catastrophe options, weather futures, credit default swaps, interest-rate swaps, event-linked securities (e.g. cat bonds), collateralized debt obligations, sidecars, etc., especially for very large ventures and developments.  Financial institutions try to outspread risk as widely as possible, sometimes even without all parties comprehending what they are getting into.  I am assuming that my general topic observations will still hold true, anyhow, for the long run.

There are two aspects of risk underwriting that are rapidly changing and that will facilitate structural adaptivity in our built environment.  These are prospective underwriting (and cat tails for future disasters), and geospatial analysis.

Prospective underwriting.  In the past, the risk component was based primarily on history.  The premium/fee/price of the underwriting and the interest rates, premium rates, and other costs were set relative to this determination of risk, among other factors, based primarily on actuarial underwriting, i.e., detailed statistical analysis of past events.

More recently, however, underwriters have become more aware of the large quantity and severity of risks that cannot be calculated based on available information about the past.  For example, what is the risk of a mortgage on a structure located in a hurricane-vulnerable area where there have been few, if any, hurricanes in the past (about which full knowledge was obtained and recorded)?  What are the risks that might be associated with future terrorist attacks in an area, the occurrence of a pandemic, or the occurrence of a massive meltdown of a nearby nuclear power plant?  What are the risks of failure of a particular urban region being unable to cope with its necessities for a fresh water supply or being unable to control its crime or congestion? 

Risk underwriters have the same problem that city and regional planners have with the increasing rapidity of change and the increasing inability to forecast change.

Therefore, the underwriters are turning increasingly to the same devices and perspectives that are used by futurists.  They are turning to prospective underwriting, including scenario analysis, wild card analysis, scanning, and similar tools to be able to better calculate future risks. 

In other words, they are designing their own new models of future "harms" that may occur in each of the many, many different sorts of neighborhoods and other small areas around the nation. 

Likewise, they are doing so with far more attention to the potential size of large catastrophes that may occur rather than only the past frequency of occurrences of small to moderate size losses.  They could not do this before.  Now, with enhanced computer capacities and speeds and with new forecasting models, they are attempting to come to terms with costing for wild cards and black swans.  Because of this, it is changing the way in which business leaders think.  Risk analysis is becoming a huge component in business management and planning.

In fact, new research related to prospective underwriting is describing the problem as being that natural disasters do not have normal distributions for sizes of occurrences.  Instead, they seem to have fat tail distributions.  I understand this to mean that if one plotted all of the recent occurrences of an event, such as large hurricanes to strike the US in the past 50 years or so, the tail on the end of the distribution curve would not be rapidly going down towards zero.  The tail would be extending much farther out than would be expected and it would not necessarily be going down. 

For example, 28 of the 30 worst hurricanes to hit the US recently caused somewhere between $1 and $29 billion dollars in damages.  However, the other two flouted these averages.  The second largest hurricane caused $45 billion in damage and the largest caused well over $100 billion in damage.  There is no way anyone could project a hurricane with $100+ billion in damages grounded on the trends of the other twenty-eight or twenty-nine.  The distribution graph has a fat tail. 

This also suggests that the next time a hurricane strikes that is greater than the current record holder, it just as easily could be 10% larger, or 100% larger, or 1000 % larger.  This type of thinking also applies to most all other types of natural disasters, and most likely to man-made disasters as well. 

Geospatial analysis.  Equally important, the risk underwriters are turning to "spatial (locational) analysis methodologies" that can perform property-specific risk determinations.

In the recent past, much of the analysis used to determine premiums by insurance companies and re-insurers, and by other financial institutions, was linked to postal codes as the smallest unit for analysis.  Postal code areas can be quite large at times and can periodically be transformed.  They also are limited as a base unit for the inclusion of other socio-economic and geographic data. 

The new trend is to use examination based on Geographical Information Systems data.  With GIS tools, property, project and enterprise locations can be narrowed down to latitude and longitude measures, i.e. to almost exact locations.  This allows correlation with, among many other factors, physiographic information.  Physiographic information is provided by many government agencies and often includes the locations of areas prone to wildfires, earthquakes, hurricanes, and storm surges, floods and similar hazards.  It also allows comparison with urban densities, locations of hazardous waste sites, railroads and other transportation facilities, open spaces, emergency medical service stations, fire stations, and even fire hydrants.  These features can thus be included in an analysis of risk and the pricing of premiums, interest rates, or other charges to a business or household.

(This capacity also means that, in choosing which factors to use in determining the pricing of premiums and similar rates, the underwriters will be in effect establishing ad hoc regulations for many project developments to the same end as are now imposed by zoning authorities, but with less political interference.)

Many companies are now supplying software to utilize such information.  Moreover, the software allows the use of such material in real time.  Premium prices and other costs can now be determined quickly and efficiently for especially small areas or even for specific properties.  Additionally, the characteristics of their project or property development (multi-use, cluster development, de-construction capabilities, adaptive infrastructure features, etc.) can be rated and likened as well.

With this new technology, developers/consumers can now be charged the true price of the perils of their projects.  Once they are required to make outlays on this basis, customers will have to choose between the trade-offs of, for example, living where they aspire and the costs of doing so. 

This, in and of itself, will have a major impact on the locational patterns of habitat and business locations in the US.  People and business will begin to choose resilient locations and resilient project/development characteristics in keeping with the recommendations of structural adaptivity and similar resilience strategies.

My thesis, which is based on the writings of an increasing number of underwriter research organizations, and of the underwriters themselves, is that before long these types of location-specific and prospective underwriting will become the norm.  Also, I believe that the costs to obtain such protections and safeguards against risk will much more truly reflect the risks their individual customers are facing in our new age of unpredictable change. 

Then, when the individuals, families, organizations, corporations, and governmental units all are having to pay the true costs of their location risks, as well as other true costs associated with their individual circumstances, they will start making locational decisions which will significantly change the urban characteristics and spatial patterns of our nation. 

Of course, this will also depend on the actions of our governments.  In the past, our national government has been the ultimate underwriter of risk in our country. 

The national government, and in some cases state government, has repeatedly stepped in and bailed everyone out when catastrophes, business failures and other perplexing events occurred which were too large or too disagreeable to allow the private sector and/or smaller governmental units to absorb. 

My assertion is that eventually our governments will no longer be willing or able to do this.  Our governmental institutions will come to comprehend that the underwriting of risk cannot continue without everyone having to pay the true cost of their individual risk situations. 

There may be some competitive advantages to our country in the global economy, at least for a while, by continuing to spread risk across the whole nation (including the basket of tools used by other financial institutions).  However, in the longer run we will enlarge our competitive advantages when each region and each locality is taking every action possible to decrease the risks to businesses and people located there.  We will also increase our chances of mitigating the negative effects from future, unpredictable harms that almost inevitably will come from an ever-changing future.

William Schnaufer