Downward counterfactual analysis-described as the process of considering "what if" historical near misses had become major disasters-can be a useful process for insurers to better analyse risks, says a new report from Lloyd's and modelling company RMS.
Major global events could have had even more serious impacts if things had happened just a bit differently. For example, consider “what if” a solar storm had struck during the London 2012 Olympics?” It could have seriously disrupted satellite communications and the commercial success of the Games.
And what if the wind had blown radioactive contamination onshore during the Fukushima nuclear plant disaster during the 2011 Tohoku earthquake? From RMS’ wind rose data around Fukushima, there was a significant chance of the wind direction blowing inland, causing more widespread radiation contamination. Fortunately, the wind blew most radiation out to sea instead.
In the same vein, the worst disaster in aviation history was narrowly avoided in July, for example, when a passenger plane pilot descending into San Francisco airport pulled up at the last second.
The new report from Lloyd’s and RMS, Counterfactual Disaster Risk Analysis: Reimagining History, sets out how such lateral thinking, called "counterfactual" can bring a range of benefits to insurers.
Mr Trevor Maynard, Head of Innovation of Lloyd’s and a co-author of the report, explained: “The fact that downward counterfactual events are anchored to actual historical experience helps facilitate complex explanation, deeper understanding and more coherent communication of future risks and modelling uncertainty to board members, policyholders, policymakers, risk managers and others.”
RMS Catastrophist Gordon Woo, also one of the co-authors, added that insurers will benefit from looking at the past as just one realisation of what might have happened.
“Whatever the past, risk insight is gained from exploring how things might have turned for the worse – the downward counterfactuals. By adopting a counterfactual perspective and exploring how historical events could have unfolded differently, additional insight can be gained into rare extreme losses that might otherwise come as a surprise,” he said.
He noted that downward counterfactual risk analysis helps address the bias that can be inherent in some models that are based on the same historical data sets, and thus can be useful for the modelling process.
“By expanding the data available based on what could have happened, these models can be built with less reliance on single-source data, which might improve their accuracy. It also provides a useful tool for regulators to stress-test catastrophe risk models,” he said.
Mr Maynard said that while thoughtful risk management is already in place, this proposed methodology could be a useful addition to the suite of tools that insurers and risk managers already use.
“After a disaster risk analysts tend to carefully study what happened, but comparatively little attention is paid to what might have happened. This is a demanding technical undertaking, but we think insurers will benefit from a systematic assessment of downward counterfactuals,” he said.
The report can be found here.