GREY SWANS AND BLACK ELEPHANTS: WHY WE KEEP GETTING SURPRISED AND WHAT WE CAN LEARN FROM THEM

Rade Musulin Principal, Finity Consulting, Sydney, Australia

Leigh Wolfrom Policy Analyst, Directorate for Financial and Enterprise Affairs, OECD, Paris, France Agenda Rade Musulin, Finity • Catastrophic complexity, swans, elephants, and butterflies Consulting • Big mistakes and examples of catastrophic complexity • Grey swans • Evolving the risk management paradigm “A Black Swan has three attributes: unpredictability, consequences, and retrospective explainability.” Catastrophic complexity, - Nassim Taleb swans, elephants, “Everything under heaven is in and utter choas; the situation is butterflies excellent.” .ELECTED WORKS OF - Mao Tse-tung MAO TSE-TUNG \' lu1m I David Brooks

Opinion Drilling for Certainty

By David Brooks

May27. 2010 f Ill

In the weeks since the Deepwater Horizon explosion, the political debate has fallen into predictably partisan and often puerile categories. Conservatives say this is Obama's Katrina Liberals say the spill is proof the government should have more control over industry.

But the real issue has to do with 1isk assessment. It has to do with the bloody crossroads where complex technical systems meet human psychology.

over the past decades, we've come to depend on an ever-expanding ru-ray of intricate high-tech systems. These hardwru·e and software systems are the guts of financial mru·kets, energy exploration, space exploration, air travel, defense programs and modern production plants.

These systems, which allow us to live as well as we do, are too complex for any single person to understand. Yet every day, individuals ru·e asked to monitor the health of these networks, weigh the tisks of a system failure and take appropriate measures to reduce those tisks.

If there is one thing we've leru·ned, it is that humans are not great at measuting and responding to tisk when placed in situations too complicated to understand.

In the first place, people have trouble imagining how small failings can combine to lead to catastrophic disasters. At the Three Mile Island nuclear facility, a series of small systems happened to fail at the same time. It was the interplay between these seemingly minor The New York Times events that led to an unanticipated systemic crash.

https://www.nytimes.com/2010/05/28/opinion/28brooks.html

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 5 Drilling for certainty – The Deepwater Horizon

• On the Deepwater Horizon debacle, “…the bloody crossroads where complex technical systems meet human psychology” • Humans often design systems which: • let small failings lead to catastrophic disasters • allow ourselves get acclimated to risk • place too much faith in elaborate backup devices • match complicated systems with complicated governance • spread good news and hide bad news CBS News • are overcome by “Groupthink” • “We have constructed a world in which the potential for high-tech catastrophe is embedded in day to day life”; he referred to this as “catastrophic complexity”

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 6 Nassim Taleb and Gregory F. Treverton

A FOREIG 9 AFFAI~ ~bylM COUIIOI oa Fom,p R.tI.atDII

January/ J- e bruary 201 '.> [SSAY

The Calm Before the Storm Why Volatility Signals Stability, and Vice Versa

Nassim Nicholas Taleb and Gregory F. Treverton

NASSIM NICHOLAS TALES is Distinguished Professor of Risk Engineering at New York University's Polytechnic School of Engineering ond the outhor of Antifraglle: Things That Gain From Disorder /1 ] . GREGORY F. TREVERTON is Chair of the U.S. National Intelligence Council. Fram 2009 to 2014, he was Director of the RAND Corporation's Center for Global Risk and Security (where he wrote this article). This essay" adapted from a RAND risk-methodology repon funded by the U.S. government.

Even as protests spread across the Middle East in early 201 1, the regime of Bashar al -Assad in Syria appeared immune from the upheaval. Assad had ru led comfortably for over a decade, having replaced his father, Hafez, who himself had held power for the previous th ree decades. Many pundits argued that Syria's stu rdy police state, which exercised tight control over the country's people and economy, would survive the Arab Spring undisturbed. Compared with its neighbor Lebanon, Syria looked positively stable. Business Insider Leading Authorities Civil war had torn through Lebanon throughout much of the 1970s and 1980s, and the assassination of former Prime Minister Rafiq Hariri in 2005 had plunged the country into yet more chaos.

11 1/iJtory of the But appearances were deceiving: today, Syria is in a shambles, with the regime fighting for its very survival, U.S. National fr11PfligP11Ct! C.Ou1,cil whereas Lebanon has withstood the influx of Syrian refugees and the other considerable pressures of the TH E civil war next door. Surprising as it may seem, the per capita death rate from violence in Lebanon in 2013 was lower than that in Washington, D.C. That same year, the body count of the Syrian conflict surpassed BLACK SWA Nassim Taleb is Distinguished 100,000. Professor of Risk Engineering Gregory Why has seemingly stable Syria turned out to be the fragile reg ime, whereas always-in-turmoil Lebanon at New York University’s Treverton is the has so far proved robust? The answer is that prior to its civil war, Syria was exhibiting only pseudo-stability, former Chair of its calm fac;ade concealing deep structural vulnerabilities, Lebanon's chaos, paradoxically, signaled 4li Tandon School of Engineering strength. Fifteen yea rs of civil war had served to decentralize the state and bring about a more balanced the U.S. National Th ,• I M"' "' or t h r and author of “The Black sectarian power sharing structure. Along with Lebanon's small size as an administrative unit. these factors II I G II L, I \I P II O U \ U I. t: Intelligence added to its durability. So did the country's fre e-market economy. In Syria, the ruling Baath Party sought to Swan” control economic variability, replacing the lively chaos of the ancestral souk wi th the top down, Soviet p Council style structure of the office building. This rigidity made Syria (and the other Baathist state, Iraq) much more t~litN.l b) vulnerable to disruption than Lebanon. l\assim Nicho las Tnl eb Uobert I lutchin~ & Grq.;ory f'. Tn.:\-Crton https://www.foreignaffairs.com/articles/africa/calm-storm

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 7 The Calm Before the Storm

• Why volatility signals stability, and vice versa • Past experience is a good indicator of “normal” risk, but a bad bellweather of tail risk • Instead of trying to predict “black swan” events, it is more fruitful to focus on how systems can handle disorder • Generally, systems which experience periodic and moderate amounts of change and disorder become more Crop failures resilient, while ones which suppress change and natural cycles become fragile (e.g. periodic disorder is a vaccine against massive upheaval) • Do efforts to create stability sow the seeds for “black swan” events? From top: NASA, Foreign Policy, CNN

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 8 Black elephants

• A black elephant is a cross between “a black swan” (an unlikely, unexpected event with enormous ramifications) and the “elephant in the room” (a problem that is visible to everyone), something no one wants to address even though we know that one day it will have vast, black-swan-like consequences • • “There are a herd of black elephants around, such • as global warming, deforestation, ocean • • acidification, mass extinction and massive fresh • water pollution” (Adam Sweidan, 2014) • • Is COVID-19 an example of a black elephant? A GLOBAL PA DE IC EXERC SE e https://www.centerforhealthsecurity.org/event201/

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 9 Butterflies

• The “butterfly effect” per Cambridge Dictionary: • Refers to a situation in which an action or change that does not seem important has a very large effect • Chaos theory relies on the idea of the "butterfly effect," that even slight imbalances in starting conditions lead to huge final variations in outcome because of the fundamental instability of the system • Important to understand that small, random events can have enormous consequences • Examples: • Gore vs. Bush A plot of Lorenz's strange attractor for values ρ=28, σ = 10, β = 8/3 • Archduke Ferdinand’s driver made a wrong turn in 1914 Wikipedia • Lt. Col. Petrov chose not to report false missiles in 1983

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 10 “I’ve always believed that America’s government was a unique political system — one designed by Big mistakes geniuses so that it could be run by idiots. I was and examples wrong. No system can be smart enough to survive this level of incompetence and recklessness by the of catastrophic people charged to run it.” complexity - Thomas Friedman, New York Times

2008 Carrington Event – it happened before (technology) (I)

A, STORM . OF ELECTRICITY TELEGRAPH . WIRES USELESS JfOR SMVERAL HOURS. In 1859 a severe solar storm ONE OF TIIE MOST SEVERE DISTonnANCEB FOR MANY YEARS, EXTENDING EVEN TO caused auroras visible as far south EUROPE-TELEPJIONE 'IVInES ALSO OB· BTRUCT&D-BUSIN&SS DELAYED A GOOD PART OF TIIE DAY. as the Caribbean and knocked out Yesterday's storm was accompanied by a more serlou~ electrical dlsturbaooo tbau hat been known for years. It verv seriously affected the workloi:s or the telegraph lines both on tho land telegraph communications. A and In the sen, 11nd for three hours-from O A. Y. until noon-telegraph business east or tbe MIHls· tlppi !ind north or WBSblngton was at a stand-still. similar event today would cause DAILY COURIER massive damage to electrical grids, ,v.£D ESDAT, SEPT.1:il1DJE B 14, 1860, · Northf:rn Light-, in the Tropic,, and satellite communications. All our exchnngu from the northern coast or tho Isl ud o( Cubu- fr<,111 the ,outbcrn sido ..-e b,n:e '?one!'! h.te-come to us ..- ilh glowing de­ acr1pt1one ot the rccei,t Auror:i llorcalis which Losses would be in the trillions ~pptnr to h:.Te been o bright iu the tr~pics u tn the Norlbern r.c n ~. :. o,1 fur 111oro iu1er ting. At Hnnoa IL mnde ll~ appearance n fell' minutea after nine o'clock, nud io the mo&t appro<-cd ,tyle and services might be disrupted not aa here, i:re.du~!IJ cnmsooiog o-rer tbo, kv' but quick aa ,bought 1l s!J ot up, nod in II momeii~ spro d orer the whole l\ortbero zone, from t be horizon to lbe zenitb. At firs ·t "d.S -rer.r bril­ for years. lie.01, but nt h,\lf-pnst nioa it be uo to lo! e eoma­ wb:it of ile coloring, l!.9 it <1id of its length, and at ten it cisappeisrcd ultogetbcr. Tho eky was as clear aa before.

Clockwise from upper left: NASA, Australian Broadcasting Corporation, Daily Courier, NASA

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 12 European air crisis – it happened before (technology) (II)

Estimated Spread of Volcanic Ash Cloud

SATURDAY, 2 A.M. (Eastern Daylight TTme)

GREENLAND (DENMARK)

ICELAND

Eyjafjallajokull• St.Petersburg volcano •Oslo • Volcanoes have been Moscow Berlin Warsaw • London • • • affecting Iceland for

Source: BritiSh Met Office thousands of years; why did no one think about the risk they posed to jet airplanes?

Clockwise from upper left: Royal Society, UK Met Office, Wikimedia, RT

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 13 Tohoku – it happened before (technology) (III)

Japan built a nuclear power plant in a known tsunami zone with a six-foot sea wall and failed to waterproof the backup generators.

Clockwise from upper left: Amazon, Blogspot, Wordpress, Blogspot

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 14 Thailand floods – unmodeled and unaware

Many failed to anticipate the effect of the Thai floods because there were no flood models, but just because a risk is not modelled does not mean it does not exist.

From top: BBC, CNN

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 15 Australian floods – managing one risk creates another

Water 2011 , 3, 11 49- 1 I 73; doi: I0.3390/w304 11 49 IIJRriiiii-ii water A dam built in the 1970s to manage ISSN 2073-444 1 www.mdpi.com/journaUwater Article flood risk was allowed to reach full The 2011 Brisbane Floods: Causes, Impacts and Implications capacity following a prolonged Robin C. van den Honer! * and John McAneney Risk Frontiers, Macquarie University, NSW 2109, Australia; E-Mail: [email protected] drought; a strong La Niña developed, * Author to whom correspondence should be addressed; E-Mail: [email protected]; Tel.: +61-2-9850-442 1; Fax : +6 1-2-9850-9394. several large rain events occurred, https://research-management.mq.edu.au/ws/portalfiles/portal/16832889/mq-19234- Publisher+version+%28open+access%29.pdf the dam overflowed, and billions of dollars of losses occurred where they were not supposed to. This illustrates the human factor in risk – how do you model the behavior of dam operators?

Courier Mail

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 16 We were warned and we ignored it

(fj FEMA

Hurricane Pam Exercise Concludes ~ rimson ~ Contagion r.f- -AS~~ BATON ROUGE, La. -- Hurricane Pam brought sustained winds of 120 mph, up to 20 inches of rain in parts of southeast Louisiana and storm surge that topped levees in the New Orleans area. More than one million residents evacuated and Hurricane Pam destroyed 500,000-600,000 buildings. Emergency officials from 50 parish, state, federal and volunteer organizations faced this scenario during a five-day exercise held this week at the State Emergency Operations Center in Baton Rouge.

The exercise used realistic weather and damage information developed by the National Weather Service , the U.S. Army Corps of Engineers, the LSU Hurricane Center and other state and federal agencies to help officials develop joint response plans for a catastrophic hurricane in Lou isiana.

"We made great progress this week in our preparedness efforts," sa id Ron Castleman, FEMA Regional Director. "Disaster response teams developed action plans in critical areas such as search and rescue, medical care, sheltering, temporary housing, school restoration and debris management. These plans are essential for quick response to a hurricane but will also help in other emergencies.•

"Hurricane planning in Louisiana will continue," said Colonel Michael L. Brown, Deputy Director for Emergency Preparedness, Louisiana Office of Homeland Security and Emergency Preparedness. •over the next 60 days, we will polish the action plans developed during the Hurricane Pam exercise. We have also determined where to focus our efforts in the future.•

Res ipsa loquitur (Latin: "the thing speaks for itself")

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 17 Beirut blast - becoming acclimated to risk

Authorities allowed a huge amount of ammonium nitrate to be stored in a poorly ventilated warehouse for years. Despite risks being well known to authorities, no action was taken to reduce exposure. The resulting explosion leveled much of Beirut’s port district.

From top: Irish Sun, News 18

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 18 Risk management observations

• These events (and many others like them) illustrate several important things about risk management (or the lack of it) in many situations: • Our world has become complex, interdependent, and subject to risks which are difficult to extrapolate from past events • A key issue is the collision of natural hazards and modern society • We often become too comfortable with our modeling and ignore risk that falls outside our models • Human factors are important and hard to model • However, as we will see in the next section, we have a remarkable capacity to adjust to risk and mitigate it

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 19 “Study the past if Grey Swans you would define the future”

- Confucius The gold standard and free-floating exchange rates

$2,000

• Gold standard widely used until 1971 $1 ,800

$1 ,600

• Each country’s paper currency is based on some $1 ,400 fixed quantity of gold, exchange rates stable $1 ,200 $1 ,000 • In 1971 US abandoned standard and countries $800 $600 adopted floating exchange rates $ 400 $ 200

• Significant disruptions occurred 1950 Source: https://steemit.com/bitcoin/@bobgillvan/gold-volatility-vs-bitcoin-after-usd-left-the-gold-standard • Many firms caught (example Laker Airways) • Widespread disruption • New tools • Foreign exchange hedging • Enterprise Risk Management (ERM) • Currency options, derivative markets

Airlinepictures.net

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 21 1970s oil crises and inflation

• Two oil shocks led to huge increases in oil Australian and US Inflation 1960-2014 1973 {Sources: RBA and FRED) prices and a large bout of inflation First Oil • Many financial firms had mismatched assets Shock and liabilities

.., 0 N m ..... :g ., 0 N ...... "' ~ ., ., ., .,"' ., ~ 1979 :!: ~ :!: :!: :!: :!: :!: l;l ~ ~ l;l > .D > <> li i ~0 i 0 <( g ,,: • New techniques developed Second Oil i i .'f ~ 0 z 0 z c5 Shock --AU Year-on-Year CPI Inflation --AU Expected Inflation (lOy break even} • Contractionary monetary policy US Year-on-Year CPI Inflation Note: AU 1nnation adusted for one-time change in prke level due to GST. • High interest rates Source: https://theconversation.com/look-at-the-data-to-understand-the-risks-for-the-australian-economy-28311 • Use of inflation linked bonds • Asset/Liability matching (ALM) • Enterprise risk management (ERM) • Have lessons of this era been forgotten?

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 22 Hurricane Andrew - catastrophe risk management

• Andrew decimated insurers: • Destroyed 63,500 homes and damaged 124,000 others • 11 insurers became insolvent • 900,000 policyholders lost coverage • Massive rate increases • Andrew demonstrated risk control failures: NOAA, Wikimedia

• Inadequate pricing techniques, previously US hurricane insurance losses as percent of US industry capital· based on “excess loss (wind) procedure” • Poor understanding of large loss potential

• Cheap insurance = overdevelopment, poor !Katrina Andrew Maria llrma Sandy Ike HaNey Wilma Ivan Rita building practices 2005 1992 2017 2017 2012 2008 2017 2005 2004 2005 Source: Sigma (No 1 / 2018), Swiss Re Institute

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 23 After Andrew

• Government actions: • New regulatory structures for solvency and Florida Hurricane Catastrophe Fund price regulation • Formation of government reinsurer, insurer, and stronger insolvency fund • Stronger building codes • Insurer risk management improvements: ~ ITIZENS • Sophisticated catastrophe models PROPERlY INSURANCE CORPORATION • Exposure management • New insurers and reinsurers • New pricing techniques • Led to a recovery of the insurance market

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 24 World Trade Center – 9/11

• Government response: • “War on terror” • Airport security screenings • Hardening of infrastructure • Huge investment in security • Risk pools (ARPC, Pool Re, TRIA) • Insurer risk management improvements: • Terrorism models • Policy wordings • New pricing techniques From Top: New York Dailey News, • Led to a partial recovery of the terrorism POOL National September 11 Memorial reinsurance market REINSURING TERRORISM RISK

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 25 Global Financial Crisis of 2007-2008

• Causes:

• Exotic financial instruments (CDOs) Dow Jones (1987-06-19 through 1988-01-19) • 2800 Banks taking excessive risk 2700 r \ 'I 2600 • US housing bubble I/ V \_J-1 2500 I \ _,f'l"1 v--1 \./ • Relaxed regulation 2400 \

2300 \ • I Response – stronger capital requirements: 2200 • Overhaul of financial regulation 2100 (\ 2000 • \ { ;I\ Uv Introduction of Basel III in 2010 1900 'l\~J\. 1800 V '1/V • Contingent capital requirements lJ 1700 • Higher capital quality and larger buffers 07/01/87 08/01/87 09/01/87 10/01/87 11/01/87 12/01/87 01/01/88

Source: https://favpng.com/png_view/stock-market-black-monday-wall-street-crash- • Capital maintenance and reporting requirements of-1929-stock-market-crash-dow-jones-industrial-average-png/BGigWUhV • Are similar issues lurking (google “CLO”)?

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 26 Lessons from the past – surprise, surprise

• There are many other examples of events like this • Most or all these examples contain elements of black swans, black elephants, and butterflies; they also illustrate concepts of fragility and catastrophic complexity • In each case the situation looked dire in the moment, but new institutions and tools emerged to manage risk • There are lessons in these events for the current COVID-19 pandemic: • Risk is best understood through a combination of models and mindset • Complex systems are rife with interconnected risks • Human psychology is a key factor, and something very difficult to model • Risk mitigation and adaptation can transform seemingly impossible problems • Many risks are global; neither viruses nor carbon, for example, respect borders

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 27 A final thought…calamities can be avoided

• Y2K • Montreal Protocol on Substances that Deplete the Ozone Layer • Tylenol poisoning (1982) and tamper- resistant packaging • “Nutrition Facts” labeling • Depletion of fish stocks – cod recovery • Lead paint phaseout • 4 Florida hurricanes 2005

Centerfor ;"~ Jet Propulsion Laboratory I Near Earth Object • Center for Near Earth Objects , California Institute of Technology cneos Studies

From Top: Weekly World, NASA, NASA

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 28 “Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that Evolving the is to say we know there are some things we do not risk know. But there are also unknown unknowns—the management ones we don't know we don't know. And if one looks paradigm throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

- Donald Rumsfeld McKinsey: Six problem-solving mindsets

Faced with an inscrutable problem? Try a more creative approach. McI

Being ever-curious Six problem-solving about every element of your mindsets for very problem Practicing Being an uncertain times show and tell, imperfectionist, recognizing with a high Even the most inscrutable problems have solutions­ that storytelling tolerance for or better outcomes than have been reached so far. Herc's how the best problem solvers crack the code. begets action ambiguity bf Charles Cam ood Robert Md..ean 6 mutually Great problem solvers au:t mado. not boln. !hat's what we've found allOf docades of pioblcm solving with leade!s across bus.111CSs, nof'4)rohl, and pohcy sec lots. These reinforcing leaders learn to adopt a pa1 hculaily oi>en aod cu,k)OS rr"liodset. afld adhele to a Tapping into sysl~latic pmcess lex cracking eve-,1 1he most inscrutable problems. They'1e terrific mindsets Having a problem sot,t!l's under ar,y cond1 t1MS. And when (.°00d1l100S ol uncE!f lainty cue al ll~r collective intelligence, dragonfly-eye paak.thf:iy'real lheu bc1lianlbesl. acknowledging view of the world, Six mutually remfOl'o l'ig &1>1>1oaches urtdefty 1hen success: (1) berig eveN:u11ous that the smartest to see through about ew:- ryfflel'll(!l1I at a pwblem; ('2) being imperfectiornsts, with a high tolerance lot people are not ambtgt11 ty: (3) having a "dtagonflyeye"view ol lheWOlld. losoo thlOIJ(Jh mulhplelooses: multiple lenses (4)pu,stung occuuenf behaviof and expcrnnenbog 1clc n Uessly: (6) lapping into the in the room Pursuing coJlectJ11e lnteaigence, ockoowlo:,dgiog that the sma,1est J)(!Opleare nol in the 100111; and occurrent behavior (6) practicirio ·snow and /ell." because stt)lylelling begels achon (exhibit). and restless Here's how lt\Qy do1t. experimenting

I . Be ever-curious Asaoy pa,ent knows, fou,.ye..1r.c~ds me uncoasmg asl«Hs. lhink ol lhe ooveM'Jndmg •wtiys• that make l1lHo duld1Ct1 so deAtg hl1 ul- and 1clef1lless. F01 the vciy young, evei yth1 ng is new and wildly urk.:ei lain But they're 1)11 a nuss,oo of disc0Vefy, and tt~·,e clele, mined lo ligt•e lh111gsoul. And lhey'1e Ol)ocl at 11! Thal lllgh•enetgy1oqu1Sihveness is why we h

When )OtJ taco 1achcal unce1!runty, rcmcrnbcr you 1our-yea,-old OI' channel tho foUI • year•old wi1111n you. Relentlessly aSK, "Why is lhis so?" U11f01tunatety, somewhere McKinsey &Company

https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/six-problem-solving-mindsets-for-very-uncertain-times

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 30 A better crystal ball

A Better Crystal Ball The Right Way to Think “When it comes to About the Future J Peter Scoblic and anticipating the future, then, Philip E. Tetlock

very policy is a prediction. Tax the United States is getting Ecuts will boost the economy. Sanctions will slow Iran's nu­ clear program. Travel bans will limit the spread of covm-19. These claims all the worst of both worlds. It posit a causal relationship between means and ends. Regardless of party, ideology, or motive, no policymaker J. Peter Scoblic spends untold sums of wants his or her recommended course of action to produce unanticipated conse­ quences. This makes every policymaker a forecaster. But forecasting is difficult, money preparing yet still particularly when it comes to geopoli­ tics -a domain in which the ru les of the game are poorly understood, infor­ finds itself the victim of mation is invariably incomplete, and expertise often confers surprisingly little advantage in predicting future events. These challenges present practical surprise—fundamentally ill problems for decision-makers in the U.S. government. On the one hand, the limits of imagination create blind spots that policymakers tend to fill in with equipped for defining events,

J. PETER SCOBLIC is Co-Founder of Event Horizon Strategies, a Senior Fellow in the International Security Program at New America, such as the emergence of and a Fellow at Harvard's Kennedy School.

PHILIP E. T ETLOCK is Leonore Annenb erg University Professor at the Unive rsity of Pennsylvania. Co-Founder of Good Judgment, Philip E. Tetlock and a co-author of Superforecasting: The Art COVID-19.” and Science of Predic tion.

https://www.foreignaffairs.com/articles/united-states/2020-10-13/better-crystal-ball From Top: New America, Wharton Press

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 31 Improving forecasts

• Tetlock published a study in 2005 demonstrating experts had trouble outperforming “dart-tossing chimpanzees” when it came to predicting global events • Hedgehogs vs. foxes: those who are surest often fare the worst • Instead of asking experts to evaluate long-term scenarios as a whole: • Develop questions which pass the clairvoyance test (sharply defined) • Break down future states into a series of clear and forecastable signposts • Use “question clusters” which are diverse • Draw upon a group of experts instead of individuals • Regularly update scenarios and forecasts reflecting if events follow signposts • Blend scenario analysis and probabilistic forecasts, “A scenario planner’s conviction that the future is uncertain need not clash with a forecaster’s quest to translate uncertainty into risk.”

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 32 Closing thoughts on managing risk

• There is no way we can anticipate what exposures may face us decades in the future, so we need to design systems for resilience and adaptability • Focus on building resilience: • Opposability (be able to hold conflicting ideas in one’s mind, be open to new ideas) • Adaptability (do not fear saying “I was wrong” or “I have changed my mind”) • Study history and see how new technology is affecting old perils • Think stochastically – embrace uncertainty! • Brooks – develop new skills to deal with catastrophic complexity • Taleb and Traverton – understand why volatility signals stability, and vice versa • McKinsey – adopt a problem-solving mindset based on their six approaches • Scoblic and Tetlock – use clusters of sharply defined questions

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 33 Leigh Wolfrom, OECD OECD Poll

• Are these insurable? (yes or no):

• Infectious disease outbreaks • Social instability • Inter-state conflict • Terrorist attacks • Cyber attacks • Critical infrastructure disruption • Climate change

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 35 Uninsured, Underinsured and Uninsurable Risk

True premium cost

If this gap cannot be closed, risk may be uninsurable

Capital Expected loss requirements Uncertainty magnitude (diversification, aggregation)

Willingness (or capacity) to pay

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 36 Future uninsurable risks? Ask the experts

5.0 □ 2019 ■ 2020 High severity/ Cyber attacks High severity/ -7 4.5 Low likelihood High likelihood ------, 23% Interstate conflict Pollution E Information 20% Natural disasters ..__ - infrastructure 7 4.0 - Financial risks 15% breakdown ♦ 21% Extreme weather - ♦ I--- Infectious diseases '-- =====:J 27% 3.5 Natural resources and biodiversity risks 22% - Data fraud and theft 7 ~ 16% Terrorist attacks Macroeconomic risk 24% 3.0 Social instability I- - Critical Infrastructure I--- 7 New threats to security - 17% Failure - 30% 2.5 ~ ~ ~ 28% Social discontent and local conflicts 33% - 2.0 - -i 42% Geopolitical instability 38% - 1.5 - 7 56% Cybersecurity risk - 51% ~ __J 1.0 ~ 67% Climate change 54% - - '----- 7 '-- 23% 0.5 Pandemics and infectious diseases 56% Low severity/ I - Low severity/ Low likelihood High likelihood 0% 10% 20% 30% 40% 50% 60% 70% 80% 0.0 Share of respondents that selected the risk among top 5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

Source: AXA, “Future Risks Report 2020” Source: WEF, “The Global Risks Report 2020”

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 37 Climate change is expected to increase losses

ARTICLE 11) Check fOf updates

o,g/10.1038/541467--020- OPEN Compo un d.ing impact fuels marine h ea t waveof i severeth weath er events

B. DzwonkowskiO 1,2 8 , J. Cooganl,2,5 S F . n e coasta I 0 Cea n , . ourn1er3, G• Lockridge2 , K. pa rkG 4 & T. Lee G) 3

ARTICLE Freq 0 PE"' . Uen PubThelished: poleward 14 May 2014 migration of the location of tropical Iner,ease cy· of sev Anja T: R" In th ere th . ad/ere '-2 e 21 Und , Pieter H st C erst cyclone maximum intensity . Greene . entUr rne,jer2 y d OTlJJ. s ac , Eberh Ue t ros ard Faust ' 0 . . S E James P. Kossin El, Kerry A. Emanuel & Gabriel A. Vecchi , Robert S lJ.Sing . Urope ausenl Inst b exp and Tomas p . . a iiity ected t uc,p 0 Nature 509, 349-352(2014) \ Cite this article 1909 Accesses \ 243 Citations \ 851 Altmetric \ Metrics

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 38 Climate-related losses are already increasing in many countries..

■ Storm D Flood ■ Wildfire

1000% ,.i,.,, 1158% Increase in average annual economic 3427% 900% losses (2010-2019 vs. 1990-2009) -

800%

700%

600%

500%

400% - ~ - 300% - - 200% - - 100% -

0% n ....1... -

Source: OECD calculations based on data provided by Swiss Re sigma

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 39 ….but not everywhere

■ Flood D Storm ■ Wildfire

20%

0% n - I n - ■ - ■ I -20% - - - -40%

- -60% ~ - - -80% ~ Increase (decrease) in average annual -100% economic losses (2010-2019 vs. 1990- 2009) -120%

Source: OECD calculations based on data provided by Swiss Re sigma

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 40 Higher losses could lead to future insurability challenges

The Big Read Insurance ( Add to myFT ) + BIZ & TECH // NET WORTH - KATHLEEN PENDER Climate change: can the insurance As California wildfire risl< increases, industry afford the rising flood risl{1 insurance nonrenewals surge

Kathleen Pender I Oct. 20. 2020 I Updated: Oct. 23.2020 10:27 p.m. Floods were once considered too irregular to insure against. Bu t global warming has changed t he calcul ation San Francisco Chronicle

Robert Armstrong in New York and Oliver Ralph in London FEB RU ARY 18 2020 How climate change is contributing to soaring insurance Financial Times costs

Dr Karl Mallon La test News

The Canberra Times

A 2°C world might be insurable, a 4°C world certainly would not be - Henri de Castries, Chairman & CEO, AXA (2000-2016) in May 2015

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 41 General improvements in insurance coverage (so far)

■ Storm □ Flood ■ Wildfire North Carolina Texas Florida Others (wind) California

Sum insured by state Sum insured by residual plans in wind California residual 60% states (2019 USD bn) plan (2019 USD bn) Increase (decrease) 300 90 50% in share of losses insured (2010-2019 80 vs. 1990-2009) , 40% 250 ...... / 70 30% 200 / 60 20% / -··-··-·· .:::i.... :.:.....-. ··-··-··-··-·· -·· 50 10% 150 -·· ---...... 40 0% -. -·-·--·--·-·-·- 100 30 -10% ------20 -20% 50 ------10 -30% ------0 0 2013 2014 2015 2016 2017 2018 2019

Source: OECD calculations based on data provided by Swiss Re sigma Source: OECD calculations based on data published by Insurance Information Institute 12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 42 Real challenge remains widespread underinsurance

• Storm D Flood • Wildfire

Share of losses uninsured (2010-2019) 1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

Source: OECD calculations based on data provided by Swiss Re sigma

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 43 Plenty of warnings of pending cyber catastrophe

$19 Billion in Potential Losses from Cloud Platforms Reports JRS 2020 Videos • English V Sign-In Q. Services Failure Mostly Uninsured: Lloyd's, Global Agenda Insurance Cybercrime Cybersecurity AIR Cyber insurance is only a few claims away from By Suzanne Barlyn I January 23, 2018 disaster. This is why it matters Insurance Journal How insurable are cyber risks?

Cyber risks constitute a big challenge for the insurance industry, not just because of the risk of change and the accumu lation risk bu t also due to hidden exposure in po licies from different lines of bus iness - sil ent cyber. What is Munich Re's approach?

24.07.2018 Stefan Golli ng

Oct 20, 2020 News > Risk Management 07 Oct 2020 A single systemic ransomware event has the potential to trigger multiple claims from domino­ like disruption that can generate widespread, aggregate losses across otherwise independent insureds. Economic loss from a major systemic ransomware attack could exceed USD 15 billion, Cyber insurance growth may require PPP support inflicting significant damage to the global economy, and significant losses to re/insurers' portfolios without well-managed cyber risk. By Anoop Kh anna I 07 Oct 2020 AIR Worldwide Asian Insurance Review

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 44 Cyber insurance doesn’t provide much protection (overall)

Businesses with cyber insurance coverage

D 250 or more employees ■ 249 or fewer employees Cyber insurance penetration – while United States I 58% 21% growing quickly – remains well below I 58% United Kingdom 20% other commercial lines I 62% Spain 33%

I 49% Netherlands 21%

I 55% Germany 23% Cyber insurance policy limits D FY2019 ■ FY2018 0% 10% 20% 30% 40% 50% 60% 70% Share of organisations with cyber insurance Source: Hiscox, “2018 Cyber Readiness Report” 21.3 Marsh clients (all) 20.9

65.3 Policy limits purchased remain low Marsh clients (>USD 1 bn revenues) relative to potential loss 62.4

0 10 20 30 40 50 60 70 Average insured limit (USD mn) Source: Marsh, “Cyber Insurance Purchasing Report (2020)” 12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 45 Low share of information assets and cyber losses insured

Share of potential losses insured

■ Plant, property, equipment D Information assets 70% As a result, some estimates suggest that share of potential losses 60% insured is significantly lower for information assets

50%

40% Insured Insured Loss Economic Loss 30% Equifax US$125 mn > US$1 bn 20% Merck US$275 mn > US$1.5 bn 10% FedEx US$0 > US$300 mn 0% 2015 2017 2019 2020 Maersk US$0 US$300 mn Source: Aon & Ponemon Institute, “Financial Impact of Intellectual Property & Cyber Assets Report Nuance Comms US$30 mn UNK Others US$0 US$600 mn Large cyber events in 2017 resulted in most losses being absorbed by businesses (not insurers) Source: PCS, based on data from PCS Global Cyber, Capsicum Re and PCS internal research

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 46 A number of types of cyber attacks are likely to be uninsured

Physical damage State-backed cyber attacks

Image source: wallhere.com Image source: PBS

No internet Internet Cyber attack Try: • Checking the network cables, modem, and router outage on critical • Reconnecting to Wi-Fi • Running Windows Network Diagnostics infrastructure

DNS_PROBE_FINISHED_NO_INTERNET

Image source: TechGenez 12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 47 Infectious diseases – devastating and more frequent?

"Pandemics are fundamentally uninsurable events"

by Lyle Ad riano 19 May2020 Free e- newsletter - get the latest news! ii::ii

Insurance Business America "Foolish" & "lazy" to say pandemic risk is comp,letely uninsurable: Chubb's Keogh t 30th September 2020 -Author: Luke Gallin GaviL The vaccine alliance Reinsurance News wcf~tcHJ, ECF E IC Agenda Platforms Reports JRS 2020 Videos G English"'

Global Agenda COVID-19 Future of Economic Progress Global Economic Imbalances $82 trillion over 5 years? Cambridge study

counts the cost of coronavirus The Insurer

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 48 COVID-19 – loss magnitude and premium requirement estimates

Comparative loss magnitude Comparative premium requirements Comparative premium requirement (high range) ■ Comparative loss magnitude (low range) □ Comparative loss magnitude (high range) □ ■ Comparative premium requirement (low range) 80 80% Multiples of largest Share of gross 70 catastrophe loss 70% (direct) property premium 60 60%

50 50%

40 40%

30 30%

20 20%

10 10%

0 0%

Note: Pandemic-related business interruption losses were estimated based on estimates developed: (i) in the United States by the American Property Casualty Insurance Association of monthly business interruption losses; and (ii) in France by Observatoire français des conjonctures économiques of total revenue losses to the economy (of which the corporate sector is estimated to account for 65%). These estimates were applied to other countries based on relative economic size. The loss estimate for each country was compared to the largest economic loss from a natural catastrophe since 2000 (as reported by Swiss Re) and is reported as a multiple of that loss. The premium requirement estimate was calculated as the 2-month business interruption loss estimate divided by 100 (assuming a 100-year return period) and is presented as a share of gross direct fire and property damage premium written in each country (for 2018 as reported to the OECD). It should be noted that the premium estimate includes both commercial and residential property coverage. 12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 49 What future risks are insurable?

Capital Expected loss Uncertainty requirements magnitude (diversification, aggregation)

Well-modelled but Geographic diversification Increasing losses should remain possible likely (how large?) uncertainty in climate impacts (correlated increase?) Increasing exposure Modelling at early Significant accumulation with digitalisation stages/data gaps potential and limited geographic diversification

Increasing frequency? Global pandemic cannot be Modelling of BI losses – improved capacity to diversified – always global? at early stage manage? (and always lockdown)?

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 50 Can catastrophe risk insurance programmes reduce underinsurance and/or expand insurability?

Insured share of losses 100% 90% The existence of a catastrophe risk insurance 77.9% 80% 68.1% programme often leads to a higher share of losses 70% 60.0% 62.1% insured 60% 56.3% 46.8% 50% 40% Peril average insured share 29.1% 30% 20% 14.9% 15.3% Private Retention D Private Pool D Public Reinsurance D Private Retrocession D State/Residual 10% 4.1% 3.1% ■ 0% Insured losses (Sept 11 - 2016 USD bn) 30 25 20 15 Retention levels and reinsurance use can be 10 adjusted over time as private market capacity 5 increases (or returns) 0 Austalia (2007) Australia (2017) United Kingdom United Kingdom United States United States (2014) (2017) (2007) (2017) Programmes can support the development of risk analytics for perils not covered in private markets (e.g. terrorism)

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 51 Some challenges with catastrophe risk insurance programmes

Insured terrorism losses: 2001-2016 • September 11th • All other events • Often designed to deal with the last event • For reinsurance programmes - require corresponding changes in primary market • Difficult to adapt to emerging risks – e.g. for terrorism pools: • Casualties vs. property losses • Loss of attraction Source: OECD calculations based on data provided by Swiss Re sigma • Cyber-terrorism and state-backed cyber

Can add complexity for policyholders – is there not a way to provide an all-risk coverage

12-November-2020 Grey Swans and Black Elephants: Why we keep getting surprised and what we can learn from them 52 Rade Musulin Principal, Finity Consulting, Sydney, Australia Thank you Discussion Leigh Wolfrom Policy Analyst, Directorate for Financial and Enterprise Affairs, OECD, Paris, France