Dear friend,
I suppose I’d better try and explain the intriguing front cover of the April 2008 magazine.
It all started when I bought a book that I had been meaning to read for ages — it was The Black Swan: The impact of the highly improbable by Nassim Nicholas Taleb
You should get yourself a copy, it’s a unique concoction — a readable book on the philosophy of risk. It’s packed with ideas that are so ingenious that you wonder why you’d never thought of them yourself
Taleb writes like a street preacher, spitting out ideas with a wild fervour
Back in the European dark ages, people were sure all swans were white. If you suggested that such a thing as a black swan existed, they would tell you to take a hike. A couple of centuries later and Europeans travelled to Australasia — where they ‘discovered’ black swans. The point is black swans existed all along — it’s just beyond the realm of the human psyche to imagine there are things out there beyond our knowledge
Hence the cover. Now we know black swans exist, what’s the chance that there aren’t a few pink ones hiding somewhere? The trouble is, these ‘outliers’ can mess things up, especially when it comes to finance. We can guess what happens when you’ve modelled your company to take a maximum hit to capital of 20% from a 1-in-250 year even and it turns out that you take a 2000% blast. Oblivion is obviously what happens
When Taleb expands on black swan theory, things can get quite scary
The trouble with the outliers is that they tend to be as large as they are improbable and end up having disproportionate effects on the manageable world that we like to theorise about. A market rises steadily and then crashes 25% in a single day, blowing leveraged investors out of the water, or a long-dormant volcano suddenly blows its top without warning
In Taleb’s universe, all modelling and projection of the future is a fraud — the only thing that counts is evidence that you have built up and evaluated rigorously. He is what he calls an empirical sceptic. The trouble is that experience can also be misleading. Taleb uses the example of the farmed turkey’s life. Every day the nice farmer feeds and tends to the turkey, so in the turkey’s experience the farmer is a friend. Then suddenly on Christmas Eve, the poor turkey’s knowledge and understanding of the true nature of the farmer is dramatically changed! There are many other examples and thought experiments in the book
Taleb recounts a risk seminar he attended at a top casino in Las Vegas
The casino used high-tech surveillance and risk limitation strategies to make sure it was never taken to the cleaners by either card counters, high rollers or a mathematically improbable run of bad luck on the tables
When he asked what the largest losses to hit the company had been in the past five years, one was a situation where a manger had had a family member kidnapped and another involved a rogue clerk who inexplicably failed to file IRS returns. It was these ‘freak’ events that had caused the most damage and cost them undisclosed millions
As you can see, the real conundrum of the book from an underwriting point of view is that if exposure rating is a fraud and experience rating is also highly misleading, then maybe we should pack up and go home? Are we just successful underwriters because we are unaware of the true risks we run and are simply lucky? Well, sorry to report that according to Taleb, we almost certainly are! Chin up, chancers!