Preparing for the Black Swans

Vinod KrishnanAon Benfield Asia

Black Swans

• Theory popularized by Nassim Nicholas Taleb

• Black Swan event:

– is an outlier as it lies outside the realm of regular expectations,

– carries an extreme impact, and

– makes it explainable and predictable retrospectively.

• Typically, falls under the risk category ‘Unknown Unknowns’

• They can and do occur on a regular basis and

likely to become more common

Black Swans

• The occurrence of black swans can, and repeatedly does, overwhelm the

insurance industry

• Left unattended, black swans can threaten a company’s very existence

• Rating agencies, investors and increasingly regulators are less likely to

provide favorable opinions when insurers fail to demonstrate emerging

risk management processes

It is not the strongest of the species that survive, nor the most intelligent, but

the one most responsive to change

Unknown Author

Black Swan = Crisis

Motivated by an essay by David Brooks reflecting on the Deepwater Horizon oil spill:

“Over the past decades, we’ve come to depend on an ever-expanding array of intricate high-

tech systems. These hardware and software systems are the guts of financial markets, energy

exploration, space exploration, air travel, defense programs, and modern production plants.

These systems, which allow us to live as well as we do, are too complex for any single person

to understand. Yet every day, individuals are asked to monitor the health of these networks,

weigh the risks of a system failure, and take appropriate measures to reduce those risks.

If there is one thing we’ve learned, it is that humans are not great at measuring and

responding to risk when placed in situations too complicated to understand.”

Eyjafjallajokull ChernobylDeepwater HorizonChallenger Titanic

Black Swans History

1816 - “The Year Without a Summer”

• In April 1815, Mount Tambora on the island of

Sumbawa, Indonesia erupted

• Greatest eruption in recorded history

• Explosion heard >2,000 km away

The estimated volcanic ash fall

during the 1815 eruption

Local and Global Impact

• Local Impact:

– Darkness within 600km radius for 1-2 days

– About 10,000 people died on Sumbawa and 80,000 due to famine and

disease in the surrounding regions

– Massive crop failure led to famine; it took up to five years for

vegetation to return 400 km around Tambora

• Global Impact: the “Year without a Summer”:

– Sunlight was blocked by acid aerosols, led to global cooling and

worldwide harvest failure

– Rains were interrupted in India, leading to deadly Cholera outbreak

– Crops failed in Europe

– Floods occurred in China

– Snow fell in northeast US in June

1908 Tunguska Explosion

• On 30 June 1908 in Tunguska, Russia,

the most powerful natural explosion in

recent history rocked the earth

• Believed to be an air burst of a

meteorite 6-10 km above the earth’s

surface

• Explosion was 1,000 times more

powerful than the atomic bomb

dropped on Hiroshima

• 20,000 Near Earth Objects of concern

An area of 2150 square kilometres and

about 80 million trees were destroyed

The event occurred in a remote part of

Siberia in Russia

1918-1919 Influenza Pandemic

The pandemic was caused by a form of influenza that probably originated due to army barrack conditions during World War I

1918-1919 Influenza Pandemic – Effects

• First reported cases in Fort Riley, Kansas - January 1918

• Within weeks 1,127 soldiers were infected and 46 died as virus spread

across the US

• The flu appeared in France in August 1918, spreading East and South to

Russia, Africa, and eventually to China and Japan

• 27% of global population infected, killing 3%-6%, making it deadlier than

World War I

September 11, 2001 – Direct Effects

• 19 al-Qaeda terrorists hijacked 4 passenger jets

and crashed them into the World Trade Center,

the Pentagon, and a field near Shanksville,

Pennsylvania (the intended target was in

Washington D.C.)

• Direct losses:

– 2,977 victims and 19 hijackers killed

– $133 billion of Economic loss

– $40.1 billion of insured loss

– Over $10.4 billion of reinsurance loss

United Airlines Flight 175

crashes into the south tower

The remains of 6 World Trade

Center, 7 World Trade Center,

and 1 World Trade Center

September 11, 2001 – Indirect Effects

U.S. Soldiers in Afghanistan

• Dow Jones fell 14.3% in one week

• $24.8 billion loss to the aviation industry

• Estimated debris removal cost of $5

billion

• 70,000 people are estimated to be

affected

• US announced War on Terror

• Afghanistan and Iraq wars

• Additional spending on two wars and

from homeland security were at least $5

trillion

September 11, 2001 – A Black Swan Event

• Would 19 people have that impact in 1800?

– Limited destructive technology

– Smaller cities

– Slower communications

• 19 people can now affect the lives of billions in almost no time

– Intrusive transportation security measures

– Global wars

– Economic losses

• Governments have taken strong actions to mitigate the risk

2004 Indian Ocean Earthquake and Tsunami

• One of the deadliest natural disasters in recorded history

• Claimed more than 230,000 lives in fourteen countries (including

Indonesia, Sri Lanka, India and Thailand)

• Tsunami waves up to 30 meters high

2008 Sichuan Earthquake

• Magnitude 7.9 earthquake killed an estimated 68,000 people

• The deadliest earthquake to hit China since the 1976 Tangshan earthquake

and the strongest since the 1950 M 8.5 Chayu earthquake

• It was also felt in nearby countries and as far away as Beijing and Shanghai

-1,500 km and 1,700 km away

2010 Pakistan Flood

• Resulted from heavy monsoon rains

and affected the Indus River basin

• Approximately one-fifth of Pakistan's

total land area was underwater

• About 20 million people were affected

and 2,000 people died

• Has cost more than 5.3 million jobs

• Total economic loss USD 43 billion

2011 Tohoku Earthquake

• A totally unforeseeable event - a seismological “black swan”

• M 9.0 earthquake and tsunami caused a nuclear disaster, persistent power

shortages, and a host of other major societal and economic challenges

• The Japan Trench was not expected to generate quakes

above magnitude 8.0

• A surprise to catastrophe risk modelers

Potential Future Black Swans

Volcanic Eruption - Effect of a Year Without a

Summer Today?

Upper level atmospheric map from late

July and early August 2011 showing an

‘omega block’ in western Russia

Russian Heat

Wave

Contributes to doubling of wheat

price

Food prices spike,

help trigger unrest

1908 Tunguska Explosion – Today

• The graphic shows the 1908

Tunguska event overlaid over

Manhattan with estimated property

losses of $1.19 trillion (RMS 2009)

A Pandemic Today

• Estimates of the economic impact of a similar

epidemic today:

– 175 – 350 million deaths

– GDP reduced by $2 trillion

• Improvements since 1918:

– Better medical technology (e.g. antibiotics)

– Planning due to SARS and bird flu scare

• Additional complexity since 1918:

– International air travel

– Modern cities

– More interdependent and vulnerable

society (e.g. commuting)

1859 Geomagnetic Storm – The “Carrington

Event”

• 1859 the largest ever recorded geomagnetic

storms occurred in 2 phases between 28th

August and 3rd September

• Global effects:

– Aurorae observed in Cuba, Mexico, Hawaii

and Italy

– Global telegraph outages/disruptions

– Telegraph pylons threw sparks, set fires,

and telegraph paper caught fire

spontaneously

1859 Geomagnetic Storm – Modern Implications

• Economic costs today - several trillion

US dollars

• Electrical grid disruption for years

• NASA has developed the project “Solar

Shield”

• Governments plan to harden their

electrical and communications grids

Severe atmospheric geomagnetism would

induce currents in electrical power grids and

damage critical components, causing

widespread outages

Critical infrastructure relying on electric power

would be immediately affected

Satellite communication and control could

cease due to failure of internal components

1859 Geomagnetic Storm – When next?

"Even a below-average solar cycle is capable of producing severe space

weather. The great geomagnetic storm of 1859, for instance, occurred during

a solar cycle of about the same size we’re predicting for 2013.“

Doug Biesecker of the NOAA Space Weather Prediction Centre

These X-ray images of the Sun

show solar activity waxing and

waning between the sunspot

maxima in 1991 and 2000

Lessons

Tohuku Event

• Fukushima nuclear plant designed to withstand multiple perils:

– Earthquake

– Tsunami barriers

– Walls thick enough to sustain air crashes etc

• Damage caused by tsunami (with run-up heights over 35m above sea

level)

• Loss not due to negligence of tsunami as a foreseeable scenario, however

specifically because it was assumed that a sufficient barrier height had

been built

• Considerations that include the likelihood of occurrences

• Itemized and excluded if unlikely, however effects are drastic

Challenges faced

• Climate change and socio-economic change

– Source of weather-related black swans in future

– Impacts are more serious now than they were in the past

• Increasingly complex and interdependent society

– Communications and the internet

– Globalized supply chains

– Air travel

– Urbanization

• Interaction with economic and non-insurance environments

– Unforeseen exposures, peril correlation, dominos

• How can we handle black swans and extreme scenarios outside of our

experience?

Preparing for the ‘unforeseen’

• What you don’t know is far more relevant than what you do know

• You can't prepare for a specific event, but you can prepare for the impact

• Improvements in cat models to capture the black swans

– Focus on robustness of errors rather than accuracy of forecasts

– Focus on uncertainty in results rather than mean

– Focus on tail rather than body of loss distribution

• “what-if” and “as-if” analyses

– Realistic disaster scenarios (RDS)

– Historical events if they were to occur in today’s socio-economic

environment

• Understanding economic linkages and dominos

Insurance and Preparedness

• Beyond pre-existing plans, effective response depends on the ability of all

concerned to react flexibly and creatively as the situation unfolds

• Despite the sheer diversity of risks, different emerging risks can produce

similar symptoms and therefore a common response applied

• For illustration, a business continuity procedure to allow key personal to

operate remotely can serve for pandemics, terrorism and other risks off

the radar

• Detect any major organizational issues impeding the management of

black swans

• Preparedness includes identifying and allocating adequate levels of

sufficiently skilled resources to monitor black swans and recommending

responses should the risk emerge

• Use historical “grey” swans to price policies (with a loading). This can be

done on a global or regional basis

Reinsurance

• Reinsurance Capacity is available to spread the burden

• Reinsurance as a Risk Transfer tool :

– Geographic diversification

– Sharing of risks among players

– Reinsurers should become experts in extreme losses,

including black swans

• Need to understand black swans to buy adequate/ sufficient

cover

• Statistical analysis can be of limited value and re/insurers

need scenario planning (RDS)

Lessons from these events

• Black swans are out there

• They have occurred in the last 200 years

• There are new types of loss exposure

• We have developed powerful tools to mitigate risk:

– Technology, such as satellites and catastrophe models

– Enterprise Risk Management

– Reinsurance and modern financial tools

• Are our risk management tools keeping pace with the

exposure?