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COMMENT: Black swans and black turkeys
21 April 2010
Rather than breathe a sigh of relief that there will be no insurance large losses from the Iceland volcano, the industry should spot the opportunity in such events to create new products, says Reactions’ contributing editor Garry Booth.
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The Black Swan: The Impact of the Highly Improbable
Nassim Taleb
The explosion of the Eyjafjallajökull volcano is what celebrated author Nassim Taleb might call a black swan event. He is author of the New York Times best-seller The Black Swan: The Impact of the Highly Improbable and a scholar of risk and model error.
Insurance underwriters call a black swan a “who would have guessed it” event. A volcano located in a remote country erupts properly for only the second time in 10,000 years and the next thing you know it seems like half the population of the developed world is stuck in the wrong place because European airspace is closed.
The eruption started on March 20 and after a pause in activity, a new vent opened on 13 April generating a column of ash several kilometres high and causing melting of overlying glacier ice. The prevailing weather system meant the ash cloud moved very slowly across Britain and the rest of Northern Europe. Air traffic controllers responded by… well we all know what happened next.
Prof Bill McGuire of the Aon Benfield Hazard Research Centre tells us it is not particularly unusual for ash from Icelandic eruptions to reach the UK. Though he adds that the most notable occasion was as far back as 1783, when a cloud of ash and sulphurous gases from a major eruption lay across Europe from the summer of that year and into 1784.
The cloud resulted in elevated summer temperatures and resulted in poor air quality that caused a significant increase in mortality in the UK and elsewhere in Europe. Such a large eruption occurring today would have the potential to severely affect air travel at high northern latitudes for six months or more.
Incidents where ash clouds have created a problem for aircraft have happened more recently elsewhere in the world. Over the past few decades there have been more than 80 encounters between civil aircraft and ash clouds, resulting in a number of terrifying situations where crashes have only narrowly been avoided.
Most notable was in 1982 when a British Airways 747 entered an ash cloud from Galunggung volcano in Indonesia. Ash in the engines resulted in all four failing, causing the plane to plunge 7,000m before the engines could be restarted. Even then, landing was made extremely difficult by the fact that the windscreen had been scoured opaque by the ash. (Volcanic ash is silica-based material and highly abrasive, clogging engines and causing them to flame out).
The insurance industry is relaxed about the scale of possible losses, however. Closed airspace means aircraft will not be falling from the sky. Moreover, interruptions in the business operations of airlines and airports are generally not covered unless they result from material damage.
Business interruption claims from the non-delivery of air-freight shipments are also expected to be limited because covers are generally triggered only if an interruption results from material damage. So that’s alright then.
But are insurers missing a trick? Instead of congratulating themselves over avoiding the risk exposure, insurers and reinsurers might do well to think about the possible opportunities posed by such a well publicised event. Take those BI products for instance: why do they have to be triggered by material damage?
Many big corporations are actually crying out for contingent business interruption insurance – a product that covers business interruption not caused by material damage in their own processes. Let’s call it black swan insurance.
Of course these things take time to design and construct and re/insurers have to be sure they don’t encounter aggregation issues as a result of extending what is essentially a form of cat cover. But pricing itself isn’t an issue is it? “Loss of profits” or “increased costs of working” can be worked out – it’s only the trigger that’s changed.
To make this work the industry first needs to make more buyers aware that black swans do exist. Indeed, a very large black swan has just appeared on the horizon – in the shape of inclement solar weather.
Scientists say solar activity – more sunspots or solar flares - is beginning to pick up after a long lull and is expected to peak around 2012.
In 2008, the number of days when no sunspots were recorded was the highest for a century. They have now started to increase and there have only been a few days so far this year when no sunspots were observed.
Increased solar activity creates all sorts of problems from knocking out satellite systems to damaging power transmission lines. No-one really knows what effect solar weather will have on wi-fi technology because it didn’t exist to such an extent when the solar weather was last bad.
It is quite possible that the bad solar weather will have minimal effect on earth bound businesses. But the insurance industry would do well to recognize that many would surely like to have cover in place to protect against the financial fall-out of such a black swan event – even if it turns out to be a black turkey…
Click here to read: Ash cloud could lead to new products