PROJECT M
 
John Drzik
Myles Allen
Michael Bruch

Conference call: a moving target

As the major transitions of our times continuously reshape the risk landscape, the financial service industry is faced with a multitude of interconnected risks – with the potential to lead to a domino effect

Conference call: a moving target

As the major transitions of our times continuously reshape the risk landscape, the financial service industry is faced with a multitude of interconnected risks – with the potential to lead to a domino effect


Michael Bruch

Gentlemen, aging societies and climate change, technological innovation and increasing geopolitical risk are just some of the major transitions we face. John, what is your analysis?

John Drzik

The range of risks is broadening, and their interrelationships are ever more complex. For 2017, I see two growing areas of risk: geopolitical risks, as nationalist, populist tendencies foster an economically protectionist climate, and emerging technology. The pace of technological innovation is leading to a growing threat of cyber-attacks as well as other new risk exposures. For example, artificial intelligence (AI) creates economic risks from job losses and new governance risks around liability ownership. Social instability acts as a two-way catalyst at the center of these developments as some risks feed social instability while others are fed by it.

Michael Bruch

What do you see as the major source of this instability?

John Drzik

Many people are struggling with their economic future either due to unemployment or retirement insecurity. This is creating pressure for political change and rising social unrest. While some of this is cyclical and will decrease to its normal level, some underlying structural trends are likely to continue and sustain social instability well into the future.

Michael Bruch

Such as new technologies. Between 1997 and 2007, as many as 86% of manufacturing job losses in the US were due to rising productivity and robotics. Protectionism is hardly a solution.

John Drzik

I agree. The current political reaction has been to become more nationalist, but this is not going to stop the rise of technology.

Michael Bruch

For the insurance industry, one challenge is a shift from tangible to intangible risk. Take, for example, business interruption, caused by a tangible risk, such as fire. Intangible risks, events without physical damage, are increasing. In this area, insurers are under pressure to provide innovative products, but also better advice and alternative risk transfer.

Myles Allen

My impression is that the financial service industry’s main exposure is to stranded asset risk, that is investments in technologies that will become inappropriate or outdated due to climate change. And it seems to me that the vast majority of the industry players are ignoring this risk. But maybe you see this differently. On the liability side, a changing climate challenges insurers in quantifying risk, as historical risk is no longer a particularly good guide. There is also the risk of governments intervening in the market, as was the case with flood risk insurance in Florida where private sector providers have essentially been driven out by subsidized state insurers. This is my perception from the outside but I am very interested to hear your thoughts.

John Drzik

Well, on the liability side, the insurance market has deep capacity to take on natural catastrophe and weather risks. Losses in recent years have not been that significant relative to some of the big years in the past. Right now, the capacity is broader than in the past as you have both traditional insurance and capital markets capacity. There are concerns that the latter might withdraw in case of a significant catastrophic event, but our view is that there is more stability in capital markets capacity than there was in the past. The risk modelling industry works together with insurers to build forward-looking models which aim to quantify the potential effect of climate change trends. Naturally, this is an imperfect science, but there is clear recognition that historical trends may not apply and a lot of brain power is going into this industry.

Myles Allen

Do you see state-subsidized insurance, as it was offered in Florida, as a risk?

John Drzik

I don’t think it is a very good idea for governments to intervene in insurance markets that can be better handled by the private sector. With respect to natural catastrophe events, there is also a limitation to what governments could and should do, simply due to the scale of the risk.

Michael Bruch

Such offers create major distortions as they are a disincentive to invest in flood or other loss prevention measures. Additionally, they make the construction of more homes in flood-prone areas more likely as protection is guaranteed.

Myles Allen

Clearly yes, and we see that in the UK.

Michael Bruch

Regarding the stranded assets risk: the market does not allow cherry picking in the sense that an insurer can choose to cover a utility’s wind turbines and solar devices but leave out its coal-fired energy production. But I would also like to raise the issue of interconnectivity. Is there a semblance of the financial crisis in these transitions?

John Drzik

The financial crisis was a cascade of directly connected events that followed from an initial stimulus event. In the interrelationships among current risks there are connections that are less direct but could still create a domino effect. Let’s say there is civil unrest in a country, stimulated by high unemployment. This might create pressure for policy changes which affect how a country interacts politically and economically with others. This could lead to political conflict between countries in other spheres, such as climate change policy or cyber governance. So one pressure pushes another one to the brink which in turn pushes the next one. But these events are not as directly interlinked as was the case in the chain reaction that was the financial crisis.

Myles Allen

There is a little-noted clause in the addendum to the Paris climate agreement. It states that article eight on loss and damage due to climate change shall not provide a basis for liability and compensation. The fact that certain countries felt it was necessary to write that into the agreement makes it clear that this is becoming a concern. To me, the tensions that can arise from the fact that one nation’s actions can cause weather events in another state are the greatest threat of climate change. Conflicts based on the uneven effects of climate change will occur long before melting ice sheets and rising sea levels become an issue.

Michael Bruch

Lawsuits against energy providers, such as the German firm RWE, are a first signal of that.

Myles Allen

Right. It may be difficult to establish a causal link now, but it will not always be impossible. As the science becomes clearer and the impact of weather events more costly, there will be pressure for a liability regime.

Michael Bruch

That is why we regularly screen the emerging risk landscape to understand the impact of new technologies such as autonomous cars, drones or 3D printers.

John Drzik

In our experience, the top risk on the minds of business executives today is the threat of cyber-attacks. Cyber needs to be treated as a risk topic, not an IT topic. Looking ahead, we expect to see more sophisticated frameworks to deal with the economics of cybersecurity.

Michael Bruch

What do you think are the unknown unknowns in terms of transition risk? What is happening in our blind spots?

John Drzik

Well, one area could be artificial intelligence. AI is being built into more and more products, devices and services. It may be a known risk but we don’t know yet how it is going to play out. Biotech and nanotech have some similarity. They offer significant potential for productivity growth, but I don’t think that our risk governance has caught up yet with the innovation in these areas.

Myles Allen

I think we have to acknowledge that many of us were caught out by the recent resurgence of political risk. That ought to be a lesson. So although political risk is a known unknown, the form it could take is open. While we have seen a resurgence of the anti-government, antiregulation populist movement, we have not yet seen a complementary resurgence of the populist left. There is the real risk of heavy-handed political intervention, not just in the insurance sector.

Michael Bruch

One of the things that come to my mind is the transfer of tasks from humans to machines. So the question is how to engineer intelligent systems that take over social obligations. Meanwhile, many thanks for your time and insights, gentlemen.

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