A senior figure from insurance giant Lloyd’s has spoken out in support of counterfactual analysis, saying the alternative approach could lead to a better understanding of potential risks.
“Once insurance players recognise the benefits that counterfactual risks analysis brings, we hope to see a widespread adoption of this way of thinking and a systematic approach,” said head of innovation Trevor Maynard.
Counterfactual analysis involves reimagining history to understand how much worse major global events could have been if things had happened slightly differently.
For example, the worst disaster in aviation history was narrowly avoided earlier this year when the pilot of a passenger plane pulled up at the last second, missing four other planes by just a few metres – but what if he hadn’t?
“Counterfactual risk analysis stretches the range of event possibilities in a plausible and scientific way by encouraging a different thinking,” explained Maynard. “It explores the mechanism for producing a loss thus revealing and identifying potential black swan events that could impact brokers’ business performance and exposure to risks.”
Maynard’s comments come after Lloyd’s and modelling company RMS published a report –
Counterfactual Disaster Risk Analysis: Reimagining history – which explains how counterfactual lateral thinking can be applied to insurance in order to better analyse risk.
However, while Maynard insists the approach has multiple benefits, he says few insurers are currently applying it – for a couple of reasons.
“Firstly, in most people there is an inherent outcome bias in reviewing losses. Decisions tend to be judged according to the outcome,” he told Insurance Business. “In the case of (re)insurance, favourable underwriting results do not trigger the same level of post-mortem analysis as a severe and unexpected underwriting loss.
“Furthermore, little compels management to conduct a root-cause analysis of near misses that could have been catastrophic had environmental conditions been slightly different.”
Secondly, Maynard says systematic counterfactual analysis is rarely undertaken because of the substantial effort required – and because its purpose and value are still underestimated. However, if the approach was more widely adopted, it would have a clear impact on brokers – in terms of understanding and communications of risks, pricing and capacity management, and product development.
“As downward counterfactual examples are always based on actual historical experience, brokers could use them to help communicate future risks to board members, policyholders, risk managers, as well as non-experts,” says Maynard. “Counterfactual risk analysis can also be used to price risks with limited historical losses to allow exposure managers to derive a probable maximum loss (PML) that can be used to set risk tolerances and to gain confidence in the tail of the catastrophe risk distribution.
“This might refine underwriters’ capacity for business that was previously priced on a single data point or release capacity for new business.”
Finally, Maynard said this deeper understanding could help brokers to tailor covers and rates for clients and to offer new products – especially for emerging risks and man-made catastrophes such as cyber and terrorism that have been quantified using a counterfactual framework approach.
“We believe that counterfactual is a useful addition to the suite of tools insurers and risk managers already use to analyse risk, including stress-testing techniques and statistical modelling, and could help them prepare business strategies, highlight potential vulnerabilities and make informed capital decisions,” he concluded.
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