Discounting risk can be costly
The chart is taken from a December edition of Fortune Magazine. These estimated costs — almost certainly underestimated — reflect a record-setting $380 billion in global economic losses; nearly two-thirds higher than in 2005, the previous record year. (See more from Munich RE.)
This week’s leader in The Economist is entitled, “The Rising Cost of Catastrophes” (see below and for a link to a more detailed article). In the run-up to the 2012 Davos Summit the World Economic Forum has identified key global risks and gives special attention to the implications of the earthquake-tsunami-nuclear emergency in Japan. They warn about “seeds of dystopia” being planted worldwide. Fortune, The Economist, and WEF… in the business world this is a thoughtleader trifecta.
The unprecedented scale and recurrence of these losses may — but I emphasize, may — have begun to influence strategic decisions by some major players. A once-upon-a-time client lost nearly $1 billion as a result of the floods in Thailand. They are certainly learning from hard-knocks what a decade-ago I tried to communicate as a competitive opportunity as well as competitive risk.
So attention must be paid, either now through thoughtful mitigation or at some future point through even higher declared losses.
And yet, last week I was with three serious, practical business leaders who seemed unaware of the triple-header in Japan or the epic flooding in Thailand or the eventual shift in the San Andreas and New Madrid faults. They have not personally experienced anything analogous. Accordingly such high impact risks are only “theoretical”, which being serious, practical men they cannot allow to distract from what they know and know how to manage.
To ponder the experience of a peer from Sendai or Bangkok would require a kind of empathy, imagination and vulnerability that does not typically earn seven-figure bonuses. Will the criteria for bonus payments shift to reflect a shifting context? Hiring criteria?
The potentially catastrophic risks that I use as examples currently tend to be dismissed as either “ancient history” or “fanciful futures.” It is helpful when Fortune and The Economist and the World Economic Forum begin to sing a similar tune.
Over the last year, Klaus Schwab, the founder of the World Economic Forum, has argued, “In the past the decisive factor in success was productivity, the efficiency with which you used resources. Today the most important success factor is to recognize risks and mitigate those risks.” If the pace of global economic growth continues to slow, risk-mitigation will become even more critical to bottom-line success… even survival.
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The following was published in The Economist on January 14
COMMERCE has long been at the mercy of the elements. The British East India Company was almost strangled at birth when it lost several of its ships in a storm. But the toll is rising. The world has been so preoccupied with the man-made catastrophes of subprime mortgages and sovereign debt that it may not have noticed how much economic mayhem nature has wreaked. With earthquakes in Japan and New Zealand, floods in Thailand and Australia and tornadoes in America, last year was the costliest on record for natural disasters.
This trend is not, as is often thought, a result of climate change. There is little evidence that big hurricanes come ashore any more often than, say, a century ago. But disasters now extract a far higher price, for the simple reason that the world’s population and output are becoming concentrated in vulnerable cities near earthquake faults, on river deltas or along tropical coasts (see article). Those risks will rise as the wealth of Shanghai and Kolkata comes to rival that of London and New York. Meanwhile, interconnected supply chains guarantee that when one region is knocked out by an earthquake or flood, the reverberations are global.
This may sound grim, but the truth is more encouraging. When poor people leave the countryside for shantytowns on hillsides or river banks they are exposed to mudslides and floods, but also have access to better-paying, more productive work. Richer societies may lose more property to disaster but they are also better able to protect their people. Indeed, although the economic toll from disasters has risen, the death toll has not, despite the world’s growing population.
Preparing for the worst
The right role for government, then, is not to resist urbanisation but to minimise the consequences when disaster strikes. This means, first, getting priorities right. At present, too large a slice of disaster budgets goes on rescue and repair after a tragedy, and not enough on beefing up defences beforehand. Cyclone shelters are useless if they fall into disrepair. A World Bank study recommends using schools and other bits of normal public infrastructure in disaster-protection plans, so that the kit and buildings are properly maintained.
Second, government should be fiercer when private individuals and firms, left to pursue their own self-interest, put all of society at risk. For example, in their quest for growth, developers and local governments have eradicated sand dunes, mangrove swamps, reefs and flood plains that formed natural buffers between people and nature. Preserving or restoring more of this natural capital would make cities more resilient, much as increased financial capital does for the banking system. In the Netherlands dykes have been pushed out and flood plains restored to give rivers more room to flood.
Third, governments must eliminate the perverse incentives their own policies produce. Politicians are often under pressure to limit the premiums insurance companies can charge. The result is to underprice the risk of living in dangerous areas—which is one reason that so many expensive homes await the next hurricane on Florida’s coast. When governments rebuild homes repeatedly struck by floods and wildfires, they are subsidising people to live in hazardous places.
For their part companies need to operate on the assumption that a disaster will strike at some point. This means preparing contingency plans, reinforcing supply chains and even, costly though this might be, having reserve suppliers lined up: there is no point in having a perfectly efficient supply chain if it can be snapped whenever nature takes a turn for the worst. Disasters are inevitable; their consequences need not be.
