It’s improbable…

A quotation: “There is a tendency in our planning to confuse the unfamiliar with the improbable. The contingency we have not considered seriously looks strange; what looks strange is thought improbable; what is improbable need not be considered seriously.” Thomas Schelling, a game theorist and nuclear strategist.

An apt warning for any underwriter!

Consider, for example, climate risk, a topic which was barely considered even a generation ago and has now become “endemic” in terms of being a material focus. It is not as if traditional (re)insurers are unfamiliar with climate-related risks. After all, what else is much of the NatCAT business but a probabilistic assessment of exactly that? However, because the boundaries appear to be changing, what were seen as “reasonable verities” no longer are.

Of course, the Earth’s climate is a complex system; which means that what was hitherto thought improbable can happen if the inputs within that system change, as they have been.

So the question becomes, in any assessment or analysis of a risk, whether or not one has confused the unfamiliar with the improbable. The current pandemic was an unfamiliar risk, perhaps, but it was certainly not improbable. There were clear precedents.

Similarly, in the realm of the credit, economic and financial risks in which Awbury specializes, it is all too easy to believe that past is prologue, and so it is improbable that “new” and unexpected risks will arise, or existing ones change their frequency. However, one should perhaps try telling that to (re)insurers grappling with exposures to businesses that suddenly had no revenues, and with uncertain prospects for recovery.

As usually tends to be the case, it is our own inability or unwillingness as a species to understand or accept the “improbable” that makes us vulnerable. We know that bad things happen, and every underwriter is properly paranoid about “event” risk. We create “emerging risks” committees, and checklists to try to fathom the improbable but potentially real, yet we are far better at seeking precedents from the past, and latching on to them, than at taking a realistic view of future probabilities. There is no point in being right even a hundred times, if being wrong once ruins you, which is the whole point of diversifying risk portfolios, and identifying and managing correlations and aggregates.

If that is the case, how is one to create a process that reduces the risk of being over-exposed to the improbable, and does not set the bar for the “impossible” too low?

In the view of the Awbury Team, we believe that the best way to do this is, for every risk we underwrite, and once we have created our core thesis as to why the risk/reward ratio on a particular risk meets our already stringent criteria, to ask a very simple pair of questions: “But what if we are wrong? What could invalidate our thesis?” We can do this because our business model is built upon the provision of carefully structured, bespoke solutions for our broad range of clients, rather than commoditized “flow” business. We can explicitly try to “test to destruction” ex ante every risk we take- while still being completely paranoid about what we may have missed!

The Awbury Team

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