Introduction to Risk

Modelling
Dr Iqbal Adjali
Senior Research Fellow
Energy Systems Modelling
KAPSARC, Saudi Arabia
Outline
• What is Risk?
• Importance of risk management to policy/decision making
• Risk modelling approaches (statistical, mathematical, computational)
• Risk modelling examples:
• Credit risk
• Insurance risk
• Wider considerations
• Limitation of current approaches
• Human factors
Risk, Peril and Hazard
• Risk is a (quantifiable) probability of loss given an event occurring
• Peril is an identifiable cause for the loss
• Hazard is a situation/condition that increases probability of loss

Example: assessing house insurance premium

• Risk is total loss of property as a result of a fire
• Peril is fire itself (as a direct cause for the loss)
• Hazard can be: faulty gas appliance, occupier who smokes...
Risk Management
• Understanding relationships between events, consequences and
outcomes
• Assessing the likelihood and impact of possible outcomes
• Developing risk mitigation and response strategies
• Requires quantification of risk => Modelling

Basic risk formula:

Risk Probability Loss

(Frequency of event) (Severity of event)

Risk management areas
• Economics and Finance
• Engineering
• Natural/environmental disasters
• Infrastructure and security
• Health and safety
Approaches to Risk Modelling
• Statistical
• Predominant approach Survival Analysis
• Data driven
• Does not require a detailed understanding of cause and effect
• Mathematical Black-Scholes Model
• Equation/theory driven
• Requires an understanding of underlying mechanisms
• Computational Agent Based Modelling
• Empirically driven
• Simulation techniques
• Scenario analysis Monte-Carlo simulations
 Example: Credit Risk
EL = PD x LGD x EAD
Expected loss (£) Exposure at
Loss given Default (£)
Probability of
Default (%) default (%)

• BASEL II directives require banks to follow prescribed approaches for

calculating EL for different retail bank asset classes
• Expected loss (EL) is usually priced in the interest charged for the loan
• Example: Mortgage = £100k, PD = 2%, LGD = 25% -> EL = £500
• Banks are also required to set aside capital to cover unexpected losses (UL)
• Estimation of EL and UL require the modelling of the PD and LGD distributions
Credit Risk Modelling
• PD is usually modelled using Poisson distribution
• LGD is sometimes modelled with Beta distributions (finite support)
• EL then takes the form of a Gamma distribution

• Empirical validation
• External factors as covariates
Time hazard models - 1
• ‘Time to event’ is the random variable of interest
• Large class of applications: insurance, epidemics, conflicts, disasters,
etc
• Key concept is the Hazard function (known by different names –
failure rate, force of mortality, intensity, etc)
• The Hazard function (t) is the instantaneous rate of occurrence of
the event of interest at time t
• Shape and form of  determine the temporal behaviour of the
stochastic process
Time hazard models - 2
•  is unobservable (cannot be measured directly), but can be
estimated from the density of events f at duration t, and survival S to
a given duration t:

• Three typical regimes:

• d/dt = 0: Constant hazard, frequency of events is Poisson distributed
• d/dt > 0: Increasing hazard, propensity of event increases over time
• d/dt < 0: Decreasing hazard, propensity decreases over time
• The (2-parameter) Weibull distribution, (t)=atα-1, is frequently used
to model the three cases above
• External factors can be modelled by regressing  on appropriate
covariates (e.g. Mortality risk)
Limitations of current approaches - 1
• Risk = frequency of event x severity of event
• In most applications the distributions used to model both frequency
and severity impose strong, often unrealistic assumptions
• Assumptions of normality and exponential decay pervade most risk
models (e.g. Black-Scholes option pricing model)
• Cannot explain or predict unexpectedly large events or clustering
effects
• ABM and computational approaches can use empirical (fat tailed)
distributions that are more realistic and can accommodate large
deviations from the expected values
Limitations of current approaches - 2
• We’ve considered risk as an objective entity that can be measured
and quantified
• However, risk based decision making has an important subjective side
• Attitude to risk (risk appetite)
• Bounded rationality (limited information)
• Cognitive bias (systematically downplaying or emphasising certain risks)
• Cultural bias (groupthink, social influences on risk perception)
• Policy and decision makers dealing with risk management must take
human factors into accounts
• Difficulty to incorporate some these factors into risk models
 Q&A
A couple of links to explore risk modelling further:
• General info/case studies: Institute of Risk Management www.theirm.org. Runs
free webinar series on various topics in risk management
• MOOC course (free): Introduction to Actuarial Science (Insurance risk modelling):
https://www.edx.org/course/introduction-actuarial-science-anux-anu-actuarialx-1

• Any questions, comments, feedback please email me

• I can be contacted at iqbal.adjali@kapsarc.org

Thank you