Climate Change is widely regarded as being a threat to society at large and now needs to be regarded as a systemic risk according to the authors of a new academic paper written for the publication, Advances in Climate Change Research.
Systemic Risk as defined by the Financial Stability Board (FSB) as the risk of disruption to the flow of financial services that is either caused by ‘an impairment of all or parts of the financial system’ and has the potential to have serious negative consequences for the real economy.
As the authors of the report argue, Climate Change is a systemic risk, as it is “a holistic risk generated by the interconnection, interaction, and dynamic evolution of different types of single risks, and its fundamental, defining feature is cascading effects. The extent of risk propagation and its duration depend on the characteristics of the various discrete risks that are connected to make up the systemic risk.”
The report argues that the increasingly complex connections among different socioeconomic systems, and continuous changes in exposure and vulnerability, have created the conditions necessary for Climate Change to now become a systemic risk.
The paper contrasts “conventional risks” whose impacts are bounded and limited, with the risks of climate change, which are systemic. The direct impact of climate change is local, but it has knock-on effects across regions and sectors, and “through interconnected socioeconomic and financial systems, which are secondary risks generated by the propagation of direct risks in the human system.
The authors also highlight the “interaction between climate and complex human systems such as global food markets and national and international security.”
At a high-level view, systematic risk caused by climate change can be broadly classified into emergency risk and incremental risk. Emergency risk often arises from a shock event - a ‘black swan’ event.
A feature of incremental risk is the fat tail effect. Changes occur slowly, which means that the consequences take a long time to emerge, and long-term consequences are easily underestimated at first, hence the Chinese old saying “one ant hole may cause the collapse of a thousand-mile dyke (qian li zhi di kui yu yi xue).”
Therefore: “Incremental risk often arises from ‘grey rhino’ events. Compared with the unpredictability and sporadic occurrence of a black swan event, a grey rhino event is not a random incident, but a high-probability event that occurs following a series of signs and warnings. Once incremental risks cross a critical point, they are difficult to manage. Most climate change-induced systemic risks are incremental risks.”.
From a (re)insurance perspective, once a systemic risk occurs, it often cascades in a way that is hard to predict. Because of this, any framework that seeks to name and know systemic risk is challenging.
Therefore: “Systemic risk analysis usually assumes a scenario first and then deduces the conditions for the occurrence of the scenario backward. Incremental risks are usually less obvious but can pose serious threats. Their long latent period leads to severe underestimation of long-term consequences.”.
Another paper on this theme: “Climate Endgame: Exploring Catastrophic Climate Change Scenarios” – shows that conventional scenario analysis understates the long-term risks, because it fails to analyse more extreme climate outcomes (the fat tails).
As the statistician Nassim Taleb has pointed out in the context of financial markets, conventional models struggle to handle the consequences of fat-tail events, creating a dangerous blind spot in their outlook, according to an article in Project Syndicate.
More connected risk equals a fatter tail which is potentially a huge exposure for reinsurers not capturing the potential losses across their entire portfolio, exposing them, their cedants and the ultimate insureds to a protection gap that spirals full circle in a “doom loop” of capital value destruction.
There is an opportunity for (re)insurers, brokers and corporates to collaborate and work on forward looking connected insights that offer hopes to businesses worried about their continued viability in a world of grey rhinos and black swans.