Big Bang Or Creeping Death: Can Insurers Survive Armageddon Scenarios?

International Editor

London

Could the insurance industry survive an “Armageddon scenario?” The answer is, it depends. It depends on how well insurers and reinsurers have planned for the unthinkable, according to several industry experts.

Nikolaus von Bomhard, board member of Munich Re, defined the Armageddon scenario as events that might wipe out the entire insurance industry.

He looked at two basic scenarios that could conceivably lead to mass insolvencies. He called the first scenario the “big bang,” such as was seen with the World Trade Center disaster and the San Francisco earthquake of 1906, both of which caused Munich Re its largest losses.

The second scenario is the “creeping death,” which are latent exposures not accounted for in risk modeling, he said during a speech in May at a seminar held by the International Underwriting Association in London.

Discussing the big bang scenario, Mr. von Bomhard said the World Trade Center was the only loss in Munich Res history that came up to the size of the earthquake in San Francisco, in terms of loss to net earned premiums.

“The earthquake in San Francisco took away almost 13 percent in volume of our net earned premiums,” while the World Trade Center surpassed that number, with 14 percent, he said.

He cited the Bhopal loss in India in 1984 as a disaster that could have been extremely expensive to the insurance industry if it had occurred in a different country at the time or in India years later.

As it was, only $200 million was paid by the insurance industry, although 15,000 people died as a consequence of that event and 200,000 were injured, he said.

“What can the industry do to prepare for the big bang scenario?” he questioned.

“First, we learned from the World Trade Center that we have to stretch our brain more and think the unthinkable,” he said. “Follow the traditional risk management approach: identify your risks and think the unthinkable.”

“Then you have to manage what you put down as a number and either control the risk or think of financing it,” he said.

Controlling includes putting the right price to whatever is expected as a return period, Mr. von Bomhard said.

He indicated that Munich Re has prepared models that calculate the effects on the company of two 100-year losses in one year.

This is an exercise that needs to be repeated frequently, he emphasized. “Its not enough to do it once. You have to follow it up and make sure that you keep pace with developments, even terrorism activity, what have you, but never stand still,” he said.

After going through this exercise, he said, its important that an insurer or reinsurer apply a consistent policy throughout the company, he said.

Companies tend to write more of those risks that they feel comfortable with and take less of those they are less comfortable with, he said.

While theres truth in that approach, he warned its important to be consistent in the preparations for the big bang. “Dont overexpose yourself in areas you think you know.”

When it comes to terrorism, Mr. von Bombard said its very hard to come up with a model to appropriately assess the risk of terrorism.

“Its not enough to cap the overall exposure. As such, on a single-risk basis, we felt we had to cap the frequency problem,” he said, noting that Munich Re did that by including a 14-day cancellation clause on all policies from a certain limit upward.

While this hasnt been received well, Mr. von Bomhard said Munich Re does not think it can appropriately model the risk of terrorism.

He noted there is an interdependence between financial markets and insurance markets, which can affect the asset side of a companys balance sheet.

As a result, its important to do a stress test and again imagine the unthinkable, he said, such as what happened in the months after the World Trade Center disaster when the German stock index dropped by 90 percent.

As a result of these lessons, he said, during the past three years of depression in the stock exchange, Munich Re has been extremely conservative when calculating the appropriate risk capital.

The reinsurance industry has demonstrated over time it is capable of handling a one-off hit, he said. This assumes that insurers maintain historical solidarity and are willing to accept higher premiums after such a loss, he said. “The question is how far can you stretch solidarity.”

Mr. von Bomhard then discussed the second scenario, the creeping death scenario, which he defined as latent exposures not accounted for in risk modeling, such as asbestos, genetically modified foods and climatic change.

In their risk modeling, he said, companies tend to focus on the last man standing, rather than the last men standing (or how such scenarios affect the entire insurance industry).

The problem with these scenarios is that at “first you know little and you would theoretically be able to do a lot; the more you know, the less you can do,” he said. “It has to do with public awareness.” He said that the more the public knows, the more research will be done and the less room the insurance industry will have to maneuver.

What should a company do to prepare for such a scenario? Again, he suggested applying the same risk management approach. “Try to identify the risk and introduce monitoring systems. You have to have people in the field that really try to get hold of the issue and get an idea of what could be the problem over the five, 10 or 15 years.”

Then its important to manage the findings, he said. “Some people stop too early. Once you knowyou have to do something.You have to get ready and prepare yourself,” he added.

“You have to talk to underwriters and set up an according policy. You have to talk to risk modelers; you have to factor that into your risk capital calculations,” he said.

He suggested that scenario planning is an example of the process you can apply to discover the threat for the future. “You have to come up with a couple of scenarios to [look at the threats] to your company or the entire industry,” he said.

“Then you have to monitor the process,” he said, noting that some industries are better at monitoring trends than others, such as the oil industry.

Although the threats the oil industry faces are different than the insurance industry, “they always work with very well-developed scenario planning because changes in politics and changes in energy consumption” are so important to their investment strategies.

Mr. von Bomhard said the industry has to be proactive about the creeping death scenario. “You have to look to the future and not too much in the back mirror.”

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 1, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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Big Bang Or Creeping Death: Can Insurers Survive Armageddon Scenarios?

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