In May, the Leicester City Football Club, an organization that spent most of its 132-year history on the outside looking in at the titans of soccer, shocked the world to win their first English Premier League title. This result was, to put it mildly, unexpected. As recently as 2009, the Foxes found themselves relegated to England’s third-tier league, and prior to the season, bookmakers were offering 5,000-to-1 odds for anyone mad enough to pick them to win the title – the same odds quoted on Elvis Presley being found alive this year.
This may have been the biggest upset in the history of sports, but it just seemed like the new normal in 2016. In June, the Cleveland Cavaliers became the first team to ever overcome a 3-1 deficit to win the NBA Finals, breaking a 147-season championship drought for the city of Cleveland’s professional sports teams. Then in November, long-suffering Cleveland baseball fans were on the brink of celebrating the city’s second championship of the year when the Chicago Cubs came back from a 3-1 deficit of their own to win their first World Series since 1908. As a lifelong Cardinals fan, I really hope this doesn’t become a regular thing.
2016’s unexpected events were not limited to sports arenas. To the surprise of pundits and pollsters, the U.K. voted to “Brexit” the European Union, and American voters elected a reality TV host as the next president. Two rare blue lobsters were caught off the shores of Nova Scotia three days apart, and a North Carolina woman scored two major lottery prizes in a span of three months. The year even saw the first full moon on the summer solstice in almost 70 years followed by three consecutive months with “supermoons,” including the largest since 1948.
Now fear not, fans of the Foxes, Cavaliers, Cubs, Brexit, President-Elect Trump, lotteries, blue lobsters, or even supermoons – I am not here to make value judgments about these events whatsoever. Nevertheless, I am struck by the feeling that rare, unexpected, and highly improbable events are occurring with increasing frequency, in violation of the fundamental laws of probability. As an actuary, I am used to dealing with risk and uncertainty, but this level of unpredictability scares even me. I want to understand why, and more importantly, determine what insights we in the insurance industry might glean from this year’s “unexpected” events. Here is what I’ve learned:
1. Rare events are rarely rare.
Statistician David Hand states that “extremely improbable events are commonplace.” 2016 provided pretty persuasive plausibility for the professor’s paradoxical precept. After all, winning the lottery is unlikely enough – but twice in the same year? With an Illinois man named Gambles (natch) also scoring his second win? The genetic mutation that turns crustaceans blue occurs in only one out of every 2 million lobsters, so finding two in three days in the same waters? With a Massachusetts lobsterman also catching one... for the second time in his career?
In these situations, we see the “Law of Inevitability” and the “Law of Truly Large Numbers” at play. With respect to the lottery, someone has to win, and there are a plethora of chances to do so (yes, El Guapo, a plethora). In Illinois, for example, Mr. Gambles can play Powerball and Mega Millions twice a week, the Illinois Lotto three times a week, and each of the Pick 3, Pick 4, and Lucky Day Lottos twice a day, for a total of over 2,500 drawings per year – and over 40 other states offer similar opportunities. And while many people join in the fun when multi-state jackpots get ginormous, state lotteries are typically the dominion of a finite cadre of devoted gamblers. Reports also often stretch the definition of what it means to “win the lottery” by including smaller payouts such as those that are awarded for picking four out five numbers (i.e., the “Law of Near Enough”).
Given all of this, it is inevitable that we will occasionally see some repeat “winners.” The only surprise might be that people keep playing after they’ve already won, but human behavior often is unexpected – we’ll get to that later. Like winning the lottery, the odds of any one person finding a blue lobster are very low, but since 200 million lobsters are caught annually in the North Atlantic, at a rate of one in 2 million, we should expect around 100 of them to be blue. The real question then isn’t “Why were three blue lobsters caught in 2016?” It’s rather “What happened to the other 97?”
Extensive research shows that humans are epically bad at intuitively sensing probabilities. This can be demonstrated by our instinctively counterintuitive reactions to the “birthday paradox” (that in a room of 23 people, there is a better than 50/50 chance that two of them share the same birthday) and the “Monty Hall problem” (in a game with a prize behind one of three doors, you significantly increase your odds of winning by switching your choice from door #1 to door #2 after being shown there is no prize behind door #3). Mind. Blown.
So uncertainty is certain and humans are hard-wired to underestimate it. But there is good news: this is exactly why the insurance industry exists! We have the power to provide consumers financial security in times of great uncertainty. But with great power comes great responsibility. So while it may seem a fool’s errand to predict the likelihood and impact of black swan events like pandemics, nuclear terrorism, or sovereign default with (thankfully) little historical data to go on, it is still each insurance company’s solemn duty to ensure there is sufficient capital – or reinsurance ;) – to withstand a wide range of “unexpected” events.
2. People are not machines.
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