The Recoil of Risk

May 22, 2020

Alex Hutley

The Taoist’s got it all wrong. In committing themselves to the belief that life is centred around order and chaos, they missed out in viewing the world in the (obvious) spectra of Risk and Insurance, the true opposing life forces of the earth. After all, without risk, it’s probably not worth doing. Without Insurance however, Capital assets don’t build, Innovation & creativity become undesirable and World Trade dies after lunchtime. Today however, despite giant leaps in risk prevention and mitigation, the risks facing humanity are becoming increasingly entropic, with the World’s biggest risks not only becoming more likely, but also much more severe.

Whilst COVID19 rightly dominates Global Headlines, employees, companies and entire economies are beginning to shake off the gathering dust as they emerge from an Isolated Lockdown. In looking ahead to the future however, a likely short term symptom of Isolation might produce temporary amnesia when we try to remember what the World Stage looked like when governments called for the Interval.

This article will look and discuss how the world left the resting balance between Risk and Insurance before COVID19 took over. Serving as a tripartite edition, Part One seeks to lay the foundations on how yesterday’s  risk story will affect today’s Insurance. Part Two and Three will serve as commentary for the leaders at the front – how Lloyd’s BluePrint One Initiative, released September last year, will counter Insurance related challenges.

The World Economic forum, the world’s largest community for the promotions of stakeholder fulfillment, published, as it has done since its inception in 1971, its Global Risks Perception Report, on which much of this article is based. Inside details the responses of the collected responses of over 1,000 stakeholders and their sentimentality on the largests challenges for humanity over the coming years. Excluding significant exemptions on Medical Impacts from Coronavirus, there was very little in the report that would come as a particular surprise.

The importance of Climate Change and Biodiversity loss is hardly overstated, recognition of Economic slowdowns, and emerging Cyber threats all topped commercial concerns. Sitting at the heart of the report however is the deteriorating capability of Nations to cooperate effectively together and deal with the World’s biggest challenges. Not only are the World’s problems getting more urgent, but the World is getting worse at dealing with them.

Disorderly disturbances

Back in late 2017, after having seen unexpected and remarkable success in the polls, Marianne LePen, Emmanuelle Macron and the entire European Union held its breath as they awaited for the results of the Presidential Election to be announced. The choice between continued globalisation and resurgent nationalism couldn’t have been made more clear between the two candidates.

The French Election was especially effective in representing a rising struggle between the two forces that have been locking horns for the past 100 years, since the birth of the League of Nations in 1920. Powerful technological, demographic and economic alterations have all resulted in an anti-elite populist narrative that has had the power to disrupt age old international alliances[1]. Whilst Political commentary here is best avoided, its effects on multilateral action and global commerce weighs heavily on what now forms today’s socioeconomic risk factors and have played significantly into the global economic slowdown.

Low Trade Barriers, High Foreign Direct Investment and strong Fiscal Prudence all sit at the very core of global trade and thus, the Global economy. Not surprisingly therefore, it’s the first symptoms that economists try to look at when reacting to a global economic slowdown.

Typical symptoms resemble feverishly high Trade Barriers, Dry Foreign investments and achingly short term Fiscal outlooks, which regrettably, all form today’s economic reality. Economic progress will continue of course, as long as foundations remain but the first victims to go however, are the vulnerable, and amid political fragmentation, economic cohesion is the first to perish.  Global FDI inflows and outflow have both decreased 27% and 41% respectively.

Restrictions on trade have become 30% higher[2], and Trade Liberalisation has slowed by 60% in just one year.  Fiscal policy across the world has become increasingly short term, with a 15% reduction in sustainability[3].

No surprise then, that world merchandising trade halved in 2019. If the rest of 2020 continues in a similar fashion, Trade disagreements alone will result in $700 billion in lost output. To help conceptualise, that’s equivalent to the lost output of the entire European Union from 2008-2010.

As the infection spreads and symptoms deteriorate, business sentiment dwindles, capital flows self-isolate and wait for conditions to improve elsewhere. As governments and its protesting citizens become increasingly frustrated with seeing so much of each other, governments’ ability to deal with economic certainty shies away as traditional emergency monetary stimuli are traded in as buoyancy aids just to keep the world economy afloat.  And this was before COVID19 emergency packages were implemented across the world.

Whilst the Global Pandemic can provide useful distractions and mascarade global trade issues, emergency Corona packages are only more of the same when it comes to short termist Fiscal concerns and debt-laden economic growth. It is true, harmonious governmental responses make it harder for citizens to lay the blame at any one government. It is also true that crises often have a consistent habit of inflaming existing issues and one only needs to review 2019 in order to see how effective public discord can be at interrupting economic revival. Gilet Jaunes, Extinction Rebellion, Anti-Extradition protesters in Hong Kong are still firmly in the public psyche. As opinions polarise in line with partitioning groups, the risks facing globalised Stakeholder Capitalism are stacking up. 

Room for Insurance?

There is little that the insurance community can do in providing solutions to Political and economic fragmentation but listen, observe and document the challenges that lie ahead for political risk assessments. Insurance is not however without a few weapons that help steady the political instability and those most exposed to its risks.

In preparation, it is important that the Insurance Industry continues to conduct detailed business and country analysis for their Policyholders. To name a few, insurers are much better equipped to face future uncertainty through enhanced due diligence reports, outlining socio-political contexts, monitoring ongoing and developing relationships with influential decision makers and citizens. This will greatly facilitate any significant developments that take place where exposures are held and construct appropriate contingency plans and transfer risks where appropriate.

In terms of building resilience, the insurance industry has launched global initiatives in recent years to promote resilience and sustainable development. These include the Insurance Development Forum (IDF) – comprising representatives from The World Bank, United Nations and other development-oriented NGOs plus senior leaders from major (re)insurers and brokers. Establishing strong relationships with Third-party business intelligence/risk management companies like the Eurasia Group or S-RM, an XL Catlin partner, can also provide useful support in assessing a country’s political climate.

In developing appropriate responses, the need for brokers’ to forge strong connections with clients’ enterprise risk management programs that are capable of encompassing sustainable protection systems to better safeguard fixed and mobile assets, employees and reputation wherever significant investments and operations lie.

 Climactic Corrections

The threats posed by climate change are almost insurmountable. In order to give the planet a fighting chance, Global initiatives have set an ambitious target of Net Zero in carbon emissions by 2050, with the UK Government being the first major economy to enact legislation in this area.

With progress rearing its head, development of the Low-Carbon Economy is making current fuels redundant, whilst increasing the risk of incurring large pools of stranded assets, as oil and gas are slowly being converted from assets to liabilities. More worryingly however, is the imminent threat faced by Pension and Mortgage industries, who are being warned by Central Banks to deleverage their investments in fossil fuels.

Affronted with increasing shoreline erosion, coastal flooding and agricultural disruption, wealthier nations will pay with economic decline and poorer nations will pay with their livelihoods destroyed and communities obliterated.  Faced with little other option, poorer populations migrate to greener pastures, only to be met with hostility and backlashes as geopolitical tensions rise as over 200 million people look to displace themselves in the coming years.[4]

Beyond the shock and horrors of flooding, fires and hurricanes, the business case for collective action against climate change centres itself around the need to protect global supply chains. By 2050, humanity will have grown by another 25%, and will have 2 billion more mouths to feed. To reach that goal, our food and water supplies will have to double output just to keep up.

Against a backdrop of (relative) historic success in this area, this challenge may not seem so daunting. In fact, since 1913, humanity has managed to increase its supply chains 4000 times over, mostly coping with a population increase of over 178% in the same time period. Global Supply chains have consistently made these demand targets attainable through a consistent commitment to trade network diversity, becoming less reliant on fewer suppliers and becoming more attractive to more customers. Over time, sustainable supply chains have been formulated through an avoidance of geographic clustering of suppliers (Spatial Aggregation) , reliance on one supplier (Supplier Aggregation) and avoiding reliance on one product for production (Product correlation).

In this area, company size and scope dictates diversity. Automotive giant Volkswagen represents the best case in point, requiring 30,000 individual and independently sourced parts in order to create one of many single sellable units of output. Unrelenting in their globalised strategy, Volkswagen have diversified their customer base to a total of 153 countries, allowing sales to increase by 72% in 8 years.  Companies that do not at least try to emulate this kind of sourced complexity will face extinction in the wake of humanity’s upcoming climactic and existential threat.

In reaching modernity however, Humanity’s techniques in meeting exponential growth and demand has placed suppliers in an awkward position. With temperature records being broken year upon year, and with each added degree becoming disproportionately more destructive than the last, unprecedented wildfire destruction and frequenting hurricanes are now becoming the new norm.

The challenge of climate change is therefore one of compounded difficulty for all companies that are currently looking to increase supply chain, customer diversity, sales and ultimately sustainable profits. Unsurprisingly therefore, the proportional exposure for small to medium size enterprises, whose capacity to diversify dwarfs in comparison to Multinationals, will be over the medium to long term, disproportionately affected by rising ocean sea levels, acidity and temperature as well as the weather systems and ecosystems that they disrupt.

Supply chains that manage to ignore changing ocean compositions, especially in the subtropics, will need to guard against dramatic changes in their physiological composition. Most worrying to food production is the expansion of drylands, which now cover up to half of the world’s land mass, and are home to just under 40% of the population.

As seen in the last section, the political economies of the world have become increasingly introverted, just at a time when the call for collective action against climate change and its effects on supply chains is reaching its zenith. Where Governments and International fail, what can the private sector do to answer the call?

Helping Hands

Typically, it has been insurance that has made global production possible and export credit markets viable. Without effective risk management and insurance controls in place, companies’ access to credit ceases to make enterprise viable and their appetite for innovation overly risky. In more ways than one,  insurance protection is the key to maintaining confidence in the existing global supply network, all the way from food to car production. 

Typically, insurance has abated creditor fears through the offerance of  Business Interruption Insurance (damage to your assets), and Contingent Business Interruption insurance (damage to someone else’s assets that you need) that provides compensatory relief , keeping Income:Asset ratios healthy and leverage ratios suitably balanced. When severely  interrupted  however, businesses face adverse shocks to branding, revenue, market share and stock price volatility. No wonder then, that as many as 90% of medium-sized enterprises that  suspend trading for more than 4 days become insolvent the following year. Climate Change should therefore be creating a huge market for business interruption insurance, given the widening Insurance Gap between exposure and coverage. 

Whilst most would expect this situation to serve as a powerful corollary for dramatic uptake in Business Interruption Insurance, global purchases for Business Interruption Insurance have had a hard time keeping up. Far from increasing, medium to large sized firms are finding it increasingly efficient to keep risk within their own balance sheets. In fact, it’s estimated that 69% of supply side participants have no form of Business Interruption insurance. Herein lies the modern problem for the insurance market. Despite the widening Insurance gap, Insurers are becoming a less relevant option when firms look to manage their risk. For BI and CBI Insurance, the problems are far from small. 

Problems, solutions and more problems

In line with expectation, companies are universally adopting more and more technology. Some of the most impressive advances of the 21st century have come in the form of machine learning, advanced robotics and Artificial Intelligence, relieving business of their formerly sluggish productive potentials and performing much of the heavy lifting when it comes to operating complicated supply chains. Progression in cognitive automation, a scalable form of AI, allows the casual processing of terabytes or even petabytes of data, which is increasingly becoming integrated into physical and virtual (cloud based) technology.

Here is the start of the headache for insurers. Supply chain participants are jumping onto the benefits of technology faster than Insurers can evaluate the risks accruing to diversified supply networks. There’s simply too much data. Some of it is poor and some of it is irrelevant to the coverage in hand. Actioning large scale changes to historic supply chains off the back of poor data quality leaves insurers making ‘faith based decisions’ when assessing policyholder risk[5] and makes creating standard and bespoke contracts alike a particular difficulty.  As a result, Insurance is becoming at risk of either being too expensive or ineffective at providing suitable cover.

At the risk of becoming too despondent however, insurers have seen this as a challenge, not necessarily a barrier to growth. Technology and data are allowing Insurers to fight fire with fire. In fact, contemporary advances in Insurtech are signalling the potential capabilities of Supply Chain Trackers, Distributed Ledger Databases and Web Scraping facilities that all allow effective data analytics, monitoring and surveillance of exposure management. With the correct application, supply chain insurance can become adequate, timely and most importantly, relevant in their response to Policyholders’s needs. To facilitate this process, Insurance companies looking to streamline legacy processes and introduce innovations should consider collaborating with or even acquiring InsurTechs to benefit from their entrepreneurial culture and technical expertise. InsurTechs can benefit as well by taking advantage of established players’ market expertise, capital, and brand recognition.

In order to do that, insurers must plug the widening gap between what policyholders can reasonably cover themselves and the final cost of the bill. In terms of mitigation, multilateral decisions will need to be far more effective than previous efforts have been in achieving this outcome. Mandates like the Paris Climate Agreement and COP25[6] will need to be more effective in standing up to political alliances, which, discussed in the previous chapter are rapidly breaking asunder.

Technological Tacticians

Highlighted earlier was the brief mention of Technology as a main actor on the Geopolitical theatre, who now takes centre stage as the Industrial Revolution returns for its 4th performance in nearly 300 years. The accumulated benefits of such a revolution will directly accrue to the world’s online population who now outnumber those not connected, with one million additional entrants arriving everyday. The acceptance of the new age has promulgated a series of Technological waves, flexed with the tidal forces of innovation, technology supply, capabilities and complexity having all improved for the greater. In turn, humans are more social (⅔ world’s population now own a phone), more productive (14% increase in global growth in 10years) and more likely to solve humanity’s greatest issues.

Advocates and pessimists of technological change alike unite in their surprise for the sheer scale of progress that has been achieved in the last 30 years. It is authoritative personalities however, be them parents, businesses, regulators or governments, who are invariably forced to play catch-up as the medium to long term effects of technological integrity and revolution kick in.

Perhaps the most obvious to note, is the relief given to online Hackers and Cyberattackers in response to the due advantage given to faceless criminals when technological progress far outpaces regulatory sophistication. As mentioned earlier, this rapidly growing industry has managed to equip the world’s population and their businesses with a series of cost saving functionalities that often make advantage of integrating physical and virtual assets together. No surprise therefore, that nearly all businesses that are placed into the firing line of cyberattackers are immediately stagnated following Malware or DDOS attacks[7] that directly target business operations and steal data. Attacks in the US have increased consistently, enabling a 55% increase from 2010-2019. In particular, attackers are leveraging the exponential usage of the ‘Internet of Things’ market to increase attack frequency by 300% by 2025. Concerns like these only become more elevated when we scale to the effects these could have upon integral industries, like Energy, Healthcare and Logistics, whose combined commercialised data cost alone in 2019 reached upwards of $200 Billion. The aforementioned concerns of those responsible for safety are only legitimised in the face of other technological industries which are still in their infancy.[8]

 

Raising Standards

Having now identified the need for Security measures, Governments across the world have attempted to wrestle with the complexities of placing border restrictions on applications which facilitated international Trade and Communication. And yet, governments are all of them suffering from option paralysis when it comes to deciding on a mutually assured ‘best’ outcome, resulting from multiple trade-offs when determining technological regulation. 

Consider the following situation. If regulators allow businesses to freely innovate, gain competitive advantage over other countries and capture market share, governments are thus forced to enable undue private sector influence when it comes to standard settings. Worse, government infrastructure and military defenses are laid bare in the face of increasing Technological Warfare. Or rather, should governments place restrictions on tech in pursuit of long term security and risk foreign expropriation of virtual assets and see your country’s competitive advantage sink away? Increasingly, game theory across the world is being used to try and explain the possible steps governments are likely to take when it comes to deciding upon short term gains or long term security.

The answer, again, lies with and depends upon the effectiveness and harmony of the international community. Indeed, various countries across the world have sought to further their own leading capabilities by trying to promote their own data standards. The proliferation of which has made it increasingly hard for one data set to be adopted unilaterally. Take for example, the AI sector, which now has at least 80 different data frameworks, the Council of Europe’s inability to accord together partisans on the Budapest Convention, and the OECD’s failure to implement standards on Technology Taxes. This is only more bad news where international diplomacy is concerned, and has indeed led to and been made worse by geopolitical tensions described earlier in this series.

Technology and Political tensions once again take centre stage when it comes to Trade discussions. The UK’s  decision to implement 5G  communications over US equivalents, on top of following through with its new 2% Technology Tax, will only seek to frustrate the Sino-American War on telecommunications as well as jeopardising future UK<>US trade talks in the wake of Britain securing its economic future. Ruptured negotiations seen with US TTIP deals with the European Union is also another good example.

In order for Insurance services to properly benefit from leveraging the advantages of technological progression, the industry will have to be wary of the risks posed by multilateral indecision on standards and come to terms with trying to draft standards of their own, less they face the perils of policyholder information and other important data to be exposed. Secure outcomes in this arena however are likely to be rare, given the insurance industry’s aversion to its increasing irrelevance as a secure Transfer of Risk.  As long as insurance remains technologically deficient, it will need to remain conscious of the dependency of their  own innovation efforts recently outlined in its BluePrint One outlier, which plans to make effective use of the Internet of Things and Cloud-Based transformations. Following this level of implementation will also require insurance companies to recognise the importance (and of course, risks) associated with the disaggregation of their current Value Chains.

[1] https://news.harvard.edu/gazette/story/2017/02/in-europe-nationalisms-rising/

[2] Measured as Service Trade Restriction Index (STRI) by the OECD

[3] CPIA Fiscal Policy index aggregations over the last 8 years.

[4] International Organisation for Migration, Climate change and Migration

[5] AIrMic Hidden Vulnerabilities in Supply Chain Risk

[6] Efforts to homogenise climate change business rulebooks

[7] DDOS – Distributed Denial of Service. Whereby attackers overload traffic by overwhelming servers through multiple pathways.

[8] Quantum & Cloud Computing, 5G,  Artificial Intelligence

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