Tag Archives: Bank of England

10 x Hopelessly Lax = ?

The economist Sir John Vickers, himself an ex Bank of England Chief Economist, recently had a pop at the current Bank of England’s governor and chair of the Financial Stability Board, Mark Carney.  He countered Carney’s assertion that “the largest banks are required to have as much as ten times more of the highest quality capital than before the crisis” with the quip that “ten times better than hopelessly lax is not a useful measure”. I particularly liked Vickers observation that equity capital is “a residual, the difference between two typically big numbers, of which the asset side is hard to measure given the nature of banking, and dependent on accounting rules”.

In a recent article in the FT, Martin Wolf joined in the Carney bashing by saying the ten times metric “is true only if one relies on the alchemy of risk-weighting” and that banking regulatory requirements have merely “gone from the insane to the merely ridiculous” since the crisis. Wolf acknowledges that “banks are in better shape, on many fronts, than they were a decade ago” but concludes that “their balance sheets are still not built to survive a big storm”.

I looked through a few of the bigger banks’ reports (randomly selected) across Europe and the US to see what their current risk weighted assets (RWA) as a percentage of total assets and their tier 1 common equity (CET1) ratios looked like, as below. The wide range of RWAs to total assets, indicative of the differing business focus for each bank, contrasts against the relatively similar level of core “equity” buffers.

click to enlarge

Wolf and Vickers both argue that higher capital levels, such as those cited by Anat Admati and Martin Hellwig in The Bankers’ New Clothes, or more radical structural reform, such as that proposed by Mervyn King (see this post), should remain a goal for current policymakers like Carney.

The latest IMF Stability Report, published yesterday, has an interesting exhibit showing an adjusted capital ratio (which includes reserves against expected losses) for the global systemically important banks (GSIBs), as below.

click to enlarge

This exhibit confirms an increased capital resilience for the big banks. Hardly the multiple increases in safety that Mr Carney’s statements imply however.

Stuff Happens

Mervyn King is not remembered (by this blogger at least) as a particularly radical or reforming governor of the Bank of England. It is therefore surprising that he has written an acclaimed book, called “The End of Alchemy”, with perhaps some of the most thoughtful ideas on possible reforms we could make to get the global economy out of its current hiatus. One of the central themes in the book is the inability of existing Western economic orthodoxy to adequately consider the impact of radical uncertainty. He quips that “current policies based upon the model of the economics of stuff rather than the economics of stuff happens”.

King defines radical uncertainty as “uncertainty so profound that it is impossible to represent the future in terms of probabilistic outcomes”. A current example could be the Brexit vote this coming Thursday, with commentators struggling to articulate the medium term knock-on impacts of this tightly forecasted vote. This post is not about Brexit as this blogger for one is struggling to understand the reasons and the impacts of the closeness of the vote. I do think the comments from Germany’s finance minister, Frank-Walter Steinmeier, this week that a leave vote would mean “the EU will find itself in a deep crisis” are pertinent and amongst the many issues we will likely face in the medium term if the UK actually disengages from the EU. The current mood of voters in Western economies, such as the UK and the US, does underline the urgent need for radical thinking to be adopted into the way we are addressing global economic and social issues in my view.

King’s book is not only full of interesting ideas but he also has a cutting turn of phrase. Amongst my favourites are:  “economists mistrust trust”, “liquidity is an illusion”, and “any central bank that allows itself to be described as the only game in town would be well advised to get out of town”. Before I go over some of King’s ideas, I think it would be useful to recap on the conclusions from other recent books from UK authors on policy measures needed to address the current stagnation, in particular “The Shifts and the Shocks” by the highly regarded Financial Times commentator Martin Wolf and (to a lesser extent) “Between Debt and the Devil” by the former UK financial regulator Adair Turner. Wolf’s book was previously reviewed in this post and Turner’s book was referenced in this post.

Wolf articulated the causes of the financial crisis as “a savings glut and associated global imbalances, an expansionary monetary policy that ignored asset prices and credit, an unstable financial system, and naive if not captured regulation”.  Wolf argues for practical policy measures such as much higher and more resilient capital requirements in banking (he rejects the 100% reserve banking envisaged by proponents of the so-called Chicago Plan as too radical), resolution plans for global systemic financial institutions, more bail-inable debt in banking capital structures and similar alignment changes to the terms of other financial contracts, proper funding of regulatory bodies and investigators of criminal misbehaviour, tax reform with a bias towards equity and away from leverage, tax on generational transfers of land, measures to address income inequality (due to the resulting dilution of demand stimulus measures as a result of the rich’s higher propensity to save) and measures to encourage business and infrastructure investment, education and R&D.

Wolf also highlights the need for new thinking at global institutions, such as IMF and those (unelected) bodies governing the Eurozone, particularly the urgent need (although he is pessimistic on the possibility) for global co-operation and radical action to address the imbalances in the global economy. The need for deeper co-ordination, irrespective of narrow short term nationalistic interests, is nowhere more obvious than in the Eurozone with the alternative being financial disintegration. The Brexit vote is an illustration of the UK electorate’s preference for disintegration (as is the popularity of Trump in the US), presented by shady politicians as a return to the good ole days (!??!), and is perhaps a precursor to a more general disintegration preference by voters across the globe. Wolf observes that “financial integration has proved highly destabilizing” and that “the world maybe no more than one to at most two crises away from such a radical deconstruction of globalized finance”.

Turner’s book is more focused on the failure of free markets to “ensure a socially optimal quantity of private credit creation or its efficient allocation” and the need for policy makers to constrain private credit growth, particularly excessive debt backed by real estate, and the creation of less credit intensive economies. Turner argues that “the pre-crisis orthodoxy that we could set one objective (low and stable inflation) and deploy one policy tool (interest rate) produced an economic disaster”. In common with Wolf, Turner also advocates structural changes to tax and financial contracts to incentivize credit away from land and towards productive investment and policies to address income inequality. Turner also rejects 100% reserve banking as too radical in today’s world and favours much higher capital requirements and restrictions on the shadow banking sector. On the need for China and Germany to take responsibility for the impact of their policies on global imbalances, he repeats the pious lecturing of current elites (without the negativity of Wolf on the reality of such policies actually happening). Similarly he repeats the (now) consensus view on the need for the Eurozone to either federalise or dissolve.

As to real solutions, Turner states that “our challenge is to find a policy mix that gets us out of the debt overhang created by past excessive credit creation without relying on new credit growth” and favours the uses of further monetary measures such as Bernanke’s helicopter money, once-off debt write off and radical bank recapitalisation. Although he highlights the danger of opening the genie of money finance, his arguments on containing such dangers in the guise of once-off special measures are not convincing.

King highlights many of the same issues as Wolf and Turner as to how we got to where we are. The difference is in his reasoning of the causes. He points to significant deficiencies in the academic thinking behind the policies that govern Western economies. As such, his suggestions for solutions are more fundamental and require a change in consensus thinking as well as changes in policy responses. As King puts it – “I came to believe that fundamental changes are needed in the way we think about macroeconomics as well as in the way central banks manage their economics”.  According to King, theories upon which policies are based need to accommodate the reality of radical uncertainty, a model based upon the economics of stuff happens rather than the current purest (and unrealistic) models of the economics of stuff. King states that “we need an alternative to both optimising behaviour and behavioural economics”.

One of King’s most interesting and radical ideas is for a compromise between the current fractional banking model and the 100% reserve narrow bank model proposed under the so-called Chicago Plan. As King observes “to leave the production of money solely to the private sector is to create a hostage to fortune” and “for a society to base its financial system on alchemy is a poor advertisement for its rationality”. The alchemy King refers to here (and in the title of his book) is the trust required in the current “borrow short-lend long” model we employ in our fractional banking system. Such trust is inherently variable due to radical uncertainty and the changes in the level of trust as events unfold are at the heart of the reason for financial crises in King’s view.

Perhaps surprising for an ex-governor of the Bank of England, King highlights the dangers of overtly complex regulations (the UK PRA rule-book runs to 10,000 pages for banks) with the statement that “by encouraging a culture in which compliance with detailed regulations is a defence against a charge of wrong-doing, bankers and regulators have colluded in a self-defeating spiral of complexity”.  He warns that “such complexity feeds on itself and brings the system into disrepute” and that “arbitrary regulatory judgements impose what is effectively a high tax on all investments and savings”. This is a sentiment that I strongly agree with based upon recent experiences. All of the authors mentioned in this post are disparaging on the current attempts to fix banking capital requirements, particularly the discredited practise of applying capital ratios to risk weighted assets (RWA). A recent report from the Bank of International Settlements (BIS) illustrates the dark art behind bank’s RWA calculations, as per the graph below.

click to enlargeAverage Risk Weighted Assets

King’s idea is to replace the lender of last resort (LOLR) role of Central Banks in the current system to that of a pawnbroker for all seasons (PFAS). In non-stress times, Central Banks would assess haircuts against bank assets, equivalent to an insurance premium for access to liquidity, which reflect the ability of the Central Bank to hold collateral through a crisis and dispose of the assets in normal times (much as they currently do under QE). These assets would serve as pre-positioned collateral which could be submitted to the Central Bank in exchange for liquidity, net of the haircut, in times of stress who would act as a pawnbroker does. The current regulatory rules would then (over a transition period of 10-20 years) be replaced by two simply rules. The first would be a simple limit on leverage ratio (equity to total nominal assets). The second rule would be that effective liquid assets or ELA (pre-positioned collateral plus existing Central Bank reserves) would be at least equal to effective liquid liabilities or ELL (total deposits plus short term unsecured debt). The graphic below represents King’s proposal compared to the existing structure.

click to enlargeFractional Banking Pawnbroker Seasons Banking

King states that “the idea of the PFAS is a coping strategy in the face of radical uncertainty” and that it is “akin to a requirement on private institutions to take out compulsory insurance”. He highlights its simplicity as a workable solution to the current moral hazard of the LOLR which recognises that in a crisis the only real source of liquidity is the Central Bank and it structurally provides for such liquidity on a pre-determined basis. Although it is not a full narrow bank proposal, it does go some way towards one. As such, and as the graphic illustrates, it will require a significant increase in equity for private banks (similar to that espoused by Wolf and Turner, amongst others) which will have an impact upon overall levels of credit. Turner in particular argues strongly that it is the type of credit, and its social usefulness, that is important for long term sustainable economic growth rather than the overall level of credit growth. Notwithstanding these arguments, the PFAS is an elegant if indeed radical proposal from King.

Another gap in modern economic theory and thinking, according to King, is the failure to follow policies which address the problem of the prisoner’s dilemma, defined as the difficulty of achieving the best outcome when there are obstacles to co-operation. King gives the pre-crisis failure to recognise that each private bank faced a prisoner’s dilemma in running down its holdings of liquid assets, and financing itself as cheaply as possible by short-term debt, as the only means of competing with its peers on the profit expectations of the free market. The global economy currently faces a prisoner’s dilemma as the current (tired) orthodoxy of trying to stimulate demand is failing across developed economies as people are reluctant to consume due to fears about the future. In his own acerbic way, King quips that we cannot expect the US “to continue as the consumer of last resort”.

Current policy measures of providing short-term stimulus through low interest rates are diametrically opposite to those needed in the long run in King’s view. People, in effect, do not believe the con that Central Bank’s artificial reduction in risk premia is trying to sell, resulting in a paradox of policy. King believes that “further monetary stimulus is likely to achieve little more than taking us further down the dead-end road of the paradox of policy“. This means that Central Banks are currently in a prisoner’s dilemma – if any of them were to unilaterally raise interest rates, they would risk a slowing of growth and possibly another downturn in their jurisdiction. A co-ordinated move to a new equilibrium is what is needed and institutions like the IMF, who’s role is to “speak truth to power”, can hypnotise all they like about what is needed but the prisoner’s dilemma restricts real action. Unfortunately, King does not have any real solution to this issue besides those hopeful courses of action offered by others such as Wolf and Turner.

The unfortunate reality is that we seem to be on a road towards more disintegration rather than greater co-operation in the world economy. King does highlight the similarities of such a multi-polar world with the unstable position prior to the First World War, which is a cheery thought. Any future move towards disintegration across developed economies doesn’t bode well for the future, particularly when the scary issue of climate change is viewed in such a context. I hope we wouldn’t get more illustrations of the impact of radical uncertainty on our existing systems in the near future, nor indeed of our policymaker’s inability to address such uncertainty in a coherent and timely way.

I do however strongly recommend King’s book as a thought provoking read, for those who are so inclined.

How low is CAT pricing?

So, the February dip in the equity market is but a memory with the S&P500 now in positive territory for the year. With the forward PE at 16.4 and the Shiller CAPE at 25.75, it looks like the lack of alternatives has, once again, brought investors back to the equity market. As Buttonwood puts it – “investors are reluctant bulls; there seems no alternative.”  A December report from Bank of England staffers Rachel and Smith (as per previous post) has an excellent analysis of the secular drivers on the downward path of real interest rates. I reproduced a sample of some of the interesting graphs from the report below.

click to enlargeReal interest & growth & ROC rates

In the course of a recent conversation with a friend on the lack of attractive investment opportunities the subject of insurance linked securities (ILS) arose. My friend was unfamiliar with the topic so I tried to give him the run down on the issues. I have posted my views on ILS many times previously (here, here and here are just a recent few). During our conversation, the question was asked how low is current pricing in the catastrophe market relative to the “technically correct” level.

So this post is my attempt at answering that question. On a back of the envelop basis (I am sure professionals in this sector will be appalled at my crude methodology!). Market commentary currently asserts that non-US risks are the more under-priced of the peak catastrophe risks. Guy Carpenter’s recent rate on line (ROL) regional index, which is a commonly used industry metric for premium as a percentage of limit, shows that US, Asian, European and UK risks are off 30%, 28%, 32% and 35% respectively off their 2012 levels.

Using the US as a proxy for the overall market, I superimposed the Guy Carpenter US ROL index over historical annual US insured losses (CPI inflation adjusted to 2015) as per Munich Re estimates in the graph below. The average insured loss and ROL index since 1990 is $25 billion and 168 respectively. On the graph below I show the 15 year average for both which is $32 billion and 178 respectively. The current ROL pricing level is 18% and 23% below the average ROL since 1990 and the 15 year average respectively.

click to enlargeUS CAT Losses & ROL Index

However, inflation adjusted insured losses are not exposure adjusted. Exposure adjusted losses are losses today which take into account today’s building stock and topology. To further illustrate the point, the graph in this 2014 post from Karen Clark shows exposure adjusted historical catastrophe losses above $10 billion. One of the vendor catastrophe modelling firms, AIR Worldwide, publishes its exposure adjusted annual average insured loss each year and its 2015 estimate for the US was $47 billion (using its medium timescale forecasts). That estimate is obviously some way off the 15 year average of $32 billion (which has been influenced by the recent run of low losses).

By way of answering the question posed, I have assumed (using nothing more than an educated guess) a base of an average annual insured loss level of $40 billion, being within an approximate inflation adjusted and exposure adjusted range of $35-45 billion, would imply a “technically correct” ROL level around 185. I guesstimated this level based upon the 10 year average settling at 195 for 4 years before the 2016 decline and applying a discount to 185 due to the lower cost of capital that ILS investors require. The former assumes that the market is an efficient means of price discovery for volatile risks and the latter is another way of saying that these ILS investors accept lower returns than professional insurers due to the magic which market wisdom bestows on the uncorrelated nature of catastrophic risk. 185 would put current US catastrophe premium at a 25% discount to the supposed “technical correct” level.

Some in the market say rates have bottomed out but, without any significant losses, rates will likely continue to drop. Kevin O’Donnell of RenRe recently said the following:

“We believe that a playbook relying on the old cycle is dead. The future will not see multi-region, multi-line hardening post-event. There’s too much capital interested in this risk and it can enter our business more quickly and with less friction. There will be cycles, but they will be more targeted and shorter and we have worked hard to make sure that we can attract the best capital, underwrite better, and deploy first when the market presents an opportunity.”

I cannot but help think that the capital markets are not fully appreciating the nuances of the underlying risks and simply treating catastrophe risks like other BB asset classes as the graph below illustrates.

click to enlargeBB Corporate vrs ILS Spreads

There is an alternate explanation. The factors impacting weather systems are incredibly complex. Sea surface temperatures (SSTs) and wind shear conditions are key variables in determining hurricane formation and characteristics. Elements which may come into play on these variables include the North Atlantic Oscillation (NAO) which is a fluctuation in pressure differences between the Icelandic and Azores regions, the Atlantic Multi-Decadal Oscillation (AMO) which measures the natural variability in sea surface temperature (and salinity) of the North Atlantic, and the El Niño Southern Oscillation (ENSO) which measures cyclical temperature anomalies in the Pacific Ocean off South America. Climate change is impacting each of these variables and it may be possible that US hurricanes will become less frequent (but likely more severe).

An article from late last year in the Nature Geoscience Journal from Klotzbach, Gray and Fogarty called “Active Atlantic hurricane era at its end?” suggests the active hurricane phase in the Atlantic could be entering a new quieter cycle of storm activity. The graph below is from their analysis.

click to enlargeAtlantic hurricane frequency

Could it be that the capital markets are so efficient that they have already factored in such theories with a 25% discount on risk premia? Yep, right.

Why Liquidity Rules

Businesses with strong cash-flow are rightfully held in high esteem as investments. Google and Apple are good examples. Betting/gambling firms and insurers (in non-stressed loss periods) are other examples of businesses, if properly run, that can operate with high positive cash-flow.

The banking sector is at a completely different end of the spectrum as liquidity transformation is essentially the business. Everybody knows of Lehman Brothers bankruptcy, which was instigated in late 2008 by an immediate need to find $3 billion of cash to meet its obligations. The winding-up of the Lehman Brothers holding company in the US is estimated to return approximately 26 cents on the dollar according to this FT article.  It was therefore a surprise to read in the FT article and in another recent article on the expected surplus of £6 to £7 billion from the winding up of Lehman Brothers operation in London after all of the ordinary creditors have been repaid in full. This outcome is particularly surprising as I understood that the US operation of Lehman did a cash sweep across the group, including London, just prior to entering bankruptcy.

In his book (as referenced in this post), Martin Wolf highlights the changing perceptions of value since the crisis by using ABX indices from Markit which represent a standardized basket of home equity asset backed securities. The graph below shows the value for one such index, the ABX.HE.1, to the end of 2011. These indices are infamous as they were commonly used to value securities since the crisis when confidence collapsed and can be used to demonstrate the perils of mark to market/model accounting (or more accurately referred to as mark to myth values!).

click to enlargeMarket Value Asset Backed Subprime Index

I have included the more recent values of similar ABX indices in the bubbles as at last year from Wolf’s book. This graph accentuates the oft used quote from Keynes that “the market can remain irrational longer than you can remain solvent”.

Wolf argues that the 3% liquidity ratio proposed under Basel III or indeed the 5% proposed in the UK are totally inadequate and he suggests a liquidity ratio closer to 10%. On capital ratios, Wolf argues for capital ratios of 20% and above with a strong emphasis on tier 1 type equity or bail-inable debt that automatically converts. This contrasts against the 6% and 2.5% of tier 1 and 2 capital proposed respectively under Basel III (plus a countercyclical and G-SIFI buffer of up to 5%). Wolf also highlights the bankers ability to game the risk weighted asset rules and suggests that simple capital ratios based upon all assets are simpler and cleaner.

Wolf supports his arguments with research by Bank of England staffers like David Miles1 and Andrew Haldane2 and references a 2013 book3 from Admati and Hellwing on the banking sector. Critics of higher liquidity and capital ratios point to the damage that high ratios could do to business lending, despite the relatively low level of business lending that made up the inflated financing sector prior to the crisis. It also ignores, well, the enormous cost of the bailing out failed banks for many tax payers!

For me, it strengthens the important of liquidity profiles in investing. It also reinforces a growing suspicion that the response to the crisis is trying to fix a financial system that is fundamentally broken.

 

 

  1. Optimal Bank Capital by David Miles, Jing Yang and Gilberto Marcheggiano
  2. The Dog and the Frisbee by Andrew Haldane
  3. The Bankers New Cloths by Anat Admati and Martin Hellwing

 

Stressing the scenario testing

Scenario and stress testing by financial regulators has become a common supervisory tool since the financial crisis. The EU, the US and the UK all now regularly stress their banks using detailed adverse scenarios. In a recent presentation, Moody’s Analytics illustrated the variation in some of the metrics in the adverse scenarios used in recent tests by regulators, as per the graphic below of the peak to trough fall in real GDP.

click to enlargeBanking Stress Tests

Many commentators have criticized these tests for their inconsistency and flawed methodology while pointing out the political conflict many regulators with responsibility for financial stability have. They cannot be seen to be promoting a draconian scenario for stress testing on the one hand whilst assuring markets of the stability of the system on the other hand.

The EU tests have particularly had a credibility problem given the political difficulties in really stressing possible scenarios (hello, a Euro break-up?). An article last year by Morris Goldstein stated:

“By refusing to include a rigorous leverage ratio test, by allowing banks to artificially inflate bank capital, by engaging in wholesale monkey business with tax deferred assets, and also by ruling out a deflation scenario, the ECB produced estimates of the aggregate capital shortfall and a country pattern of bank failures that are not believable.”

In a report from the Adam Smith Institute in July, Kevin Dowd (a vocal critic of the regulator’s approach) stated that the Bank of England’s 2014 tests were lacking in credibility and “that the Bank’s risk models are worse than useless because they give false risk comfort”. Dowd points to the US where the annual Comprehensive Capital Assessment and Review (CCAR) tests have been supplemented by the DFAST tests mandated under Dodd Frank (these use a more standard approach to provide relative tests between banks). In the US, the whole process has been turned into a vast and expensive industry with consultants (many of them ex-regulators!) making a fortune on ever increasing compliance requirements. The end result may be that the original objectives have been somewhat lost.

According to a report from a duo of Columba University professors, banks have learned to game the system whereby “outcomes have become more predictable and therefore arguably less informative”. The worry here is that, to ensure a consistent application across the sector, regulators have been captured by their models and are perpetuating group think by dictating “good” and “bad” business models. Whatever about the dangers of the free market dictating optimal business models (and Lord knows there’s plenty of evidence on that subject!!), relying on regulators to do so is, well, scary.

To my way of thinking, the underlying issue here results from the systemic “too big to fail” nature of many regulated firms. Capitalism is (supposedly!) based upon punishing imprudent risk taking through the threat of bankruptcy and therefore we should be encouraging a diverse range of business models with sensible sizes that don’t, individually or in clusters, threaten financial stability.

On the merits of using stress testing for banks, Dowd quipped that “it is surely better to have no radar at all than a blind one that no-one can rely upon” and concluded that the Bank of England should, rather harshly in my view, scrap the whole process. Although I agree with many of the criticisms, I think the process does have merit. To be fair, many regulators understand the limitations of the approach. Recently Deputy Governor Jon Cunliffe of the Bank of England admitted the fragilities of some of their testing and stated that “a development of this approach would be to use stress testing more counter-cyclically”.

The insurance sector, particularly the non-life sector, has a longer history with stress and scenario testing. Lloyds of London has long required its syndicates to run mandatory realistic disaster scenarios (RDS), primarily focussed on known natural and man-made events. The most recent RDS are set out in the exhibit below.

click to enlargeLloyds Realistic Disaster Scenarios 2015

A valid criticism of the RDS approach is that insurers know what to expect and are therefore able to game the system. Risk models such as the commercial catastrophe models sold by firms like RMS and AIR have proven ever adapt at running historical or theoretical scenarios through today’s modern exposures to get estimates of losses to insurers. The difficulty comes in assigning probabilities to known natural events where the historical data is only really reliable for the past 100 years or so and where man-made events in the modern world, such as terrorism or cyber risks, are virtually impossible to predict. I previously highlighted some of the concerns on the methodology used in many models (e.g. on correlation here and VaR here) used to assess insurance capital which have now been embedded into the new European regulatory framework Solvency II, calibrated at a 1-in-200 year level.

The Prudential Regulatory Authority (PRA), now part of the Bank of England, detailed a set of scenarios last month to stress test its non-life insurance sector in 2015. The detail of these tests is summarised in the exhibit below.

click to enlargePRA General Insurance Stress Test 2015

Robert Childs, the chairman of the Hiscox group, raised some eye brows by saying the PRA tests did not go far enough and called for a war game type exercise to see “how a serious catastrophe may play out”. Childs proposed that such an exercise would mean that regulators would have the confidence in industry to get on with dealing with the aftermath of any such catastrophe without undue fussing from the authorities.

An efficient insurance sector is important to economic growth and development by facilitating trade and commerce through risk mitigation and dispersion, thereby allowing firms to more effectively allocate capital to productive means. Too much “fussing” by regulators through overly conservative capital requirements, maybe resulting from overtly pessimistic stress tests, can result in economic growth being impinged by excess cost. However, given the movement globally towards larger insurers, which in my view will accelerate under Solvency II given its unrestricted credit for diversification, the regulator’s focus on financial stability and the experiences in banking mean that fussy regulation will be in vogue for some time to come.

The scenarios selected by the PRA are interesting in that the focus for known natural catastrophes is on a frequency of large events as opposed to an emphasis on severity in the Lloyds’ RDS. It’s arguable that the probability of the 2 major European storms in one year or 3 US storms in one year is significantly more remote than the 1 in 200 probability level at which capital is set under Solvency II. One of the more interesting scenarios is the reverse stress test such that the firm becomes unviable. I am sure many firms will select a combination of events with an implied probability of all occurring with one year so remote as to be impossible. Or select some ultra extreme events such as the Cumbre Vieja mega-tsunami (as per this post). A lack of imagination in looking at different scenarios would be a pity as good risk management should be open to really testing portfolios rather than running through the same old known events.

New scenarios are constantly being suggested by researchers. Swiss Re recently published a paper on a reoccurrence of the New Madrid cluster of earthquakes of 1811/1812 which they estimated could result in $300 billion of losses of which 50% would be insured (breakdown as per the exhibit below). Swiss Re estimates the probability of such an event at 1 in 500 years or roughly a 10% chance of occurrence within the next 50 years.

click to enlarge1811 New Madrid Earthquakes repeated

Another interesting scenario, developed by the University of Cambridge and Lloyds, which is technologically possible, is a cyber attack on the US power grid (in this report). There have been a growing number of cases of hacking into power grids in the US and Europe which make this scenario ever more real. The authors estimate the event at a 1 in 200 year probability and detail three scenarios (S1, S2, and the extreme X1) with insured losses ranging from $20 billion to $70 billion, as per the exhibit below. These figures are far greater than the probable maximum loss (PML) estimated for the sector by a March UK industry report (as per this post).

click to enlargeCyber Blackout Scenario

I think it will be a very long time before any insurer willingly publishes the results of scenarios that could cause it to be in financial difficulty. I may be naive but I think that is a pity because insurance is a risk business and increased transparency could only lead to more efficient capital allocations across the sector. Everybody claiming that they can survive any foreseeable event up to a notional probability of occurrence (such as 1 in 200 years) can only lead to misplaced solace. History shows us that, in the real world, risk has a habit of surprising, and not in a good way. Imaginative stress and scenario testing, performed in an efficient and transparent way, may help to lessen the surprise. Nothing however can change the fact that the “unknown unknowns” will always remain.