Downwards counterfactual analysis

Stress and scenario testing are important risk assessment tools.  They also provide useful ways to prepare in advance for adverse scenarios so that management doesn’t have to create everything from first principles when something similar occurs.

But trying to imagine scenarios, particularly very severe scenarios, isn’t straightforward. We don’t have many examples of very extreme events.

Some insurers will dream up scenarios from scratch. It’s also common to refer to prior events and run the current business through those dark days. The Global Financial Crisis is a favourite – how would our business manage under credit spread spikes, drying up of liquidity, equity fall markets, higher lapses, lower sales, higher retrenchment claims, higher individual and corporate defaults, switches of funds out of equities, early withdrawals and surrenders and increased call centre volumes?

Downwards counterfactual analysis is the:

  • analysis
  • of events different (counter to) actual facts
  • that are worse (downwards) than reality

For stress testing, we could take a past scenario and make it worse. What might have happened in 2007/2008 if African Bank had failed then, rather than a few years later? What would have been the result of an SA government sovereign downgrade at the same time, or if a major insurer got their hedging wrong enough to be really in trouble? What if the Cape Town water crisis hit at the same time and resulted in a cholera outbreak?

Some of those options are natural progressions of the factual scenario, whereas others (water + cholera) are mere add-ons.  The strongest sort of counterfactual analysis is where the original scenario was better than it might have been due to good luck. Tweaking that to an equally likely or even more likely but worse scenario powerfully shows how close we came to real disaster. A change in the prevailing wind during the Fukushima nuclear disaster is an obvious one.

Lloyds and RMS have put out a fascinating paper on downwards counterfactual analysis called “Reimagining history”.

It’s interesting stuff and well worth a full read.

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