Counterfactual analysis and terrorism risk

The ‘counterfactual analysis of historical events’—scenarios that could have happened but have not—is an important tool not only for the assessment of uncertainty and disaster preparedness, but also for catastrophe insurance risk management, such as the estimation of the probable maximum loss.

This is according to Gordon Woo, catastrophist at RMS, who explained to Monte Carlo Today about the importance of counterfactual risk analysis, something he believes the industry must grasp in order to carry out ‘sensible’ risk analysis of all insurance perils.

“The whole idea of counterfactual risk analysis is that insurers—generally speaking—judge these excesses of underwriting by what claims they are paying out.”

Woo explained that actual loss experience, which has long been the foundation for actuarial risk analysis, can be very misleading to insurers, leading them to underestimate certain risks if large losses do not materialise.

“If you have a situation where events are rare but you have lots of near misses, you think you’re doing well—but it could just be that you’re really lucky,” Woo explained.

This can include terrorist plots that have been partially or entirely foiled, or cyber attacks that could have been much worse if certain security measures had not been put in place.

The August terrorist attack in Las Ramblas, Barcelona, is one such example.

When looking at the details of this event, the terrorist cell was very close-knit, and was successful in avoiding attracting attention from the local police and the Catalonian intelligence service.

“Counterfactual analysis is crucial in dealing with terrorism risk because the majority of terrorist attacks against the Western alliance are actually stopped by the intelligence services, and few slipped through the net,” said Woo.

The terrorists had failed in their technical facility to be able to plan the detonation of 120 gas canisters. Woo suggested hundreds more civilians could have been killed and the damage could have been 10 times worse if this plan had materialised.

“Counterfactual scenarios such as these are important for insurers to gauge what the loss potential is for a given risk, taking into consideration not just what happened, but what might have happened,” he concluded.

Woo is writing a report on counterfactual risk analysis that will be published by Lloyd’s in October.

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