Risk modeling is about identifying and quantifying risk in light of changing variables. Within an enterprise risk management (ERM) program, models may help companies evaluate potential future losses. But to get the most out of risk models, companies need to understand them at their most basic level and prepare for the potential risks that can lie within them.
So what is a model?
Indeed, failure of financial institutions to fully appreciate and account for weaknesses in their models impacting capital and solvency may have exacerbated the financial crisis of 2008, leading regulators and rating agencies to focus more on model risk itself, encouraging companies to better manage such risk as a specific component of its ERM efforts.
In reviewing the results of any model, the reviewer should consider the following points and potential risk areas, asking questions to clarify understanding as much as necessary to insure that outputs are evaluated with appropriate caution, and any caveats or qualifications to the results are duly noted.
Minimizing Model Risk
In light of these risks, insurers have begun to better identify and strengthen their ERM efforts specifically around model risk management. As with other risks, the better that model risks are fully identified, and scored or prioritized from a potential loss or financial impact standpoint, the easier it should be for companies to identify and apply mitigating controls. Some of the specific steps companies can take to help strengthen their modeling framework, and help minimize related risks, include:
Finally, the overall profile of model risk can be raised by making it a high-level concern at the board of directors. Model risk should be discussed by the board or risk committee periodically even if, under the company’s pure financial risk assessment scale or risk “heat map,” model risk does not fall into a “Top 10” or “Top 20” list of risks. Since models often drive the priority assessments or scores of other risks (catastrophe loss, claim loss, business plan results), the inherent risk of models in itself is significant enough to warrant board attention and thought on a regular basis.
Recognizing and Accepting Model Risk