Tag Archives: Lloyds of London

London Isn’t Calling

In a previous post, I reproduced an exhibit from a report from Aon Benfield on the potential areas of disruption to extract expenses across the value chain in the non-life insurance sector, specifically the US P&C sector. The exhibit is again reproduced below.

 click to enlargeexpenses-across-the-value-chain

The diminishing returns in the reinsurance and specialty insurance sector are well known due to too much capital chasing low risk premia. Another recent report from Aon Benfield shows the sector trend in net income ROE from their market representative portfolio of reinsurance and specialty insurers, as below.

click to enlargenet-income-roe

It’s odd then in this competitive environment that the expense ratios in the sector are actually increasing. Expense ratios (weighted average) from the Willis Re sector representative portfolio, as below and in this report, illustrate the point.

click to enlargewillis-re-expense-ratios

The 2016 edition of the every interesting S&P Reinsurance Highlights, as per this link, also shows a similar trend in expense ratios as well as showing the variance in ratios across different firms, as below.

click to enlargesp-expense-ratios

Care does need to be taken in comparing expense ratios as different expense items can be included in the ratios, some limit overhead expenses to underwriting whilst others include a variety of corporate expense items. One thing is clear however and that’s that firms based in the London market, particularly Lloyds’, are amongst the most top heavy in the industry. Albeit a limited sample, the graph below shows the extent of the difference of Lloyds’ and some of its peers in Bermuda and Europe.

click to enlargeselect-expense-ratios

Digging further into expense ratios leads naturally to acquisitions costs such as commission and brokerage. Acquisition costs vary across business lines and between reinsurance and insurance so business mix is important. The graph below on acquisition costs again shows Lloyds’ higher than some of its peers.

click to enlargeselect-acquisition-cost-ratios

Although Brexit may only result in the loss of fewer than 10% of London’s business, any loss of diversification in this competitive market can impact the relevance of London as an important marketplace. Taken together with the gratuitous expense of doing business in London, its relevance may come under real pressure in the years to come. London is, most definitely, not calling.

Pimping the Peers (Part 2)

In the last post on this topic, I highlighted how new technologies, broadly under the fintech tag, had the potential to disrupt the banking sector, primarily by means of automating processes rather than any major reinventing of business models (although I did end that post with a bit of a rant about innovation and human behaviour). Blockchain is the hot topic that seems to be cropping up everywhere (I’ll leave that for another time). This post is about insurance and new technology, or in the jargon, insurtech.

The traditional business model in the insurance industry is not reacting well to a world of low or negative interest rates. For the life insurance sector, the duration mismatch between their liabilities and their assets is having a perverse impact as interest rates have fallen. Savings returns for aging populations have been sacrificed in Central Bank’s attempt to stimulate economic growth.

In addition, the traditional distribution channel for selling life insurer’s products, and the old adage is that these products are sold rather than bought, has relied too heavily on aging tied agents whose focus is on the wealthy client that can generate more fees than the middle class. The industry is generally at a loss on how to sell products in a low interest world to the mass market and to the new tech savvy generation. As a result, the industry and others are throwing money at a rash of new start-ups in insurance, as the exhibit on some of the current hyped firms focusing on life insurance below illustrates.

click to enlargelife-insurance-big-data

As the exhibit illustrates, the focus of these new start-ups is weighted towards technologies around product development, distribution, and underwriting. Some will likely succeed in trying to differentiate further the existing clientele of life insurers (e.g. real time health data). Many will be gobbled up or disappear. Differing attitudes between those aged under 34 and the older generation towards online distribution channels can be clearly seen in the survey results in the exhibit below.

click to enlargeattitudes-to-life-insurance-distribution-channels

With longevity and low interest rates the dominant challenges for life insurers today, automation of processes will assist in cutting expenses in the provision of products (mainly to the existing customer base) but will not likely meaningfully address the twin elephants in the room.  Citigroup reckons that in 20 of the largest OECD countries the unfunded government liability for pensions is around $78 trillion which compares to approximately $50 trillion in GDP for all OECD countries in 2015. I look forward to conversing with a robo-advisor in the near future on what products it recommends for that problem!

Insurance itself is hundreds of years old and although the wonderfully namely bottomry (the earliest form of marine hull insurance) or ancient burial societies are early examples, non-life insurance really took off with mass markets after the great fire of London in 1666.

The most hyped example of insurtech in the non-life sector is the impact of technologies on the motor business like drive-less cars and car telematics. This paper from Swiss Re shows that the impact over the next 20 years of such advances on motor premia could be dramatic.

Much of the focus from insurtech innovation is on reducing expenses, an item that the industry is not light on. The graph below shows examples of the level of acquisition and overhead expenses in the non-life sector across different jurisdictions.

click to enlargenonlife-expense-ratios

A recent report from Aon Benfield went further and looked at expenses across the value chain in the US P&C insurance sector, as below. Aon Benfield estimated overall expenses make up approximately half of gross risk premium, much of which represents juicy disruption targets for new technology in the insurtech world.

click to enlargeexpenses-across-the-value-chain

Insurance itself is based upon the law of large numbers and serves a socially useful function in reducing economic volatility by transferring risks from businesses and consumers. In 1906, Alfred Manes defined insurance as “an economic institution resting on the principle of mutuality, established for the purpose of supplying a fund, the need for which arises from a chance occurrence whose probability can be estimated”.

One of the issues identified with the current non-life insurance sector is the so-called protection gap. This is in effect where insurers’ risk management practises have got incredibly adapt at identifying and excluding those risks most likely to result in a claim. Although good for profits, it does bring the social usefulness of the transference of only the pristine risks into question (for everybody else). The graph below from Swiss Re illustrates the point by showing economic and insured losses from natural catastrophe events as a % of GDP.

click to enlargeinsurance-protection-gap-uninsured-vrs-insured-losses

It’s in the context of low investment returns and competitive underwriting markets (in themselves being driven by low risk premia across asset classes) that a new technology driven approach to the mutual insurance model is being used to attack expense and protection gap issues.

Mutuals represent the original business model for many insurers (back to burial schemes and the great fire of 1666) and still represent approximately a third of the sector in the US and Europe today. Peer to peer insurers are what some are calling the new technology driven mutuals. In fact, most of the successful P2P models to date, firms like Guevara, Friendsurance, and Inspeer are really intermediaries who pool consumers together for group discounts or self-financing of high deductibles.

Lemonade, which launched in New York this week, is a peer to peer platform which issues its own insurance policies and seeks to address the protection gap issue by offering broader coverage. The firm has been heavily reinsured by some big names in insurance like Berkshire Hathaway and Lloyd’s. It offers a fee based model, whereby the policyholders pay claims through mutualisation (assumingly by pools determined by pre-defined criteria). Daniel Schreiber, CEO and co-founder of Lemonade says that the firm will be ”the only insurer that doesn’t make money by denying claims”. Dan Ariely, a big deal in the world of Behavioral Economics, has been named as Chief Behavioral Officer, presumably in an effort to assist in constructing pools of well behaved policyholders.

The graphic below tries to illustrate how the business model is evolving (or should that be repeating?). Technology offers policyholders the opportunity to join with others to pool risk, hitherto a process that was confined to associations amongst professional groups or groups bound by location. Whether technology offers the same opportunity to underwrite risks profitably (or at least not at a loss) but with a larger reach remains to be seen.

click to enlargeinsurance-business-models

It does occur to me that it may be successful in addressing areas of dislocation in the industry, such as shortfalls in coverage for flood insurance, where a common risk and mitigant can be identified and addressed in the terms of the respective pool taking the risks on.

For specialty re/insurers, we have already seen a bifurcation between the capital providers/risk takers and the risk portfolio managers in the ILS arena. Newer technology driven mutual based insurers also offer the industry a separation of the management of risk pools and the risk capital provided to underwrite them. I wish them well in their attempts at updating this most ancient of businesses and I repeat what I said in part 1 of this post – don’t let the sweet scent of shiny new technology distract you from the smell of the risk…..

Naive Newcomers

The insurance sector has been hit by the Brexit fallout on worries about macro-economic impacts; albeit not to the same extend as the banks. Swiss Re has their latest Sigma world insurance report out. The impact of investment returns on the life insurance sector is obvious but it is interesting to see the contribution from investment income on the profitability of the aggregate of the eight largest markets in the non-life insurance sector, as per the graph from the report below.

click to enlargeNonLife Insurance Sector Profit Breakdown

The insurance sector faces a number of challenges as a recent FT article pointed out. The reinsurance sector also faces challenges, not least of which is a competitive pricing environment and the destabilising influx of new yield seeking capital through new innovations in the insurance linked securities (ILS) market. I have posted my views on the ILS sector many times (more recently here) and in this post I offer more similar thoughts. It is interesting to compare the ROEs in the Sigma report from the non-life insurance sector against those from the reinsurance sector (with the ROEs since 2005 coming from the Guy Carpenter composite index), as per the graph below.

click to enlargeGlobal Insurance & Reinsurance ROEs 1999 to 2016e

The graph is not exactly comparing like with like (e.g. non-life insurance versus composite reinsurance) but it gives the general idea of higher but more volatile ROEs in the reinsurance side compared to more stable but lower ROEs on the direct insurance side. The average since 1999 for insurance is 7% and 9% for reinsurance, with standard deviations of 3.6% and 4.6% respectively. It also confirms that ROEs are under pressure for both sectors and as capital markets continue to siphon off volatile excess catastrophe exposed business, the ROEs of the more proportional traditional reinsurance sector are converging on those of their direct brethren, although a differential will always exist given the differing business models.

It is important to note that these ROEs are returns on equity held by traditional insurers and reinsurers, the majority of which are highly rated by external agencies, who hold a small fraction of their total exposure (if measured as the sum of the policy limits issued) as capital. For example, the new European solvency framework, Solvency II, requires capital at a 1 in 200 level and it is generally assumed to be akin to a financial strength rating of BB or BBB, depending upon a firm’s risk profile.

As I argued previously (more recently in this post), these (re)insurers are akin to fractional reserve banks and I still struggle to understand how ILS structures, which are 100% collaterised, can offer their investors such an attractive return given their fully funded “capital” level in the ROE calculation. The industry argument is that investors have a lower cost of capital due to the uncorrelated nature of the pure insurance risk present in ILS.

My suspicion is that the lower cost of capital assigned by investors is reflective of a lack of understanding of the uncertainties surrounding the risks they are taking on and an over-reliance on modelling which does not fully consider the uncertainties. My fear is that capital is been leveraged or risks are been arbitraged through over-generous retrocession deals passing on under-priced risk to naive capital newcomers.

The accelerating growth in the so-called alternative capital in insurance is shown in the graph below from Aon Benfield, with growth in the private collaterised reinsurance being particularly strong in the last four years (now overshadowing the public CAT bond market). ILS funds, managed by professional asset manager specialists, are largely behind the growth in private collaterised deals with assets under management growing from $20 billion in 2012 to over $50 billion today. Private collaterised deals are usually lower down the reinsurance tower (e.g. attach at lower loss levels) and as such offer higher premiums (as a percentage of limits, aka rate on line or ROL) for the increased exposure to loss. On a risk adjusted basis, these don’t necessarily offer higher ROEs than higher attaching/lower risk CAT bonds.

click to enlargeAlternative Insurance ILS Capital Growth

Property catastrophe pricing has been under particular pressure in the past few years due to the lack of significant insured catastrophe losses. In a previous post, I crudely estimate CAT pricing to be 25% below its technical rate. Willis Re is the first of the brokers to have its mid-year renewal report out. In it, Willis said that ILS funds “were more aggressive on pricing during the second quarter as spreads declined for liquid reinsurance investments”. I also find it interesting that the collaterised ILW volumes have ticked up recently. Pricing and lax terms and conditions in the retrocession sector are historically a sign that discipline is breaking down. Asset managers in the ILS space must be under pressure in maintaining their high fees in a reduced CAT risk premia environment and this pressure is likely to be contributing to the potential for market indiscipline.

I therefore find the graph below very telling. I used the figures from Lane Financial (see here) for the annual total return figures from CAT bonds, which closely match those of the Swiss Re Total Return Index. For the ILS fund returns I used the figures from the Eurekahedge ILS Advisors Index which I adjusted to take out the not unconsiderable typical ILS fund management fees. The 2016 figures are annualized based upon published year to date figures (and obviously assume no major losses).

click to enlargeCAT Bond vrs ILS Fund Returns

The graph shows that ILS fund returns have broken with historical patterns and diverged away from those of CAT bonds as the prevalence in private collaterised deals has grown in recent years. In other words, ILS funds have moved to higher rate on line business, which is by definition higher risk, as they push to service the larger level of assets under management. The question is therefore do the investors really understand the significance of this change? Have they adjusted their cost of capital to reflect the increased risk? Or are some ILS funds representing the higher returns as their ability to get higher returns at the same risk level (against the trend of everybody else in the industry in a softening market)?

Innovation is to be encouraged and a necessary part of progress. Innovation dependent on the naivety of new investors however does not end well.

I can’t but help think of Michael Wade’s comment in 2009 about the commonality between the financial crisis and problems at Lloyds of London (see this post on lessons from Lloyds) when he said that “the consequence with the excess capital was that underlying risks could be underpriced as they were being passed on”. My advice to ILS investors is the next time they are getting a sales pitch with promises of returns that sound too good, look around the room, and ask yourself who is the greater fool here….

Lessons from Lloyds

There is little doubt that the financial services industry is currently facing many challenges and undergoing a generational change. The US economist Thomas Philippon opined that the finance industry over-expansion in the US means that it’s share of GDP is about 2 percentage points higher than it needs to be although he has also estimated that the unit cost of intermediation hasn’t changed significantly in recent years, despite advances in technology and the regulatory assaults upon the industry following the financial crisis.

The insurance sector has its own share of issues. Ongoing low interest rates and inflation, broader low risk premia across the capital markets, rapid technology changes such as big data and the onset of real time underwriting are just the obvious items. The Economist had an article in March that highlighted the prospective impact of data monitoring and technology on the underwriting of motor and health risks. This is another interesting post on a number of the new peer to peer business models such as Friendsurance, Bought by Many, and Guevara who are trying to disrupt the insurance sector. There can be little doubt that the insurance industry, just like other financial sectors, will be impacted by such secular trends.

However, this post is primarily focused on the short to medium term outlook for the specialty insurance and reinsurance sector. I have been asked a few of times by readers to outline what I think the next few years may look like for this sector. My views of the current market were nicely articulated by Alex Maloney, the Group CEO of Lancashire, who commented in their recent quarterly results statement as follows:

“The year to date has seen a flurry of activity on the M&A front within the industry, much of this, in my view, is driven by the need to rationalise and refocus oversized and over stretched businesses. We also continue to see a bout of initiatives and innovations in the market, the sustainability and longer term viability of which are questionable. These are symptoms of where we are in the cycle. We have seen these types of trends before and in all likelihood, will see them again.”

Lloyds of London has had a colourful past and many of its historical issues are specific to it and reflective of its own eccentric ways. However, as a proxy for the global specialty sector, particularly over the past 20 years, it provides some interesting context on the trends we find ourselves in today. Using data from Lloyds with some added flavour from my experiences, the graphic below shows the dramatic history of the market since 1950.

click to enlargeLloyds Historical Results 1950 to 2015

The impact of Hurricane Betsy in 1965 upon Lloyds illustrated a number of the fault-lines in the structure of Lloyds with the subsequent Cromer report warning on the future danger of unequal treatment between insiders (aka working Names) and “dumb” capital providers (aka all other Names). The rapid influx of such ill informed capital in the late 1970s and the 1980s laid the seeds of the market’s near destruction largely due to the tsunami of US liability claims resulting from asbestos and pollution exposures in the 1980s. These losses were exacerbated by the way Lloyds closed underwriting years to future capital providers through vastly underpriced reinsurance to close transactions and the practice of the incestuous placement of excess of loss retrocession for catastrophe losses within the market, otherwise known as the London Market Excess of Loss (LMX) spiral. There is a clever article by Joy Schwartzman from 2008 on the similarity between the LMX spiral and the financial risk transformational illusions that featured heavily in the financial crisis. Indeed, the losses from the sloppy “occurrence” liability insurance policy wordings and the tragedy of unheeded asbestos risks continued to escalate well into the 1990s, as the exhibit below from a 2013 Towers Watson update illustrates.

click to enlargeTowers Watson Asbestos Claims US P&C Insurers

What happened in Lloyds after the market settlement with Names and the creation of the “bad bank” Equitas for the 1992 and prior losses is where the lessons of Lloyds are most applicable to the market today. The graphic below shows the geographical and business split of Lloyds over the past 20 years, showing that although the underlying risk and geographical mix has changed it remains a diversified global business.

click to enlargeLloyds of London Historical Geographical & Sector Split

Released from the burden of the past after the creation of Equitas, the market quickly went on what can only be described as an orgy of indiscipline. The pricing competition was brutal in the last half of the 1990s with terms and conditions dramatically widened. Rating indices published by the market, as below, at the time show the extent of the rate decreases although the now abandoned underwriting indices published at the same time spectacularly failed to show the impact of the loosening of T&Cs.

click to enlargeLloyds of London Rating Indices 1992 to 1999

As Lloyds moved from their historical three year accounting basis in the 2000s it’s difficult to compare historical ratios from the 1990s. Notwithstanding this, I did made an attempt to reconcile combined ratios from the 1990s in the exhibit below which clearly illustrates the impact market conditions had on underwriting results.

click to enlargeLloyds of London historical combined ratio breakdown

The Franchise Board established in 2003, under the leadership of the forthright and highly effective Rolf Tolle, was created to enforce market discipline in Lloyds after the disastrous 1990s. The combined ratios from recent years illustrate the impact it has had on results although the hard market after 9/11 provided much of the impetus. The real test of the Franchise Board will be outcome of the current soft market. The rating indices published by Amlin, as below, show where rates are currently compared to the rates in 2002 (which were pushed up to a level following 2001 to recover most of the 1990s fall-off). Rating indices published by Lancashire also confirm rate decreases of 20%+ since 2012 in lines like US property catastrophe, energy and aviation.

click to enlargeLloyds of London Rating Indices 2002 to 2015

The macro-economic environment and benign claims inflation over the past several years has clearly helped loss ratios. A breakdown of the recent reserve releases, as below, show that reinsurance and property remain important sources of releases (the reinsurance releases are also heavily dependent on property lines).

click to enlargeLloyds of London Reserve Release Breakdown 2004 to 2014

Better discipline and risk management have clearly played their part in the 10 year average ROE of 15% (covering 2005 to 2014 with the 2005 and 2011 catastrophe years included). The increasing overhead expenses are an issue for Lloyds, recently causing Ed Noonan of Validus to comment:

“We think that Lloyd’s remains an outstanding market for specialty business and their thrust towards international diversification is spot on from a strategic perspective. However, the costs associated with Lloyd’s and the excessive regulation in the UK are becoming significant issues, as is the amount of management and Board time spent on compliance well beyond what’s necessary to ensure a solvent and properly functioning market. Ultimately, this smothering regulatory blanket will drive business out of Lloyd’s and further the trend of placement in local markets.”

So what does all of this tell us about the next few years? Pricing and relaxed terms and conditions will inevitably have an impact, reserve releases will dry up particularly from reinsurance and property, investment returns may improve and claim inflation may increase but neither materially so, firms will focus on expense reduction whilst dealing with more intrusive regulation, and the recent run of low catastrophic losses will not last. ROEs of low double digits or high single digits does not, in my view, compensate for these risks. Longer term the market faces structural changes, in the interim it faces a struggle to deliver a sensible risk adjusted return.

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.