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The insurance and reinsurance industries are in business to take bets on risks that can be identified, assessed, prioritized and planned for financially. Disasters like hurricanes, earthquakes, massive asbestos-like litigation and even terrorist attacks fit the bill. But what about so-called Black Swan events?

Executive Summary

Insurers and reinsurers are thinking outside of the box to try to imagine seemingly unimaginable Black Swan-like events, along with cascading and coupler effects that could magnify losses should the events come to pass. That doesn’t mean they’re sitting in dark rooms and conjuring up big thoughts; instead, they’re forming cross-functional teams internally and collaborating with outside risk experts to share information on possible disaster scenarios.

A Black Swan is a disaster or series of cascading disasters that no one saw coming—hence there was no way to identify, assess, prioritize and plan for the impact. The term apocryphally derives from the settlement of Australia by the British, who had seen white swans before but never a black one.

In the centuries since, the Black Swan theory, as developed by Nassim Nicholas Taleb in 2001, has become a metaphor for a large, surprising event that causes a catastrophic financial impact that is beyond the realm of expectation—sighting a black swan when one has only seen white ones in the past.

This distinction is important, as many pundits inaccurately describe such events as the 9/11 terrorist attacks, the SARS flu pandemic, the financial crisis of 2007 and even the earthquake/tsunami/nuclear series of disasters in Japan as Black Swans. However, each of these events was predictable—someone somewhere saw them coming, but no one listened or agreed.

The role of insurance companies and reinsurance companies is to be this “someone,” to think outside the box and contemplate truly bad stuff happening, even though the possibility of these events occurring may strain the limits of credulity.

(Editor’s Note: Nassim Nicholas Taleb introduced the Black Swan theory in his book about uncertainty in financial markets, “Fooled by Randomness,” published in 2001. He extended the theory to events outside of financial markets in “The Black Swan,” published in 2007.

“Real Black Swans don’t happen overnight; with some insight you can detect signals,” says Erwann Michel-Kerjan, executive director of the Wharton Risk Management and Decision Processes Center at the University of Pennsylvania, where he teaches classes on managing and financing extreme events.

Detecting such signals is of vital importance to insurers and reinsurers, making it incumbent for chief risk officers of such institutions to drum up improbable but possible doomsday scenarios—like a meteor hitting the planet and wiping out a major city, or a pandemic that reaches across geographic borders to kill off a good chunk of the population.

That’s exactly the kind of outlandish thinking in place at two insurers—Zurich and Allianz—whose CROs, John Scott and Thomas Wilson, respectively, are charged with protecting their company’s portfolios from an unimaginable wedge of Black Swans.

Says Wilson, “Even though this stuff is challenging to anticipate, we have a quite structured way of evaluating these emerging risks and their impact.”

Really Bad Stuff

This is not a task for the faint-hearted, given the need to predict the unpredictable. But, as Michel-Kerjan and other experts in extreme risk management maintain, history has provided clues.

We know, for instance, that there is a likelihood of a meteor causing devastation on a massive scale, since the Earth is pockmarked with the evidence. Telltale signs also exist to identify other possible large-scale disasters, such as NCBR (nuclear, chemical, biological and radiological) terrorist events, solar storms knocking out a power grid, and major casualty events like product liability litigation involving thousands of injured or ill individuals. While these catastrophes don’t fit the precise definition of a Black Swan—they’re predictable because they’ve happened—they guide an exploration of related events that have yet to occur.

“The simple act of considering a Black Swan in advance and doing scenarios where you blow up all the possible repercussions from the event and how to respond better prepares you for something unusual that you had not considered,” explains Felix Kloman, former risk management consultant at what is today Towers Watson.

A specific case in point is asbestos litigation as it relates to nanotechnology.

“Here we have this fantastic set of technologies based around nanoparticles that are smaller than the width of a human hair but do these amazing things,” Scott explains. “Look at UV sunscreen protection. Years ago, this was characterized by this white gunk that stuck to your skin. Now the gunk magically disappears on your skin and protects you from possible skin cancers. That’s because of the nanoparticles in it.”

“The simple act of considering a Black Swan in advance and doing scenarios where you blow up all the possible repercussions…prepares you for something unusual that you had not considered,” explains Felix Kloman.

All well and good, but Scott notes the potential downside of this important technology—the nanoparticles in sunscreens are so microscopic that they literally pass through the blood-brain barrier.

“While there is no accumulation of evidence that this may present a biohazard, the nanostructures under a microscope look suspiciously like asbestos fibers,” he says. “Despite no data, no scientific studies, no claims and no court cases—really no evidence at all that this may be injurious someday—it very well suggests an emerging risk that one needs to be wary about.”

He says that while insurers and reinsurers assuming the related product liability exposures cannot actually measure this risk from an actuarial standpoint, they nonetheless must monitor potential repercussions and take precautionary actions to soften them—just in case. “For example, it would be sensible to encourage customers to return used packages [of sunscreen] to prevent them from going into a landfill and possibly causing environmental issues in the future, and to protect workers in the factories from inhaling airborne particles or the stuff sticking to their clothing when they get home,” Scott says.

A pandemic that has never occurred before also would loosely fit the description of a Black Swan, and therefore may be identifiable and predictable. Such risks pose draconian financial exposures for life reinsurers, but the threat is so severe that it undermines the ability of the industry to price for it, says Max Rudolph, a consultant and actuary who recently completed a research project on emerging risks. In actuarial terms, the risk fails the fortuity test, he explains.

“We’ve seen examples of modern pandemics and near-pandemics like SARs and the MERS-CoV (Middle East respiratory system coronavirus), and we know that there have been devastating historic pandemics like the Black Death in the 14th century and the 1918 ‘Spanish flu’ pandemic,” adds Rudolph, founder and president of Rudolph Financial Consulting.

“While there is no accumulation of evidence that this may present a biohazard, the nanostructures under a microscope look suspiciously like asbestos fibers.” — John Scott, CRO, Zurich Global Corporate

“Assuming everyone infected had life insurance, the commensurate financial impact quite possibly would have doomed multiple insurers. The same would likely occur today, as insurers do not adequately price for this risk, even though they know there will be future pandemics.”

He adds, “What makes this a Black Swan is that we don’t know where the next pandemic will come from.”

The same can be said for terrorist incidents and other NCBR risks. The U.S. government, its allies and even private industry are well aware of the danger presented by al-Qaeda, al-Badr, Abu Nidal, Hezbollah and other groups designated as terrorist organizations by various countries. While many people assume that 9/11 was completely unforeseeable, Robert Muir-Wood, chief research officer at RMS, a provider of catastrophe modeling software solutions, says, “It did not come out of left field.”

Black SwanIn fact, the risk of a wide array of terrorist plots has been on the radar screen of intelligence agencies for decades. The National Security Agency and other spy agencies, according to reports released by Edward Snowden, have been able to discern and stop a great number of these planned attacks because they typically involve a significant number of people, weapons, surveillance activities and other preparations. “The ones that tend to slip through the intelligence net are those that are of much smaller scale, such as the two terrorists allegedly involved in the Boston Marathon bombing,” comments Muir-Wood’s colleague Gordon Woo, a catastrophe risk expert and chief architect of the RMS terrorism risk model.

While the insurance industry has reams of data to draw upon to posit the financial impact of a hurricane, earthquake or tornado, identifying so-called cascade events like the Fukushima earthquake, tsunami and nuclear disaster are more problematic.

“Such connections often are not clear until they are actually experienced,” Muir-Wood says. “For example, we can postulate the impact of a volcanic eruption in the traditional sense, but few people would imagine that an ash cloud produced by a volcano in Iceland would shut down air traffic for days and have a dire impact on global supply chains.” The airline industry alone suffered losses estimated by the International Air Transport Association at $200 million a day.

Still, the onus is on insurers and reinsurers to put their imaginations and creative thinking to such conceptual possibilities. A case in point is what would happen to the global technology industry if Seattle toppled from a series of cascading disasters. Not only is the Emerald City at risk of an eruption from five active volcanoes in the region, it also faces the possibility of a major earthquake in the magnitude 7.5 range and higher that could trigger a giant tsunami.

Major technology companies like Amazon and Microsoft are in the region, as well as hordes of midsize and smaller technology firms. Not only would their business be disrupted by the cascading disasters, but so would the business of companies buying their products, those companies’ insurers and the carriers’ reinsurers.

Guntram Werther, professor of strategic management at Temple University’s Fox School of Business, says of Black Swans: “Despite their definition, these large scale events are largely foreseeable. The proof is that virtually every time one occurs, someone pops up to say they saw it coming.”

Another type of Black Swan (to stretch the definition again) is what actuaries call the coupler effect—where previously uncorrelated risks suddenly start correlating. Muir-Wood cites the flooding that devastated New Orleans in the aftermath of Hurricane Katrina. “It was a pretty rare occurrence for life insurance, car insurance, home insurance and other insurance risks in one area to all suffer high-magnitude losses,” he explains. “Typically, we don’t see them all correlating.”

Woo agrees: “We’ve learned that a single disaster can have all kinds of consequences flowing from it—for example, a pandemic’s impact on the tourism industry.”

History fortunately provides a way to at least contemplate these cascading disasters and coupler effects. The Japanese trio of disasters severely disrupted global electronics production, causing lengthy business disruptions for the automotive industry. Toyota attributed $1.2 billion in product revenue declines to parts shortages that resulted in 150,000 fewer cars being manufactured in the U.S. (Source: Global Assessment Report on Disaster Risk Reduction 2013.) Such information is vital to organizations with suppliers in disaster-prone regions.

Another example is the massive flooding in Thailand in 2011, which caused severe shortages in the hard disk drive market, resulting in business disruption losses for electronics manufacturers. Nearly 1,000 factories in Thailand serving the needs of global supply chains across the globe shut down from the flooding, resulting in an estimated $20 billion in insured losses picked up by the industry. (Source: FM Global whitepaper, “Prepare for the Expected: Achieving Business Resiliency in an Era of Severe Natural Disasters,” citing Reuters.)

The solution is to imagine the unimaginable. “The insurance industry needs to be using whatever mathematical models they have at their disposal to assist their basic judgment, experience and intuition to make the best guesses they can about Black Swans,” says Guntram Werther, professor of strategic management at Temple University’s Fox School of Business. “Despite their definition, these large scale events are largely foreseeable. The proof is that virtually every time one occurs, someone pops up to say they saw it coming.”

Preparing for the Imagined Unimaginable

To better prepare for bad stuff on the horizon, Allianz has structured a four-step emerging risk management process that starts with identification, followed by assessment, prioritization and then management actions, such as capping underwriting limits. This Risk Radar system is designed to imagine risks that may occur in the future, which are then assessed and prioritized in terms of financial severity.

“We do this not in a dark closet thinking big thoughts but with other members of the industry and cross-functional teams here.” — Thomas Wilson, CRO, Allianz

“We do this not in a dark closet thinking big thoughts but with other members of the industry and cross-functional teams here,” explains Wilson. He points out that the CRO Forum, a group consisting of CROs from several multinational insurance and reinsurance companies, recently adopted an Emerging Risk Initiative to better address Black Swans and slightly more predictable events.

In assessing emerging risks, Allianz undertakes penetrating “what if?” risk-based scenario tests. This effort, in turn, helps guide expectations of possible financial impacts, which are drawn upon to prioritize worst-case scenarios. Since the financial costs of Black Swans are impossible to measure accurately, no attempt is made to put a number on them. “That would only give you a false sense of security,” Wilson explains. “We just assume the impact will be big.”

The last step—actions involving the company’s risk portfolio—include doing such things as limiting policy exposures to no more than $10 million per contract and imposing an additional limit on the total number of policies in place. Since casualty policies underwritten on a claims occurrence basis can become long-tail loss events, Allianz also takes this into account to ensure limits don’t stack up across several years. “The only surefire management action is to limit your losses,” Wilson explains.

Other risk experts say that, down the line, stronger partnerships need to be forged between the industry and governments to develop mechanisms that better share disaster-related losses.

“Clarifying who will pay for what were something to happen—that discussion at a fairly strategic level would be important,” Michel-Kerjan says, citing roles in this conversation for scientists, several government agencies and departments like Homeland Security and the Department of Defense, and members of the insurance and reinsurance communities.

Rudolph comments that the industry should consider setting up an office structure similar to the Federal Reserve, in which funds are provided a central overseer to address the financial impact of disasters occurring to insurers in different geographies. This body would serve as an adjunct to reinsurance to share the risk of loss, he explains.

“Contemplating dire scenarios is not scare mongering; for insurers and reinsurers it’s good business.” — Gordon Woo, Catastrophist, RMS

Kloman, on the other hand, brings up the idea of an expanded role for insurers and reinsurers—as disaster consultants. “Once an extreme event occurs, those affected need more than just traditional insurance financing,” he explains. “The enormity of the event also requires governmental assistance—the declaration of a disaster zone, financial assistance, and low-interest loans and tax credits. Advice and counsel also is needed. Insurance companies could help facilitate the coordination of all this help.”

All the observers say to keep in mind that Black Swans are extremely rare. They are risks that are nowhere near the constancy of a car accident or a trip and fall. When one occurs, the tendency is to anticipate another right on its heels. A good example is the undetected meteorite that hit Russia south of the city of Chelyabinsk a year ago, resulting in the injuries of nearly 1,500 people. Showers of meteors were soon predicted across the world, even though the event was a once-in-a-millennium occurrence.

While the public should rest assured that the sky is not falling, the industry still must consider the possibility. “Contemplating dire scenarios is not scare mongering; for insurers and reinsurers it’s good business,” Woo says.