Contributor: Don Canning
Insurance companies make money by taking calculated measured risks, and lose money by ignoring risks.
One of the most important thought leadership ideas of the late Nobel Laureate Friedrich Hayek was the economic concept of ‘spontaneous order.’ Hayek argued that price mechanisms serve to share and synchronize local and personal knowledge, which allows society to achieve diverse, complicated ends through a principle of spontaneous self organization.
He makes a valid point about human nature influencing economic supply chains based on individual knowledge and need. In his award-winning economic publications, Hayek’s theory provide a good metaphor for understanding the implications of organizational maturity and the engineering behind enterprise risk visibility.
When spontaneous order exists, we take it for granted and make little effort to understand it. If your risk-based capital evaluation is receiving a healthy rating, risk managers do not think about if the quantitative actuarial model calculations are considering all factors such as, how well:
- Data cleansing is working
- Process controls are managed
- Risk analytics processes identify qualitative patterns affirming volatility indicators, or whether they are missing them all together
When the system is functioning properly, we do not notice all the risk behaviors that can expose or mitigate risk across market, credit, operational and insurance risk management. Risk management staff tend to only investigate these processes when order breaks down, typically in response to a panic during a crisis, endogenous ‘shocks,’ or in the throes of a painful audit looking back over exposed negligence.
The problem in this situation is determining the origin of ‘spontaneous disorder’ and the divergence from universal risk rules that measure justified conduct. Do new risk rules and exposures emerge spontaneously? Or, is some element of outside inspection and risk management reasoning required to explain the rules that benefit a carriers’ risk positioning?
As a result of the 8.9 magnitude earthquake which triggered a tsunami last March 11, Japan’s Fukushima Daiichi nuclear power plant was hit by a 23-foot (seven-meter) tsunami wave that flooded diesel-powered backup generators mounted 18-feet above sea level. Plant engineers stated that if they were mounted twelve feet higher, totaling 30-feet above sea level, it would have averted the worst meltdown since Chernobyl. If those backup generators were mounted 12 feet higher, would that have saved the plant or would it have exposed other risks and vulnerabilities to be addressed? The power plants radiation leakage created permanent damage far beyond the damage from the earthquake itself. “The fact is that no one knows for sure what the risks are,” said Mr. Nagataki, the former chairman of the Nagasaki-based Radiation Effects Research Foundation, “but that doesn’t stop many people from saying ‘Scary! Very Scary!’”
Warren Buffett said recent natural disasters led by the Japan earthquakes eroded first-quarter profit and may lead to the company’s first annual insurance underwriting loss in nine years. The insurance segment posted an underwriting loss of $821 million. The Japan earthquake cost the firm $1.06 billion, a temblor in Christchurch, New Zealand cost $412 million, and flooding and a cyclone in Australia cost $195 million[i].
Buffett is quoted as stating “risk comes from not knowing what you are doing.” During the week of March 11, trading volume for Berkshire Hathaway Inc BRK/B: NYSE remained in a normal trading range. These major catastrophic events barely dinged Berkshire Hathaway Inc. because of Berkshire’s ability to respond to risk stability and financial integrity.
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