Economic factors dominate Towers Watson’s latest extreme risk list

For the first time resource scarcity and infrastructure failure have entered the list of the top 15 extreme risks, according to the professional services company. The risk of an insurance market crisis rose one place to eighth. Economic depression retains top spot, which it held in the previous and first edition of the list in 2009. Sovereign default has risen four places to second, while hyperinflation drops one to third. The subjective scoring system reflects both the impact and likelihood of each risk on global economic growth and asset returns. The latest research has seen the sovereign default impact-rating rise to high from moderate. Both political and economic developments in the eurozone suggest that a breakup of the euro is more likely, so it has moved from a very low risk to low. The risk currently occupies tenth place in the list, up from eleventh.hideTim Hodgson, Head of Towers Watson's Thinking Ahead Group, said: “The global economic environment continues to be characterised by significant imbalances and consequently is not in good shape to withstand any further major shocks. “This ranking lists a number of concerns that could disrupt the recovery and long-term economic developments and aims to help asset owners consider and manage their investment risk beyond the conventional VaR95 level,” he added. But he noted that even with the best analysis, it is not possible to anticipate all risks. “While we have a list of 15 extreme risks, by definition they are ‘known unknowns’ and what might harm asset owners even more are the ‘unknown unknowns’. The important thing is to build our ability to adapt and learn, enhancing the resilience of the system,” he advised. The two new risks on the list, resource scarcity and infrastructure failure, are ranked eleventh and fourteenth respectively. They replace the end of capitalism and excessive leverage. According to Towers Watson the concept of resource scarcity is broad and includes energy, metals, water or arable land. It reflects the likely mismatch between supply and demand given population growth and increasing living standards. Mr Hodgson said: “Technology optimists argue that the contribution of technological advancement can help meet the increasing demand, but certain resources—such as water or arable land—have no easy substitutes and the extreme risk lies in a scenario where technology fails to rescue us, or comes too late. While this extreme scenario may be beyond the 10-year window of this research, the fear of running out of resources could lead to price spikes in major economic inputs and increased volatility—neither of which are good news for the economy or markets.” Towers Watson research suggests that much of the increased demand on resources is expected to come from the two most heavily populated countries—China and India. They have been experiencing very fast economic growth in recent years and are expected to maintain that pace going forward. Towers Watson refers to infrastructure failure as the risk posed by the dependence of modern economies on computer networks and power grids. The cost of such a failure would rise exponentially the longer the networks remained unoperational, it said. “The wide use of computing technology means that all critical infrastructure networks, whether power plants or financial clearing systems, are vulnerable to security breaches and cyber attacks. The malfunction of a major infrastructure network for a relatively long period could severely disrupt human activity, threaten lives in critical facilities and raise the possibility of social unrest and law-breaking behaviours for survival,” said Mr Hodgson. The full list is as follows, with the position in 2009 bracketed: 1 (1) Depression 2 (6) ↑ Sovereign default 3 (2) ↓ Hyperinflation 4 (5) ↑ Banking crisis 5 (4) ↓ Currency crisis 6 (7) ↑ Climate change 7 (8) ↑ Political 8 (9) ↑ Insurance crisis 9 (10) ↑ Protectionism 10 (11) ↑ Euro break-up 11 (new) Resource scarcity 12 (14) ↑ Major war 13 (13) End of fiat money 14 (new) Infrastructure failure 15 (15) Killer pandemic Towers Watson groups the 15 extreme risks into one of three areas—financial, economic and other. Financial extreme risks revolve around solvency and whether a financial institution is able to pay its debts with available cash. The research notes the interconnected nature of the modern financial system and that high levels of leverage which mean insolvency for one institution can quickly become a systemic problem. It suggests the primary triggers for financial risks are falling asset prices and falling incomes or that they can be generated by a recession in the real economy and transmitted to the financial sector through a default on loans. The extreme risks included in this category are another banking crisis and future insurance crises. Economic extreme risks are less homogenous than the financial risks and range from a deflationary depression to hyperinflation and a return to a gold standard. “The deflationary depression risk implies that government actions will prove incapable of returning the economy to sustainable growth, while the other economic risks essentially assume that government actions are successful, but at a price. The other economic extreme risks are currency crisis, sovereign default and the resource scarcity,” said Towers Watson. Other risks relate to environmental and political issues. Political crisis, major war, climate change and a killer pandemic are included in this group. Towers Watson believes that the way the environment is handled and the absence of political structures for dealing with it adequately, as well as with the financial and economic issues, gives wide scope for negative outcomes.

Economic factors dominate Towers Watson’s latest extreme risk list

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