2016.03.29 トピックス

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2016.03.29 | トピックス

Black swans and ostriches

Whether it is financial crises, terrorism or the possible collapse of the EU, companies and countries alike need an unsparing and complete view of political, economic and natural risks. The assertion that certain crises could not have been predicted is all too often a simple case of burying one's head in the sand.

Black swans are rarely found in nature, very rarely even, but they do exist. They have become better known ever since Nassim Nicholas Taleb made "black swans" a metaphor for extremely unlikely events with extremely serious consequences. They epitomise residual risk, the catastrophic event that could not be expected, the unforeseeable – perhaps even the unthinkable – that nevertheless happens.

In contrast to this definition, in the past few years black swans have occurred surprisingly often in the economy and in nature: the collapse of financial markets as a result of the Lehman bankruptcy, the accident at the Fukushima nuclear power plant, and so on. Our world is apparently or actually becoming more and more unpredictable. So-called "one-hundred-year events" seem to be happening every five years. Some people are already calling the black swan the "heraldic animal of the 21st century".

There is indeed a noticeable increase in extreme events. Weather-related disasters are a good example. Munich Re's worldwide loss statistics are clear: events are becoming stronger and are also occurring more frequently – their return period is getting shorter. Climate change is "leveraging" weather events to some extent, turning dry summers into month-long droughts and normal high-water levels into hundred-year floods. But are natural disasters whose probability of occurrence has increased as a result of climate change really black swans, or are they events that are to be expected?
In the world of business too, the number and frequency of crises is increasing. Growth that is strongly financed by debt or excessive leverage from corresponding financial products leads to sometimes extreme fluctuations. This is intensified by a marked willingness to adopt herd behaviour. The consequences: the bubble bursts, the stock market slumps, a country goes bankrupt. If certain developments on the financial markets are exhausted and over-stimulated, can the consequences of this then really be described as black swans – that is to say as events that no-one could have foreseen?

Referring to supposed black swans is ultimately an ornithological scam. My argument is that the supposed unpredictability of events all too often serves as an excuse for the lack of risk management. In this way, human error becomes force majeure, recklessness becomes bad luck, and irresponsibility becomes fate. "There's nothing that can be done" or "no-one could have known that" are the kind of statements made to wash one's hands of responsibility. Furthermore, anyone who apparently suffers a misfortune through no fault of their own can hope to receive the solidarity of the state. Where an unforeseeable hundred-year flood inundates houses, or a business model implodes due to a seismic event on the financial markets, the state – and therefore the taxpayer – should and, indeed, must help. This solidarity is in principle also right. But only rarely does anyone ask why a flood plain was designated as a development area and the price of the land was so favourable, or why a company had invested so heavily in highly speculative financial products. This logic leads, for example, to situations in which, in the event of a crisis, companies that, as part of their conservative risk management, have stopped chasing highly-speculative returns lose the competitive edge they have actually gained from their cautious approach, as this is wiped out by government rescue measures. Black swans supposedly justify such rescue policies, which punish effective risk management and thus produce the next black swans.

The upheavals on the financial markets in 2007-08 were often labelled as a "black swan event". For example, the then CFO of a large investment bank explained the 27% plunge in its hedge fund by saying: "We were seeing things that were 25 standard deviation moves, several days in a row." In the reinsurance business, which works with very long-term models, we are used to dealing with so-called 5-sigma events. These correspond to a return period of 10,000 to 15,000 years. Examples of this would be a huge earthquake in the Rhine Rift Valley, or a hurricane season with a whole series of very severe losses in major US conurbations. However, in the case of the financial market developments in 2007, the investment bank's CFO even believed that a 25-sigma event was involved. The probability of such an event happening once is equivalent to the likelihood of winning the UK lottery more than 20 times in a row. According to the investment bank's CFO, this event did indeed happen "several days in a row". Was the financial crisis really a case of the most extreme bad luck that humanity had ever seen in its entire history? Probably more likely blind faith in defective models, excessive risk appetite, greed and inadequate risk management.

Even if one was prepared to accept that the 2007-08 financial crisis was a black swan, an early repeat would still "only" be one of many risk scenarios. No-one could any longer assert that this was something unforeseeable or even unthinkable – something that Americans would call a "freak event". The same goes for the likelihood of a major terrorist attack on a Western metropolis or a serious accident at a nuclear power plant. Would politics and business be any better prepared for this today? At best only to a limited extent. The same is true of events that even just five to ten years ago were considered to be virtually impossible, but whose probability of occurrence has increased significantly in recent years. The break-up of the EU has thus become a risk scenario that has to be dealt with. First the sovereign debt crisis and now the refugee crisis are putting the EU to the test and, on top of this, there are national centrifugal forces like the EU referendum in the UK. Another scenario, the probability of which has unfortunately likewise increased, is that of a military confrontation between the West and Russia. The Ukraine conflict and the shooting-down of a Russian fighter jet by Turkey have shown that even though a military conflict with Russia continues to be highly unlikely, unfortunately it is not inconceivable either. Are countries and companies prepared for such scenarios? People often seem to believe that something that should not happen cannot happen. So if a black swan flies on the horizon, people prefer to quickly look the other way.

Many scenarios with massive consequences are discussed as black swans, although it is only just a matter of time before they become reality. For example, it is clear that someday there will be a severe earthquake – the "Big One" – in California. It must also be assumed that, sooner or later, there will be another global pandemic. It is just a matter of time before a dangerous enough virus and the "right" circumstances coincide. Given the abundance of atomic, biological and chemical weapons in the world, unfortunately it is also foreseeable that stocks of these may someday fall into the hands of criminals or terrorists. It's no use burying one's head in the sand when faced with such scenarios. It is therefore better to take seriously Murphy's law, which states that whatever can go wrong will eventually go wrong.

Particularly in times of crisis, the effects of extremely positive events are also underestimated. Black swans are not necessarily scenarios of doom. Positive events too can have serious long-term effects. Think, for example, of a medical breakthrough that leads to a huge increase in life expectancy. Such a development would of course be a "shock" for healthcare and pension systems, as well as for the housing market, for example. Rapid technological advances can also have a serious impact on business and society. Disruptive innovations in connection with digitalisation are currently showing how corresponding developments can overwhelm companies and even make entire business models superfluous, though not necessarily to the detriment of customers and consumers.

What follows then from these considerations? We should not unquestioningly accept black swans as explanatory models. The term is all too often misused to distract from bad risk management and thus also from an incorrect assessment of probabilities. The more unlikely an event is supposed to be, the greater the hoped-for understanding for the lack of precautions.

What's needed is an honest and realistic assessment of probability and the impact of possible but also quite rare events. In particular, events with potentially major impacts should not be ignored in the risk analysis simply because their probability of occurrence is essentially difficult to determine, or is relatively low. Difficulties with estimating the probability of occurrence, the impact of events and options for action should not be an excuse for not dealing with a risk. The common first reaction – "there's nothing that can be done, so we won't deal any further with this subject" – reduces our room for manoeuvre from the outset and can have fatal consequences.

Knowledge of the risk is the basis of deliberate action and dealing responsibly with the risk. For only when one knows the risk can one act accordingly. Acting often means actively doing something, i.e. taking steps to minimise the risk or increase the prospect of successfully dealing with the consequences of the risk. However, acting can also mean omitting to do something, i.e. doing nothing. This is then the decision to tolerate the risk and accept the possible implications. Thus there are events that do result in enormous consequences but are extremely unlikely, and here we can talk about a "black swan". In both cases a conscious decision is taken – to do something or do nothing – which requires thorough knowledge of the risk. Responsible action can only follow from knowledge of the risk.

If a risk is ignored, however, the option to take action is abandoned and replaced with the willingness to be surprised. This is ultimately the same as the ostrich tactic: "what I don't see isn't there". With this tactic, you can either be lucky or unlucky. However, the expectation must be that people who bear responsibility in politics and business will not take refuge in ignorance and fatalism, but will take responsible decisions on the basis of the knowledge available.

When it comes to assessing the risks for a company, two mistakes are made time and time again. First, the retrospective historical period chosen as a basis for observations is too short. The implicit assumption is that anything that hasn't happened in recent years or decades will also not happen in coming years. A person's own range of experience reaches back no further than a human lifespan. Everything that went before is conveyed only indirectly and is therefore less present and less influential in shaping one's actions. Here it should be mentioned that some individual companies seriously affected by the financial crisis deliberately chose a short time span as the basis of their models, because it benefited them. Secondly, currently observed trends are rashly extrapolated into the future. The well-known comment made at the end of the 19th century predicting that, because of the growing number of horse-drawn carriages, the city of New York would within a few decades be buried under metres of horse manure shows how wrong one can be with a simple forward projection of currently observed trends. Not only for this reason should risk management not be reduced to the use of algorithms and forecasting tools, however sophisticated they may be. Now that data processing is so much more efficient, the risk of blind faith in models has increased in recent years. But every model is based on parameters and variables that have previously been entered in the system and are therefore assumptions derived from what is already known. Models therefore tend to be blind to black swans.

For some risks, little or no information is available in the form of data. This is the case, for instance, with risks from future technologies and from growing global interconnection. Here, tried-and-tested quantitative methods can be used only to a limited extent. In evaluating such uncertainties, we must rely primarily on the assessment of experts and to some extent also on "gut feeling". Risk management based on gut feeling or intuition is a fundamental human skill and should therefore be an integral part of professional risk management. Common sense is capable of amazing feats when it comes to risk assessment. It also makes a lot of sense to take account of psychological insights into judgment and decision-making when carrying out risk analysis on risks that are hard to quantify. This includes better understanding of human intuition and its possible distortion when assessing risks, for example due to the presence of a specific topic in the media. Besides effects on individual assessment, we must also take account of group phenomena, as groups tend towards more extreme judgments than individuals, for example. In the light of these findings, assessment and decision-making processes can be designed in such a way as to reduce distortions and ensure the greatest possible transparency.

As part of a risk management approach designed in this way, companies should go for a sustainable business strategy. Short-termism and excessive risk appetite make companies just as vulnerable to seemingly unforeseeable events as over-leveraged growth. Growth at any price or at any risk is the wrong approach. Growth per se is not bad, as some critics of growth maintain, but rather a prerequisite for and consequence of entrepreneurial success. It is also vital as the basic engine of the welfare state. All the same, for individual companies and societies as a whole, it would be better to follow a flatter and therefore steadier path of growth. This is because strongly leveraged growth almost inevitably leads to severe downturns – the list of examples of this is very long, from bursting of the 'new economy' bubble to the property crisis in Spain. The overall balance from short-term boom and subsequent collapse should normally be negative. This is particularly true for the taxpayer, when profits in the boom phase are privatised and losses from the following crisis are socialised. Crises thus become a risk for the stability of our economic and social system which needs to be taken very seriously. Society as a whole therefore has a responsibility to do everything in its power to minimise the probability and the consequences of serious crises. As well as in the case of over-leverage, it mostly also becomes critical when the level of growth and profit sought goes beyond the actual business model. Although the permanent transformation of a business model can certainly succeed and make sense, all too often the aim is solely to tap for a short time into a trend that promises gold-digger-type profits. But then one is inevitably playing a game that one only partially understands, and that others are better at. The huge losses that some financial institutions made on transactions outside their actual area of competence and responsibility show the risk that is hidden in a supposedly quick profit on unknown territory.

In order to arm oneself as far as possible against false black swans, it is therefore vital to make risks transparent. It is not about not taking any risks, but about consciously taking them. Without risk, there is no innovation and no progress. But if one doesn't want to put all one's eggs in one basket, it makes sense to take on risks only to a limited extent so that, even in the case of less probable events, a cushion still remains and the company is not immediately left standing on the edge of the abyss. This perhaps also means forgoing the last bit of margin possible in the short term in favour of a business model that is sustainable and therefore more successful in the long term.

Risk reports and the establishment of a Chief Risk Officer have proven their worth in operationalising the considerations made. It is surprising that many companies do without such tools. While, in the financial sector, risk reports are required under supervisory law, at companies in other sectors there is often no function where the company's risks are centrally researched, collected, quantified and finally weighed up along the lines of: "what is it worth to us to reduce this risk?" It is somewhat alarming how little some companies are aware of their risks. Having a Chief Risk Officer is only half the story here. It is just as important for there to be a high level of risk awareness in the company as a whole, and for management to give this subject high priority. Unless a corresponding culture is lived within the company, a Chief Risk Officer remains a fig leaf. Many not so improbable events catch such companies unprepared, and they are then absolutely teeming with black swans.

But it is not only companies that often fail to carry out consistent risk analysis and prevention. Governments too take far too little interest in the consequences of events that are improbable but would have a significant impact on the state and the population. Countries too should submit a risk report and introduce a "warning voice" – in other words a Chief Risk Officer. Who in the Federal Government has an overview of the risks for the Federal Republic of Germany? And here what is meant is risks of every kind, not just political ones. Every department deals with scenarios within its own area of responsibility, but many events would have repercussions for all ministries. There is no integrated, holistic approach.

There is, of course, already a series of good risk reports at national level too. The risk analyses for Germany submitted by the Federal Office of Civil Protection, for example, are a good first step. However, because of its focus on disaster protection, the Federal Office's view is too narrow. Events like a financial crisis are naturally left out of the considerations. Yet such a crisis presumably poses more of an existential threat to the country than any winter storm, however destructive. In the USA, the Office of Financial Research was commissioned to submit a report focusing on financial stability. The report, which appeared shortly before Christmas, is a pleasing example of appropriate risk reporting. The IMF and the ECB also regularly submit good risk analyses. But all these institutions look only at the risks in their own area of responsibility. It would be desirable to have a risk report that did not conceptually exclude from the outset any notable potential risk for the state and provided the necessary transparency about the risks. Such transparency is not only important for policy advice. It also generates understanding of political action among the population and so creates trust, with citizens feeling they are being taken seriously.

Such a government role for taking care of risk would have to be free from political influence and consideration. An independent body something like the German Council of Economic Experts would be conceivable. It would also have to deal with long-term trends like demographic developments and climate change, or the erosion of fiscal discipline in the Eurozone. Too little attention is paid to long-term developments, because they proceed only gradually and the immediate effects are initially unspectacular. The chairman of such a Risk Council could give a face to risk analysis as "Germany's Chief Risk Officer" and thus also generate the necessary media attention. And anyone who is prepared for what is in principle foreseeable then has their hands free for what is really unforeseeable when it does happen, namely when a real black swan lands.

Dealing with black swans is not about drawing only scenarios of doom. We must not be like the Gauls in the Asterix comics, worrying every day that the sky will fall on our heads. In the 21st century too, perhaps even more than ever, we need bold decisions. Good decisions are characterised by the fact that "risks and side effects" are taken into account. In companies and countries alike, we therefore need an unsparing and complete view of the risks. There are still many gaps to be closed here. A risk report and a Chief Risk Officer will increase transparency about risks, their probability of occurrence and their consequences. And black swans really do exist – in Australia the black swan is in fact so common that it has been made the state bird emblem of Western Australia.

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