Revolutions and hard markets

At last week’s Casualty Actuarial Society Spring Meeting, Guy Carpenter’s Don Mango introduced an interesting idea: The dynamic driving the underwriting cycle is similar to the dynamic that drives chaotic revolutions – think France in 1789, Russia in 1917, the fall of communism in 1989 and the Mideast revolts today.

I’m not sure I buy the theory he touted in his presentation at the CAS session on Systemic Risk in the U.S. Insurance Market. But I think it’s interesting to consider. And his conclusions and mine are pretty close.

Mango’s presentation (pdf) picks up the hypothesis that economist Timur Kuran of Duke University summarized in a 1989 paper called Sparks and Prairie Fires (pdf). (Kuran was at USC when he published this work.) Kuran noted that revolutions surprise everybody, including the instigators and tried to explain why.

Examples: The Ayatollah Khomeini, famously, didn’t anticipate the revolt that left him in charge of Iran in 1979, and Lenin didn’t foresee the events of 1917 leading to revolution. (Neither thought their rabble-rousing would cause change when it did. Both, if I recall, were in exile when their revolutions began.)

In Mango’s description of Kuran, people harbor resentment against oppressive regimes for decades, an “inner belief.” Because the regime is oppressive, no one talks about their resentment. So there’s an “external expression” of support, usually at odds with the inner belief.

That’s a little abstract, but it happens at work a lot. Everyone laughs at the boss’ jokes, but no one thinks they are funny.

Kuran calls the process preference falsification.

The title of the paper – Sparks and Prairie Fires – describes how this plays out:

  • The oppressive regime seems all powerful, even as resentment grows – because no one is expressing their resentment. And any opposition seems weak, even though there is a powerful (suppressed) support for it.
  • Eventually, the gap between what people believe and what they say grows intolerably large.
  • There is a spark. Often it’s so tiny, it can’t be isolated, even after the fact.
  • The spark starts a wildfire – a conflagration that envelops the entire society, and the oppressive regime is overthrown.

Fascinating, no? Mango suggests that markets behave this way, too. His example – the subprime crisis.

  • Inner belief: These mortgages are crap.
  • External expression of belief: These mortgages are AAA-rated and can’t possibly default.
  • There is a spark: Bear Stearns goes belly-up, overinvested in subprime debt.
  • A revolution spreads.

Then he extends the reasoning to the soft market phase of the underwriting cycle:

  • Inner belief: Prices are too low.
  • External expression of belief: Prices are just fine.
  • There is a spark: In 2001, for example, it was the World Trade Center attacks. (If you weren’t insurance-minded them – the attacks, in addition to the human trauma and tragedy, were an unprecedented insurance event. Insurers hadn’t considered the concentration of risk that terrorism events cause, with claims in property, workers comp, general liability, aviation, accident and health. And the early estimates of losses hit $70 billion – though the final tab was only about 40% of that.)
  • The revolution occurs – prices rise.

Some would argue the cycle is about to repeat, with the string of earthquakes, fires and floods over the past 15 months, capped by Japan’s tsunami, amounting to a spark.

It’s a tempting theory, but I don’t think it stands up to rigor.

  • When the market is soft, there is no external expression that rates are climbing, or even stable. Rates are capably monitored by at least three widely publicized services (Council of Insurance Agents and Brokers, MarketScout, Towers Watson’s CLIPS). They may vary by degree, but when they say rates are falling, you don’t hear people saying they are actually climbing.
  • What constitutes a spark? The 2001 market was already creeping up in a couple of lines (medmal), and WTC definitely created a hard market. But in 2008, the capital markets collapsed and a major hurricane (Ike) tore through Texas – all in the same weekend. That’s not just a spark, that’s grand-dad in the sagebrush with lighter fluid and a blowtorch. But no hard market.

This last is actually more of an objection to Kuran’s hypothesis, or at least the popular version of it. It is both unprovable and inactionable. You can’t prove the dichotomy of inner belief vs. external expression, because the inner belief is, well, inner. And any expression of it makes it external.

After the fact, it’s always provable, thanks to the combination of armchair quarterbacking and circular logic. Obviously, everyone in Libya privately thought for decades that Kadhafi was a jerk. How do I know? Well, look what’s happening. They must have hated him all along.

They just needed a spark. What was the spark? Well, sometimes the spark is so small that it can’t be discerned, even after the fact. So I don’t need to show you a spark.

Heck, I can use a theory like that to explain everything from the Reformation to Seinfeld ratings. And you can’t prove me wrong. I get to choose the private belief, which you can’t disprove – since it only exists within the heart of Everyman. And I don’t have to choose a triggering event, a spark.

And the theory is inactionable. You can’t use it to forecast – at all – how to behave.  There appears to be a lot of dissatisfaction in Iran, judging by last year’s protests. And the size of the protests sure made it look like there was a spark. Yet, no revolution, at least not yet.

So here’s a hypothesis that can’t be proved. And if you proved it, you still wouldn’t be able to use it. What good is it?

But my complaints are, more or less, Don Mango’s point. You don’t know when the revolution is coming. It could be tomorrow or next month or three years from now. You can only be prepared to act when it happens.

Similarly the hard market. You don’t know when it’s coming. You only know that once it happens, it will happen quickly. And if you aren’t prepared, you’ll get swept away as fast as all those despots did.

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2 thoughts on “Revolutions and hard markets

  1. DW says:

    Not sure I buy it.

    ‘Revolutions’ in financial services have very little to do with sentiment and lots to do with money.

    If by soft market, you mean the current *level* of price (in)adequacy, that cannot change until you remove lots of capital from the business. History tells us insurers don’t do this willingly. That means (financial) catastrophe.

    The suddenness is similar to a revolution, sure, but all that ‘inner sentiment’ stuff is the wrong explanation.

    It wasn’t sentiment that killed the mortgage industry, it was money-losing mortgages.

    I suppose the root of my objection is that insurance ‘revolution’ is inevitable, whereas people could probably be dissuaded.

  2. jimlynch9999 says:

    DW, when I first thought about this, I agreed with you. I thought there needs to be a cataclysm of some sort (disaster, financial crisis) to trigger an increase in prices.
    But in a way that’s fighting the last war – in 2001, prices shot up because of 9/11 and the financial meltdown. But that combination basically repeated itself in 2008 and prices didn’t rise.
    Further, I don’t think one can point to any particular capital drain that caused the hard market of the mid-80s. I lived in Florida then, and I don’t remember any disasters on the scale of 9/11 or Hurricane Ike. And the stock and bond markets were on the upswing.

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