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26 November 2014

Stress-testing the world economy for pandemics, cyber-attacks and war

By Marion Dakers, Financial Services Editor
24 Nov 2014

Cambridge University's business school has worked out the financial effects of several disaster scenarios to help firms plan ahead

The London riots of 2011 were used to help calculate the cost of global social unrest Photo: AFP/Getty Images

Imagine a social uprising, spawned from growing unease about inequality and fuelled by social media, which has sparked protests in 1,100 cities around the world. Pockets of violence are threatening to spill over into mob rule, and the global headquarters of a London bank have just been set ablaze. What does it mean for stock prices?

The Judge Business School at Cambridge University has run this nightmare scenario and three other stress tests in an attempt to quantify the economic cost of a global disaster and help prepare companies for unlikely but emerging threats.

Academics and private sector experts have constructed scenarios with a one-in-100 chance of happening in any given year, including a flu pandemic, a military conflict between China and Japan, and a cyber attack named Logic Bomb.

Insurance firms Catlin and Munich Re have been involved alongside industry giants BP and Lockheed Martin. The UK Research Councils are also providing funding for the stress tests, dubbed “catastronomics” by Cambridge.

Like the stress tests carried out in the banking sector, these scenarios are not predictions but worst-case hypothetical cases to ensure companies can withstand large shocks.

“Insurance companies like Lloyd’s of London already have realistic disaster scenarios. We were requested to develop some stress tests for emerging risks, that they don’t model for already,” said Dr Andrew Coburn, director of the advisory board at the university’s Centre for Risk Studies.

“We were able to link these scenarios to not just what insurance claims would be but how they would affect the stock markets and investment portfolios of these insurance companies. They are hit by a double whammy.”

At a time when several countries in West Africa are battling to contain the Ebola outbreak, the academics have run a “virus pandemic” scenario that imagines a new strain of flu start in Sao Paulo, which infects half of the world and kills up to 25m people.

The insurance cost of the hypothetical catastrophe is estimated at up to $265bn and the total economic hit could reach $23 trillion, according to the researchers. Under this scenario, “[e]quities are badly hit, although winners include the healthcare, pharma, telecoms, and oil & gas sectors”.

Dr Coburn said the centre is working on modelling the possible cost of the spread of Ebola, to be published in 2015.

A mocked-up news article produced for the Logic Bomb stress test

Other tests being modelled include the global ascent of piracy, which would push up the cost of shipping and make some ocean trade routes inaccessible, and a spike in freezing weather conditions.

Several scenarios around cyber-attacks on critical infrastructure are also being examined. More than a dozen insurers pledged earlier this month to work with the Cabinet Office to ensure firms can prepare for online security threats. Online attacks cost UK firms tens of billions of pounds a year, though estimates are imprecise due to companies under-reporting.

Under the stress test of the Logic Bomb cyber threat, a made-up technology firm named Sybil has its databases infected by a low-lying attack that creates increasing numbers of glitches and errors that eventually erode business’ ability to trust IT.

The imagined attack lasts up to two years, and wipes $15 trillion from the expected global GDP in that time. The researchers said the impact could be almost as large as the financial crisis that began in 2007.

As for insurers, they could expect their investment portfolios to lose up to 8pc of their value by the time the problem was fixed, with equities particularly badly hit.

“This is a key part of what insurers do – they model for a 100-year investment return," said Dr Coburn.

The London riots of August 2011 pushed the FTSE 100 briefly into bear territory - where an index falls more than 20pc from its peak - with swings of more than 5pc during one day's trading. The academics at Cambridge predicted similar volatility in their "social unrest" stress test, though fixed income investments such as bonds were expected to remain flat.

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