How Munich Re Assesses Risk
Last Apr. 14, Iceland's Eyjafjallajokull volcano erupted. Five days later, Nissan Motor shut down three auto assembly lines in Japan. The factories had run out of tire-pressure sensors when a plane carrying a shipment from a supplier in Ireland was grounded because of volcanic ash. At a BMW plant in Spartanburg, S.C., work slowed after transmissions couldn't be delivered from Germany.
What was the probability of that happening? That's the kind of question Munich Re must grapple with. Munich Re is the world's biggest reinsurer, one of a handful of industry giants including Swiss Re and Berkshire Hathaway's Gen Re that sell policies to insurance companies to cover the risks they absorb from policyholders. That gives the 130-year-old company an unparalleled view of just about everything that could go wrong in the world. And in a global economy, figuring out where and why those things might happen is getting a lot more complicated. "The most significant changes in risk management have taken place in the past 7 to 10 years," says Joachim Oechslin, Munich Re's chief risk officer. "Today it's not only about data gathering"—using geological records, say, to predict the likelihood of a volcanic eruption—"but trying to figure out the relationship of things," such as how an event like the Iceland volcano can ripple through a supply chain. While Munich Re specialists are studying the eruption, they say they still lack the tools to accurately predict the chain of damages unleashed by such a disaster.
Inside its neo-Baroque headquarters overlooking the tree-lined walkways of Munich's English Garden, Munich Re specialists pore over data to help them calculate the likelihood of a dizzying array of mishaps. They know the probability that Los Angeles will suffer a major earthquake in the next three decades (it's 97 percent) and the odds that a 60-year-old American man will die from a heart attack by age 70 (3.2 percent if he doesn't smoke, and 8.4 percent if he does). They search for patterns in data from past accidents, learning, for instance, that boats are most likely to spring leaks during the early months of an economic upswing. The reason: During downturns, vessels are often placed in dry-dock, where wood shrinks as its dries, leaving gaps where water can enter when the boat returns to service.
Increasingly, Munich Re is focusing on what it calls emerging risks: subtle, often seemingly innocuous trends that could carry the seeds of disaster—everything from rising prices at art auctions (which can increase theft) to the widespread installation of rooftop photovoltaic panels (a fire risk). Who knew that bundled subprime mortgages would lead to a near collapse of the global financial system? Munich Re had a pretty good inkling. In 2007 its analysts concluded that collateralized debt obligations were far riskier than was generally realized. The company wrote new policies for clients in finance, setting tighter limits on its potential exposure to losses from such instruments, and came through the crisis in strong shape. In 2009, its profit rose 53 percent, to $3.5 billion, on revenue from premiums of $55.1 billion.
Munich Re learned the hard way about the need for more sophisticated risk controls. A decade ago, it had invested about 20 percent of its capital in equities. "We had the profile of a hedge fund rather than an insurance company," Oechslin says. After markets worldwide tanked in 2002, the company booked an unprecedented $492 million loss for 2003. Since then, Munich Re has greatly diversified its investments, with less than 3 percent in equities. "They have their house in much better order than they did five or six years ago," says Paul Walther, chief executive officer of Reinsurance Directions, a Florida consulting firm.
One of the new risks Munich Re is tracking is climate change. The company has the world's most comprehensive database on natural disasters, with information going back centuries. It shows that the frequency of serious floods worldwide has more than tripled since 1980, while hurricanes and other severe windstorms have doubled. "Global warming is real, and it affects our business," says Peter Hoppe, who heads the company's climate-change research. Munich Re has become a leading advocate for renewable-energy development, even joining a venture that plans to generate solar power in the Sahara and ship it under the Mediterranean to Europe.
Other Munich Re specialists try to understand human risk-taking behavior. Rainer Sachs, who heads the company's emerging risks research unit, spends his days pondering such head-scratchers as the fact that, while traffic deaths have dropped sharply in recent years, the rate of serious injuries from accidents has not. His conclusion, buttressed by studies of driver behavior in several countries: With airbags and other safety features, drivers take more risks because they believe their cars are safer. "Everyone has his own risk thermostat," he says. "We introduce risk-mitigation devices that are supposed to make life safer—and then we change our behavior to make life more interesting."
Those insights could help Munich Re develop computer models to predict the likelihood of accidents in a wide range of settings, including financial markets. Sachs contends that a similar thermostat effect figured in the global crisis. "When people invested in subprime products, they bought hedging products, so they felt safe," he says.
Other human behaviors defy prediction. Terrorism, for one. While insurers can draw conclusions by studying the actions of groups of people, "You cannot model the decision-making of small numbers of individuals," says Heike Trilovszky, Munich Re's corporate underwriting chief. "We're convinced that terrorism is not insurable."
The bottom line: As the global economy gets more connected, it has become harder for insurers like Munich Re to determine risk.