Learnings from Interconnected Risks to prepare for Climate Risk

Synopsis Interconnected risks are difficult to recognize before the initial event but are apparent with hindsight. While risk managers can only hope to become better at spotting warning signs, they can use previous interconnected risks to their advantage in the form of scenario analysis. Constructing scenarios where multiple risks occur helps organizations prepare for the next big event, such as climate change, and understand its impacts. learnings from interconnected risks to prepare for climate risk by Sonjai Kumar introduction The 2008 financial crisis. COVID-19. The Silicon Valley Bank debacle. Interconnected risks can be catastrophic. As we have seen with these examples, when it comes to interconnected risks, the crystallization of one risk can lead to multiple others. The main risk can have a cascading effect on the organization— and it may not be clear which will have the greatest impact: this main risk, resultant risks, or a combination of all. Most organizations performing risk management, whether integrated or in silos, plan for a single risk. Even stress tests are performed on one risk at a time and, often, catastrophic events are not caught. There is no doubt that it is challenging to spot the interconnected risks since historical data is not always available to calculate correlations— though initial signs of risks are always visible, and qualitative judgments are always to be applied. Because of the challenges of spotting interconnected risks, their mitigation becomes difficult, and an organization may easily find itself in crisis management mode. interconnections in action: COVID-19 Take the example of the COVID-19 Pandemic in late 2019. The novel coronavirus hit one country and rapidly spread to the rest of the world. The virus, in many cases, caused symptoms which included difficulty breathing, a higher risk of hospitalization, and sometimes loss of life. The spread of the virus globally was unanticipated, leading to lockdowns by different governments to limit contagion. The lockdowns led to the loss of jobs and the closure of factories, which sparked economic downturn. 30 Intelligent Risk - November 2023 Hospitalization claims and related deaths adversely affected insurance and reinsurance companies. As many of the insurance companies had passed on high risks to reinsurance companies, all reinsurers globally suffered very adversely. Various central banks reduced policy interest rates to boost economic activity; however, the movement in interest rates brought about asset-liability mismatches for financial institutions. For insurance companies selling maturity guarantee products, low interest rates are a risk. Figure 1: Interconnected Risks Example 1 The interconnectedness of risks can be seen: coronavirus leading to high insurance claims, lockdown, loss of jobs, economic downturn, and falling interest rates which, via their balance sheets, also negatively impacted insurance companies. Such emergence of risks from one main source can be studied through scenario analysis. Various plausible scenarios based on the current economic, demographic, and other factors need to be created and stresses applied through an array of scenarios to assess the potential impact on a company’s finances. the Russia-Ukraine war and SVB’s demise Certain risks should be known to the organization, but leadership either ignore them or are confident that the risks will not crystalize. Take the example of Silicon Valley Bank, which invested a high proportion of assets in government bonds when interest rates were low knowing that high interest rates could cause severe mark-to-market losses. The Russia-Ukraine war contributed to increased inflation, which led to central banks increasing rates, and triggered this exact outcome for Silicon Valley Bank. Other risks, like liquidity risk and customer withdrawals, crystalized in quick succession. In this situation, scenario analysis could have helped understand and predict the effect of interest rate stress. Intelligent Risk - November 2023 31 Figure 2: Interconnected Risks Example 2 Financial institutions should be practical in creating scenarios that could potentially lead to the failure of their organization. Spotting these scenarios quickly when an event happens and appropriately timing intervention is key to successfully avoiding possible failure. Velocity of risk plays a critical role in risk crystallization, so timely action is important. the case of climate risk A forward-looking case for the use of scenario analysis in the current context is climate risk. What could be the possible scenarios resulting from an increase in global temperature by increments of 0.25 degrees Celsius and the subsequent risks to human lives, agriculture, the economy, and the financial system? The impact of climate change on the job market could be over 900,000 lost job opportunities per year over the next 50 years in the US alone1.This can have a significant impact on the unemployment rate, resulting in negative consequences for lifestyle, mental health, and socioeconomic status. Further, the Swiss Re Institute anticipates rising temperatures will cut global GDP by up to 18% over the next 30 years2.This will have a significant impact on all of mankind. We are short of our 2030 net-zero emissions targets, and experts are already mentioning “Global Boiling” rather than “Global Warming.” Resultant rises in temperature may lead to prolonged excessive rain, impact daily human lives by creating a shortage of food items, inflate prices, adversely affect agriculture, jeopardize banking systems, grow insurance claims, and spread waterborne disease in addition to any unknown combinations of issues. This is not an unrealistic scenario as unfortunately predicted by unprecedented flooding in many parts of Thailand from July 2011 to mid-January 20123.The flood was so heavy that 13.6 million people were impacted and 3.3 million structures (750,000 of them residential) sustained damage as 65 of 77 provinces were designated as flood disaster zones—totalling USD $45.4 billion in damages. The catastrophe in Thailand offers risk managers seeking climate risk-based scenario data a way of constructing realistic shocks. Recommended reading4 on this disaster will help financial institutions build a full understanding, with the benefit of hindsight, of previously unforeseeable impacts. 32 Intelligent Risk - November 2023 conclusion There are many interconnected relations and resulting risks that the world needs to be prepared for. Interconnected risks are very important, and past events such as the 2008 economic crisis, COVID-19, the failure of Silicon Valley Bank, and floods in Thailand demonstrate that the causes of catastrophic events are correlated risks, not linear risks. Interconnected risks have quick resultant risks like nuclear fission, and by the time the primary risks are addressed, new risks explode. Historical events and well-constructed scenarios enable risk managers to use what we know about interconnected risks and see what unexpected risks emerge for their organization. This cannot solve future crises, given their unpredictable nature, but it can better prepare those with the ability and the speed to act. references 1. “Deloitte Report: Inaction on Climate Change Could Cost the US Economy $14.5 Trillion by 2070” (Jan 25, 2022). Deloitte. https://www2.deloitte.com/us/en/pages/about-deloitte/articles/press-releases/deloitte-report-inaction-on-climate-changecould-cost-the-us-economy-trillions-by-2070.html 2. “Annual Report 2021” (2022). Swiss Re Institute. https://reports.swissre.com/2021/vision-and-strategy/market-trends/climate-change 3. Sousounis, Peter. “The 2011 Thai Floods: Changing the Perception of Risk in Thailand” (April 19, 2012). Verisk. https://www.air-worldwide.com/publications/air-currents/2012/The-2011-Thai-Floods--Changing-the-Perception-of-Risk-inThailand 4. Kaewkitipong, L., Chen, C. and Ractham, P., 2012. “Lessons learned from the use of social media in combating a crisis: A case study of 2011 Thailand flooding disaster” (January 2012). https://www.researchgate.net/profile/Peter-Ractham/ publication/289741588_Lessons_learned_from_the_use_of_social_media_in_combating_a_crisis_A_case_study_ of_2011_Thailand_flooding_disaster/links/5efc448445851550508103d7/Lessons-learned-from-the-use-of-social-media-incombating-a-crisis-A-case-study-of-2011-Thailand-flooding-disaster.pdf authors peer-reviewed by Sonjai Kumar, CFIRM Elisabeth Wilson Sonjai Kumar is a consulting partner in Tata Consultancy Service working in India under the BFSI CRO Risk Advisory. He has a total working experience in the insurance sector close to three decades under both industry and in consulting areas. His expertise is in the areas of actuarial, enterprise risk management, operational risk, insurance and financial, risk culture, corporate governance etc. He is an enthusiastic risk management professional, a certified fellow member of Institute of Risk Management, London, and currently pursuing PhD in Enterprise Risk Management in the insurance sector. Intelligent Risk - November 2023 33