A Taxonomy of Threats for Macro-Catastrophe Risk Management

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Cambridge Centre for Risk Studies Working Paper Series1 Context and Objectives1.1 Catastrophes and SocietyThe modern world is vulnerable to the disruption of the social and economic systems that serve it.Periodically events occur that disrupt our daily lives and force changes to the ways we do business,disrupt the trading patterns of commerce, interrupt economic productivity, and devalue financialinstruments and assets. Extreme events are described as social and economic catastrophes. Wherethey cause severe impacts to more than one continent, they can be termed ‘global shocks’ or ‘macrocatastrophes’.There are many potential causes of macro-catastrophe, ranging from epidemics, tofinancial credit availability, localized destruction of means of production, and geo-political disruptionto trading systems. Managing the risks of disruption from macro-catastrophes is a major concern ofgovernment national security, international businesses, financial services and insurers, andinvestment managers across the world.1.2 Catastrophe risk management in the insurance industryThe management of risk from natural catastrophes (hurricanes, wind storms, earthquakes, floods andothers) is now a mature science. Natural catastrophe risk models have been available since the early1990s. Companies and individuals owning property that is at risk from natural catastrophes in manyparts of the world can buy insurance to transfer their risk, and the insurers and reinsurers canprofitably offer this coverage, knowing from their catastrophe models how to safely diversify this riskand avoid incurring ruinous losses.However, there are many other types of extreme events beyond natural catastrophes that pose a riskof loss to global companies. These are less well understood and the science around them may not beas well advanced. Some types of threats may not have been experienced in recent history and may belargely unappreciated. Recent years however have seen a series of occurrences of events that havebeen highly disruptive to global businesses, ranging from volcanic ash clouds, to disease outbreaks, tosocial unrest, cyber-attacks, and a wide range of other geopolitical, technological, financial, andenvironmental events that have impacted global trade and commerce. As each new type of eventoccurs, society reacts retrospectively to recognize the threat and put new safety measures into place,and companies often instigate new risk management techniques specifically for the threat that has just‘emerged’. And yet few of these disruptive events are unprecedented. It is common for riskmanagement discourse to be around ‘emerging risks’ or unforeseen perils, ‘Black Swans’ or othersurprises. Many companies have instituted ‘emerging risk’ monitoring systems, committees, or otherprocesses.It could be argued that instead of new threats becoming more common, globalization of our economyis the real driver of this emergence of frequent disruptive events: businesses that only a decade or soago were serving regional markets and familiar with the variables of one localized part of the worldare now serving global markets, carrying out business activities in hundreds of cities worldwide, andreliant on travel and communications infrastructure to interlink all their business activity into a globalsystem. These interlinkages of the global business system are vulnerable in a very different way to thephysical infrastructure of regional businesses of past generations. The world is a volatile place, andextremes of weather, geophysical processes, political and social patterns occur periodically in manylocations – possibly no more frequently that they have done before. Now however, the globalcorporations notice these extreme events in an entirely new way, as they impact some part of thelinkage structure of their global business.Global businesses are looking for ways to manage the balance sheet risk of these disruptive events,and to be better prepared for future new or ‘emerging risks’. Many of these macro-catastrophe risksCambridge Centre for Risk Studies 2
Cambridge Centre for Risk Studies Working Paper Seriesare systemic in nature – i.e. they have the ability to impact not just a single company but manycompanies, including the main business counterparts of the business and possibly many parts of theeconomic system at the same time.The systemic nature of these macro threats makes them more complex for insurance companies tocover. Traditionally insurance companies manage their risk across many different lines of business,such as property, casualty, marine, aerospace, energy, life, health, trade credit etc. These arecompartmentalized and managed under the assumption that they are broadly independent. Somemacro-catastrophes are capable of causing systemic losses across multiple lines of insurance business,and potentially even simultaneously causing a financial markets crisis, in which the insurer sufferslosses in their investment portfolio at the same time as experiencing high claims levels.Insurers and global corporations both have an interest in understanding the global risk landscape ofmacro-catastrophe threat. If these threats are better understood, they can be managed effectively bydiversification and risk management. If they are insurable, then insurance companies could extendtheir utility to global corporations in offering coverages that provide protection to the corporatebalance sheet, in ways that may not be possible today.1.3 Emerging Risk TerminologyThere is a lot of different terminology currently being used to describe these various types of systemicand unexpected risks. In some cases the terms have subtle differences. Terminology in common useincludes the following, with a suggested definition of this term and an example.Emerging RisksA cause of potential extreme loss that is becoming apparent or more significant than previouslyunderstood, either because the threat itself is growing, or because society is increasing itsvulnerability to that cause of loss.e.g. cyber catastrophe risk, climate change, laboratory-originated pandemicsCorrelated Risks / Cascading Risks / Consequential RisksOne type of peril triggers an event of another type, to cause a much more extreme event.e.g. a large earthquake causes a tsunami that triggers a nuclear meltdownClash Risks / Contingent Risks / Network Risks / Macro-CatastrophesAn event that causes losses across several lines of insurance business or that causes loss inunexpected locations or across multiple geographical markets because of the interconnectivity ofbusiness connections to the region affected.e.g. Thailand floods causing contingent BI losses to US business supply chainsSystemic Risks / Financial Contagion / Exogenous and Endogenous RisksEconomically-impactful threats that ripple through business and financial systems. The term‘systemic risk’ is commonly used in financial risk management to mean events and practicescapable of causing consequential effects throughout the financial system, so tends to have aspecific meaning in financial regulatory practices.e.g. Housing price bubble’Black Swans’ 1 / ‘Known Unknown’ 2 Risks1Taleb (2010) The Black Swan: The Impact of the Highly Improbable.2Term popularized in a press statement by Donald Rumsfeld, United States Secretary of Defense, February 2002, addressingthe absence of evidence linking the government of Iraq with the supply of weapons of mass destruction to terrorist groups.Cambridge Centre for Risk Studies 3
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A Taxonomy of Threats for Macro-Catastrophe Risk Management

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