The traditional view of a ‘black swan’ risk is an extreme catastrophe that comes out of the blue every couple of hundred years or so. Attempting to mitigate these risks is futile because they cannot be predicted and probably won’t happen in our lifetimes.
In a recent survey at Airmic by Willis Global Solutions, more than a third of the companies in the audience had no explicit financial protection from black swan events. But this is not a sensible way of managing our exposure to extreme events.
Extreme catastrophes are not the rare risks they once seemed. Population density, urbanisation, globalisation and climate change make the world increasingly interconnected. A catastrophe in a far-off locale is no longer a remote risk – it is likely to have an immediate impact on a company’s operations.
The huge Tohoku earthquake in March 2011 is a notable example. The tsunami caused massive destruction locally but triggered nuclear and supply chain crises that had global reverberations. Japan’s crucial role in the world economy meant that many businesses around the world were affected.
Since 1970, on average every four years a natural event occurs that kills more than 50,000 people. In fact, a sequence of devastating earthquakes and many weather-related catastrophes made 2011 the costliest year ever in terms of natural catastrophe losses. At about US$380bn (£242.5bn), global economic losses were almost two-thirds higher than in 2005, the previous record year with losses of US$220bn, according to Munich Re.
While these losses are huge, corporate catastrophes that result in a plummeting share price are almost never caused by ‘natural’ events. Moreover, they are caused by insurable events less than 10% of the time, according to Willis’s research on the performance over the past 20 years of more than 600 big companies. About 95% of these companies have suffered at least one extreme reversal of fortune in that time period. Yet many major companies do not make any provision for these events.
Companies believe that business-as-usual financial instruments will work in not business-as-usual circumstances. But banks usually head for the hills when a client is in trouble, making lines of credit not fit-for-purpose. Investors do not like to see companies go further into debt or deplete balance-sheet cash reserves during a crisis. Risk transfer would be better.
As most of the risks causing these problems are so far uninsurable, risk managers are left in a difficult position.
Yet they are increasingly being challenged by management about what they’re doing to make their organisations resilient to extreme shocks. Although all catastrophes have an initial negative impact on value, they can offer an opportunity for companies to demonstrate their talent in dealing with difficult circumstances. As studies by Rory Knight and Deborah Pretty have shown, if a company deals with a crisis well, its shareholder value can actually increase.
To meet these challenges, Willis has been working with clients and the wider risk transfer industry to devise a suitable solution that could help support a company when it faces a severe reversal of fortune.
A suitable product would need to pay out immediately, because it’s no good having a lengthy claims dispute in the middle of a crisis. The perils and root causes can’t necessarily be predicted, so the product should cover ‘all risks’ and have no – or very few – exclusions. Protection has to be below a company’s cost of capital, because if it’s cheaper for a company to keep cash on its balance sheet, that’s what it will do. So the product has to be relatively inexpensive. And high limits are required – at least $1 billion – because responding to a severe crisis is expensive. Resilience is about having deep pockets.
Despite all these challenges, based on our modelling of the risks, we believe products that have these features are possible, and we are working on such solutions.
Very bad, very big surprises happen often. We need to be prepared. And against a volatile economic backdrop, risk management is more important than ever. The insurance industry has a key role to play in helping business to navigate a path through these tough times.
Philip Ellis is CEO and Eamonn McMurrough is head of analytics at Willis Global Solutions (Consulting Group)