Black Swans, Butterflies, and Insurance Decision Making

In 16th Century England, events that were outside of the realm of possibility were thought of as Black Swans because everyone new that only white swans existed.  This was true until the Dutch explorer Willem de Vlamingh discovered black swans in Australia in 1697 and thereafter, the phrase took on a new meaning.  A Black Swan event soon became something that was thought as impossible but might later be disproven.   Black Swan events were rare, impossible to predict, and could have a major impact on one’s life.

In Chaos Theory, the Butterfly Effect is a term used to describe a phenomenon where a very minor change in circumstances may have a major impact on outcomes – the butterfly flapping his wings in the Sahara is the causality of the Hurricane hitting the U.S.  Or, consider that the collapse of a major hill is ultimately caused by the dislocation of a single grain of sand.  Everything starts somewhere.

What do they have in common?  What do they have to do with insurance or risk management?  Humans seek explanations, justifications, and rationality in their decision making, especially if there is a cost associated with the decision.   Seemingly rational thoughts based upon what is viewed as valid information are used to justify decisions.

In the context of property insurance a variety of differing thesis are used as justification in what type of insurance to purchase and how much.  For instance, ‘we’ve never had a flood’ or even better, ‘it flooded last year but we are in a 100 year flood plain so no need to purchase flood insurance this year’.  Or, ‘I have a friend that is a builder and they say they could build my house for $150 per square foot’.  The arguments run the gamut.  As respects liability insurance, the arguments range from no one gets sued to I will only be sued for the limits of liability insurance I purchase.  Or, my child is very responsible and would never be involved in an accident.  Many people believe that with insurance, the only thing that matters is price.  How can we justify spending money on the unpredictable especially since if it’s never happened, it will probably not happen to me?

When I started my career in insurance many years ago, the risk management mantra was to insure for the low frequency, high severity, catastrophic type of event and self-insure for the high frequency, low severity event.   That logic holds true today more than ever because we are all quickly learning that Black Swans do exist.  And as Ben Franklin once said: “an ounce of prevention is worth a pound of cure”

Tags: insurance