Should we consider Black Swan events as a strategic risk on an organisation’s risk register?

Trevor Cuthbert
Senior Risk and Insurance Manager, Charter Hall
Director, RIMS Australasia

With the backdrop of COVID-19 a question was asked at a recent meeting as to whether we should consider Black Swan events as a strategic risk on an organisation’s risk register.

This gave me cause to think back to an article published in the Harvard Business Review shortly after another Black Swan event, the 2008 Global Financial Crisis.

The article titled ‘The six mistakes Executives make in Risk Management’ covered Black Swan event themes, many of which resonate in the current environment.

I have shared my thoughts below and would welcome any comments and experiences.

Studying the past doesn’t always help us manage risk.

There is always the danger that we mistakenly use hindsight as foresight. The current COVID-19 crisis has demonstrated that events don’t always have predecessors and the lack of a precedent can contribute to the magnitude of the shock.

The oft quoted phrase “This is unprecedented” suggests that with a little extra effort, we could find precedents for anything and predict everything. But Black Swan events don’t have precedents.

Furthermore, today’s world doesn’t resemble the past; both interdependencies and nonlinearities have increased and exacerbates the randomness of economic variables.

For example, who could have imagined a pandemic health event would trigger the collapse of the oil markets.

For these larger macro events we are moving away from uniform statistical impacts and the ‘typical’ cause and effect failure.

We cannot manage risk by only predicting extreme events.

Worrying only about extreme events is a dangerous approach, for a couple of reasons.

  1. We have an abysmal record of predicting Black Swan events; and
  2. By focusing our attention on a few extreme scenarios, we neglect other more likely possibilities; and as a result, become more vulnerable.

The sensible approach is to focus on the strategic and operational consequences, that is, to evaluate the possible impact of large events.

For example, by assessing how our organisation will be affected by dramatic changes in the environment in comparison to our competitors.

COVID-19 has caused us to reassess how we approach stress testing and our evaluation of the unexpected falls in supply or demand. This real-life scenario has provided valuable insights on our ability to withstand sharp drops in customer demand, impacts to supply chain, and so on.

We don’t listen to advice about what we shouldn’t do.

Positive advice is the province of the charlatan. There are many business success stories but far fewer on failure or setbacks. The absence of cautionary tales encourages organisations to treat risk management as a separate workstream from profit making.

A better approach is to integrate risk-management activities into profit centres and treat them as profit-generating activities, particularly if the organisations are susceptible to Black Swan events.

Recommendations of the “don’t” kind are usually more robust than “dos.” For example, advising someone not to smoke far outweighs all other health-related advice you can provide. “The harmful effects of smoking are roughly equivalent to the combined good ones of every medical intervention developed since World War II.

Had banks in the U.S. heeded the advice not to accumulate large exposures to low-probability high-impact events, the GFC may have been avoided.

Similarly, time will tell as to the economic impacts on those Governments and countries that were slow to act on social distancing and border control.

Whilst a dollar not lost is a dollar earned and has the same economic impact, organisations usually don’t treat the two equally. A greater emphasis is placed on earning profits than on avoiding losses.

However, if an organisation prevents losses while its rivals go bust, opportunities will occur to increase market share and profitability.

Logical and psychological equivalents are not equal.

In 1965, physicist Richard Feynman wrote in The Character of Physical Law that two thematically equivalent formulations can be unequal in the sense that they present themselves to the human mind in different ways.

Similarly, the way a risk is framed influences people’s understanding of it. If you tell investors that, on average, they will lose all their money only every 25 years, they are more likely to invest than if you tell them they have a 4% chance of losing a certain amount each year.

Providing a best-case scenario usually increases the appetite for risk. The better approach is to continue to look for the different ways in which risk can be presented to ensure that decisions are made based on the sausage and not the sizzle.

Insurance is no longer a panacea.

The impacts of COVID-19 is a timely reminder that not all risks are insurable. For most organisations, the business interruption section of their ISR policy did not respond to the financial impacts suffered during the pandemic.

Furthermore, insurers globally are anticipating higher than normal losses as a result of COVID-19 with many reinsurers retreating from the market and those who continue to write reducing their capacity and coverage whilst increasing costs.

As annual premium spend increases organisations may need to reassess the insurable risks facing their business, be prepared to manage the risk landscape in greater detail and buy insurance to hedge their risks rather than transfer them completely.

With thanks to Harvard Business ReviewFull article:
By Nassim N. Taleb, Daniel G. Goldstein, and Mark W. Spitznagel