When Extreme Investment Risks Travel in Packs

“They have institutes full of statisticians and actuaries,” Gil said.

But Gil said she believes that typical life insurance company “quants” are used to analyzing risks that have little influence on one another.

In the world of investment management, she said, one terrible event can suddenly make many other terrible, supposedly rare events occur at the same time.

A bad storm could lead to spiking interest rates, a stock market crash and high inflation rates, and an earthquake that occurs while all of those disasters are underway could add to the misery, and lead to aftereffects that keep the period of misery going, Gil said.

The result is that, instead of a friendly bell-shaped curve describing risk distribution in the investment markets, the curve that applies is a “fat tail value at risk curve.”

In a high school math book, extreme tail risk is a little sliver of bad outcomes on the right side of the bell. In the real investment world, the right side of the curve may be a thick glob of potential catastrophes, according to the fat tail value at risk approach.

Instead of using traditional techniques for analyzing economic risks mostly separately, life insurers should use techniques such as jump diffusion theory to capture how one big shock can create ripples that roll back and forth through the economy, making risks rise together, fall and move in ways never seen before, Gil said.

The good news, Gil said, is that life insurers that generate the right mix of economic scenarios can see where the tangled threads of bad outcomes lie.

If life insures see the tangles of bad outcomes, they may be able to come up with strategies for preventing those bad outcomes from occurring, she said.

Pictured: Alla Gil. (Photo: Straterix)