Catastrophic Risk: Investing And Business Implications

There are a multitude of factors that can give rise to catastrophic risk, and it is worth highlighting them and examining the variations that you will observe across different catastrophic risks. Put simply, a volcanic eruption, a global pandemic, a hack of a company’s database and the death of a key CEO are all catastrophic events, but they differ on three dimensions:

1. Source: I started this post with a mention of a volcano eruption in Iceland put an Icelandic business at risk, and natural disasters can still be a major factor determining the success or failure of businesses. It is true that there are insurance products available to protect against some of these risks, at least in some parts of the world, and that may allow companies in Florida (California) to live through the risks from hurricanes (earthquakes), albeit at a cost. Human beings add to nature’s catastrophes with wars and terrorism wreaking havoc not just on human lives, but also on businesses that are in their crosshairs. As I noted in my post on country risk, it is difficult, and sometimes impossible, to build and preserve a business, when you operate in a part of the world where violence surrounds you. In some cases, a change in regulatory or tax law can put the business model for a company or many companies at risk. I confess that the line between whether nature or man is to blame for some catastrophes is a gray one and to illustrate, consider the COVID crisis in 2020. Even if you believe you know the origins of COVID (a lab leak or a natural zoonotic spillover), it is undeniable that the choices made by governments and people exacerbated its consequences.
2. Locus of Damage: Some catastrophes created limited damage, perhaps isolated to a single business, but others can create damage that extends across a sector geographies or the entire economy. The reason that the volcano eruptions in Iceland are not creating market tremors is because the damage is likely to be isolated to the businesses, like Blue Lagoon, in the path of the lava, and more generally to Iceland, an astonishingly beautiful country, but one with a small economic footprint. An earthquake in California will affect a far bigger swath of companies, partly because the state is home to the fifth largest economy in the world, and the pandemic in 2020 caused an economic shutdown that had consequences across all business, and was catastrophic for the hospitality and travel businesses.
3. Likelihood: There is a third dimension on which catastrophic risks can vary, and that is in terms of likelihood of occurrence. Most catastrophic risks are low-probability events, but those low probabilities can become high likelihood events, with the passage of time. Going back to the stories that I started this post with, Iceland has always had volcanos, as have other parts of the world, and until recently, the likelihood that those volcanos would become active was low. In a similar vein, pandemics have always been with us, with a history of wreaking havoc, but in the last few decades, with the advance of medical science, we assumed that they would stay contained. In both cases, the probabilities shifted dramatically, and with it, the expected consequences.

Business owners can try to insulate themselves from catastrophic risk, but as we will see in the next sections, those protections may not exist, and even if they do, they may not be complete. In fact, as the probabilities of catastrophic risk increases, it will become more and more difficult to protect yourself against the risk.