Why models need a certain culture to flourish
About half a year ago Ian Branagan, Chief Risk Officer of Renaissance Re - a Bermudian reinsurance company with a focus on property catastrophe insurance, gave a talk about the usage of models in risk management and how they evolved over the last twenty years. Ian’s presentation, titled with the famous quote of George E.P. Box: “All models are wrong, but some are useful”, was part of the lunch time lecture series of talks at Lloyd’s, organised by the Insurance Institute of London.
I re-discovered the talk online over the weekend and found it most enlightening again.So, what makes models useful? And here I mean models that estimate extreme outcomes / percentiles. Three factors are critical, according to Ian, to embed models successfully in risk management and decision making processes.
- Need - A clear defined need for the model.
- Capabilities - The skills and resources to build and maintain the model.
- Culture - An organisational culture that embraces, understands and challenges the model.
The need, if not driven internally, is often imposed by external requirements, such as regulation, e.g. banks and insurers have to use models to estimate the risk of insolvency in many countries. Building capabilities can largely be achieved by investing in people, technology and data. However, the last factor culture, so Ian, is often the most challenging one. Changing business processes, particularly in decision making at senior level requires people to change.
Where in the past senior management may have relied on advisors’ expert judgement to guide them in their decision makings, they have to use models in a similar way now as well. I suppose, in the same way as it takes time and effort to build effective relationships with people, it is true for models as well. And equally, decisions should never rely purely on either other people’s opinion or indeed model output. As Ian put it, outsourcing all modelling/thinking, and with that the decision making to vendors of models, such as catastrophe modelling companies or rating agencies, who both aim to provide probabilities for extreme events (catastrophes and companies failures) may be sufficient to tick a risk management box, but can ultimately put the company at risk, if model assumptions and limitations are not well understood.
Perhaps we are at the dawn of another enlightenment? Recall Kant’s first sentence of his essay What is enlightenment?: “Enlightenment is man’s emergence from his self-incurred immaturity.” Indeed, it doesn’t matter if we use experts’ opinions or the output of models, relying blindly on them is dangerous and foolish. Don’t stop thinking for yourself. Be critical! Remember, all models are wrong, but some are useful.