The modelers speak: risk scenarios must take impact of climate change into account

OpRisk and Compliance: This year has seen a spate of environmental events, from the devastation caused by the California forest fires to severe flooding in northern Europe and Asia. This, combined with the near shutdown of the wholesale lending sector, highlights the need to reassess the robustness of existing risk scenarios, says risk management software provider Algorithmics in its monthly FIRST newsletter.

“We have identified what we consider to be key risks affecting our working environment and have provided excerpts from cases in the FIRST database to demonstrate how large their direct and indirect impact can be,” says Penny Cagan, a managing director at Algorithmics. “We have chosen cases that have unusual characteristics that might not be considered during the process of imagining what could go wrong.”

One case Algos looked at was the damage caused by the recent fires in southern California. The Insurance Information Institute estimates the cost to home and businesses at half a billion dollars in insurable losses. The cost to San Diego county is another $1 billion. Algos warns that businesses that could be affected by similar environmental disasters should be working to develop scenarios to account for employees losing their homes and being unable get to work. Terrorist attacks can have a similar effect, and need to be considered in scenario planning.

Algorithmics also points towards the risks of shifts in global economic power. The increasing influence of emerging economies such as India and China is changing how companies conduct business in those countries, and this might require an associated shift in risk scenarios that account for overseas activities. For instance, risk profiles should consider the possibility that the government of China could pull away from capitalism and seize foreign assets.

“It is not too difficult to imagine a pulling back from the government in China one day and risk scenarios should at least include this possibility,” says Penny Cagan. “This was witnessed in Russia when the government pulled back oil company assets that it had previously privatised, saying it was making amends for flawed privatisations that had occurred in the early 1990s.”