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International Congress of Actuaries

Towers Watson

30th International Congress of Actuaries 30 March to 4 April 2014

 

Extreme risks and the insurance industry

The 2013 update and its implications for insurers

By Tim Hodgson, Stephen Lowe and Liang Yin

https://cas.confex.com/cas/ica14/webprogram/Session6958.html

or

https://cas.confex.com/cas/ica14/webprogram/Handout/Paper2936/2013%20ICA%20Extreme%20Risks%20Final.pdf

[full-text, 49 pages]

 

Abstract

Towers Watson has updated its list of potential extreme risks to the world's economic,

social and political stability. The list has been expanded and reorganized as a result of

further research on the topic. A new approach to prioritization has also been introduced.

This paper describes the results and discusses the implications for insurers.

 

 

Extreme financial risks are those in which there is an inability to meet financial liabilities, on a

massive scale, leading to a collapse of the financial system. This could occur as a liquidity

issue, such as a banking crisis, where institutions have insufficient liquid assets to meet their

current demands for payment, even if the institutions have more assets than liabilities.

Alternatively the financial crisis could be driven by insolvency, such as an insurance crisis or a

sovereign default, where assets are insufficient to meet liabilities. As in our last report, there are

three flavors of extreme financial risks.

 

 F1: Banking crisis. Central banks are unable / unwilling to supply sufficient liquidity to

institutions. Failure to make payments cascades rapidly through the financial system,

causing banking, and eventually real economic activity to stop.

 F2: Insurance crisis. Catastrophic events cause failures at major insurers, leading to

withdrawal from markets by others. The failures create adverse wealth effects for

beneficiaries and/or the lack of availability disrupts commerce.

 F3: Sovereign default. Non-payment by a major sovereign borrower causes market panic

and adversely disrupts the global economy in a major way. Failure to make payments could

cascade rapidly through the financial system, especially if there was a loss of trust within the

system.

Extreme economic risks are those where there is some form of major shock to the economic

system: a shock to growth, a shock to price levels, or a collapse in trust that is essential to the

working of the economic system. Generally these shocks stem from some form of fundamental

imbalance in the economy that reaches a tipping point. Growth shocks can take the form of a

depression or stagnation. Price level shocks can occur in opposite directions: rising prices in

hyperinflation or falling prices in deflation. In both cases the 'incorrect' price signals cause

serious economic damage and destruction of wealth. A collapse in trust could occur in the

current monetary system, leading to the abandonment of fiat money; or in the value of a major

currency, creating a currency crisis; or in the economic system as a whole, leading to the

break-down of capitalism. In our current list, there are now seven flavors of extreme economic

risks.

 

 E1: Abandonment of fiat money. A collapse in confidence in the purchasing power of

paper currency and the consequent return to a gold standard.

 E2: Break-down of capitalism. Distrust in the private capital/property system, causing a

collapse in economic activity and asset prices.

 E3: Currency crisis. A significant devaluation of a major currency that becomes selffulfilling,

with loss of purchasing power.

 E4: Deflation. Goods and services prices fall for a long period, transferring wealth from

borrowers to savers; often associated with a depression.

 E5: Depression. A rapid and painful contraction in economic activity, leading to a deep

trough in economic output, massive increases in unemployment, restriction of credit, and

shrinking investments.

 E6: Hyperinflation. Prices increase rapidly, wiping out savings, provoking extreme

consumption and hoarding of real assets.

 E7: Stagnation. A prolonged period of little or no economic growth, usually accompanied by

high unemployment and growing political dissatisfaction.

 

Extreme political risks are derived from policy decisions that turn out to be poor choices. In

some cases the policy decisions may be quite direct, while in others they may be more subtle,

however in all cases poor prior policy decisions are a necessary, if not sufficient, condition for

these risks to eventuate. Extreme political risks come in five flavors:

 

 P1: Anarchy. Income inequality, supported by modern communication, fosters extreme

social disorder in a major state, leading to government and economic collapse.

 P2: Global trade collapse. A protectionist backlash against cross-border mobility of labor,

goods and capital, causing global trade to collapse.

 P3: Political extremism. The rise to power in a major economy of an oppressive

government, leading to mass murders and threat to global peace.

 P4: Terrorism. A major ideologically-driven attack on an important target, inflicting largescale

human and financial damage. (Here we are thinking of an event worse than 9/11.)

 P5: World War III. A military war among many of the world's major countries, killing many

millions, destroying physical and human capital.

 

Extreme environmental risks are threats to human safety and well-being arising from a

disruption to planet earth's environment. Two of our risks (alien invasion and cosmic threats) are

exogenous to earth and largely beyond our control; two of the risks (biodiversity collapse and

global temperature change) could be caused by humans, and are perhaps within our control. In

considering our list of environmental risks, one could easily question the seriousness of

including alien invasion. We would respond to this question by suggesting that risk management

is planning in advance the actions one would take in response to events, and the value of the

exercise is in scanning the horizon with the broadest possible mind. Do we know enough to

conclude with certainty that a particular event is not possible? The irreversibility of time thinking

shows that there is a world of difference between a 0% probability and a vanishingly small

probability. Besides, at the assessment stage it is likely that many organizations might have

filters that would work to drop alien invasion from further consideration. Extreme environmental

risks come in five flavors:

 

 e1: Alien invasion. An invasion of non-peace-seeking aliens that seek either to remove the

planet's resources or to enslave /exterminate human life.

 e2: Biodiversity collapse Destruction of the world ecosystem leading to problems with

human food and water supplies, disease, or climate issues.

 e3: Cosmic threats. Planetary risks such as a big meteorite impact, changed orbit due to a

passing asteroid, or giant solar flare / magnetic storm.

 e4: Global temperature change. Earth's climate tips into a less-habitable state (hot or

cold), disrupting social and economic systems.

 e5: Natural catastrophe. A confluence of major earthquakes, tsunamis, hurricanes,

flooding and/or volcanic eruptions with major global effects.

 

Extreme social risks are threats that could adversely affect the smooth functioning of society.

It should be noted that that the risks in our categorization are not independent, and it should be

clear that the social risks also link to policy decisions, the environment, and in some cases

technology. This is obvious in the case of food / water / energy crisis, which will have political,

environmental, and technological drivers as well as offsets. Three of the risks are health-related,

representing different extremes. Extreme social risks come in five flavors:

 

 S1: Extreme longevity. Advances in medicine or genome science significantly increase life

expectancy, overwhelming support systems and stressing intergenerational politics.

 S2: Food / water / energy crisis. A major shortfall in the supply of, or access to some

combination of food, water or energy, causing severe societal issues.

 S3: Health progress backfire. Massive rise in morbidity or mental ill-health, perhaps due to

an unintended consequence of new health practice.

 S4: Organized crime. A significant increase in the scale of illegal operation in a major

economy, threatening the viability of legitimate economic activity.

 S5: Pandemic. A new disease, that hits the 'sweet spot' by being both highly infectious and

often fatal, spreads through human, animal or plant populations worldwide.

 

Extreme technological risks are those that arise from our increasing reliance on technology to

achieve greater efficiency in production and global communication. The risks range from a

failure in current technology (nuclear contamination, infrastructure failure), through the possible

consequences of emerging technology (cyber warfare, biotech catastrophe) to the unknowable

future event of the technological singularity.

 

 T1: Biotech catastrophe. Biological technology (genome, nano-technology, etc.) is applied

in a destructive way, either intentionally or inadvertently. This risk overlaps somewhat with

S3, health progress back-fire.

 T2: Cyber warfare. Computer sabotage/espionage on a major scale, with severe damage

to infrastructure, financial, medical or defence systems. This risk might act as a precipitant to

economic or financial risks.

 T3: Infrastructure failure. An interruption of a major infrastructure network, disrupting

economies or impacting basic needs. An example would be the loss of the electricity grid for

an extended period, particularly during the winter.

 T4: Nuclear contamination. A major nuclear event, leading to lethal effects on individuals

or large radioactivity release to the environment.

 T5: Technological singularity. Technological advancement proceeds beyond the point of

human understanding or control, threatening human life. The 'singularity' refers to the point

where a machine achieves intelligence comparable to that of humans.

 

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