How are risk and sustainability linked?

18 min read

Dominic Cortis is an actuary by training and an academic by trade. He deals mostly with probabilities and insurance. Both are intertwined as insurance is intended to cover unlikely events.

Recently technology is changing the way risk is measured and mitigated so his interest has turned into insurtech as of late as well.

Our guest today is Dominic Cortis. Dominic is an actuary by training and an economist by trade. He deals mostly with probabilities and insurance; both are intertwined, as insurance is intended to cover unlikely events. Recent technology is changing the way risk is measured and mitigated, so his interest has turned into Insurtech as of late as well. He describes himself as a probability and risk taker. The purpose of this call today is to inform how risk fits into the sustainability framework, so that it may be taken into account both from the beginning and throughout a project. So, Dominic, thank you for joining us today.

I would like to kick off today's conversation by understanding what risk is. Maybe you can tell us, you know, how would you define risk?

So, the risk is, I would say the definition is unexpected, unexpected results or deviation from results. So, let's start by using a simple example of purchasing a car. If you know that you can get a car, and if you pay one hundred euros per month for servicing, you will never have any trouble. There's no risk. If, on the other hand, there is a second option and the second option is, ‘Ah! you might need to pay you two hundred per year, or you might need to pay five thousand euros per year in damages’. Then there's a risk over there. Now, if you notice in this case the risk can be both sides, could be better off or worse off, so risk is deviation from the average from what is expected.

Very good. So, how can we therefore take into consideration risk within a project. I am calling project, anything which could be either an actual project or a business or an entrepreneurship. How can we best consider it within this framework?

Ideally when you look at risk is you know, whenever there is a project, you have some estimates of what you should expect: revenue wise, cost wise, whatever. Now you look at those particular numbers, or you look at the outcome, and you start saying ‘What scenarios, or how could these change? How could these numbers? How could these estimates change overall?’ And the best way to deal with it is to think about likelihood and effect.

So, you can either look at it from each item's perspective. How can it change? How can it fluctuate? Because some items can fluctuate naturally, some items can fluctuate due to extreme events. And then you can look at it from the other side? What scenarios could occur? So, for example, if you are, let's say you want to create a new company that leases only electric cars. For example, what scenarios would increase your profitability or sustainability, or lower your costs? And how likely are they, and what's the probability of them occurring? if we take another project for example that we are selling at a takeaway shop, in this case what could happen that affects our business? I mean, for example, one thing is that we have wrong orders. Now, the likelihood is possibly high. The effect is probably low. Another effect could be someone at the car crashes into our building. The likelihood is small, but the effect is big. So, you sort of picture them in this in the sort of two-dimensional space. There is no need to be exact. It's not about probability. So, the like likelihood could be very unlikely and likely, quite likely, daily occurrence, whatever. And the effect could be big, small, massive, it could be in any case.

Going back to what you were talking about if you were to set up an electric car company, for example, and this conversation about likelihood and effect. I believe that the timing at which a risk is going to be taken is also very important. Can you put timing as part of the scenario of the risk parameters?

Yes, timing has a big effect, and one of the major effects that it has is you could be right, but at the wrong time as well. So, for example, and if we take financial sectors anyone who in 2006 was saying, ‘Oh! The property bubble will collapse’, They would have been right, but if they went in the market at that stage or may be 2005, they would have lost their money unless they had enough to withstand two to three years when in 2007 it collapsed. So yes, timing is an issue. Know, it depends on the philosophy you believe in, and some agree that timing is a matter of luck, and I tend to be mostly from that background. But also, there is an element of skill, and that's where someone needs to understand their business.

If you're operating in a new business whatever it is, you need to understand, ‘Is the timing correct?’ And risks change over time, and the same risk could have a small effect now, but a bigger effect later, for example. So yes, timing is a huge effect to include it in a project. It's quite challenging. You need to understand the project per se. Every project is different.

Agreed. I mean, yes, you would never be able to know if you're not really inside the actual [project], you know, [that] you've saturated yourself with information from that field. But I guess there are ways of dealing with risk as well. Mitigating it perhaps is the word that comes to my mind, but how other ways are there to deal with this sort of risk.

So, let's take, we have our ideas of types of risks that can occur, type of, I would say, rather than just type of risks outcomes that have affect our risk. In that case, we have sort of some risks that we are going to ignore or retain in a way; ‘We're okay with this, it doesn't really affect us’.

In some other risks, some other scenarios we might want to diminish that, and, while some other risk we might want to transfer them to someone one else, while some of others say ‘Okay, we really don't want to even touch this’. I mean, let's go back to the takeaways example, a risk is that you have a wrong order, for example, and therefore have to redo the order and the likelihood probably high; the effect is low. But if you have many of these, the effect, the combined effect become large. So, what can we really do about it? Well, maybe can invest in more training, maybe we can see which cases in which there are you know the wrong order, maybe there's a miscommunication between the different staff and we try to simplify the method. In that case we are diminishing the risk. We are diminishing the probability.

But we mention another risk is someone crashing in our front door. Or in that case, can we diminish the risk? Well, maybe we can put fluorescent signs? But most of the case would be ideally to transfer the risk purchase insurance. So, every risk needs to be dealt with in one of these four cases or may even a combination of the four cases.

Now, when we're talking about risks, per se, and events that can affect us, there are different elements that we need to look at. One main element is, some of the risks we just think of, risk of negative things, but you may think of a scenario that might provide positive aspects. So, if we can think of a scenario that provides positive aspects, place yourself in a position which you can only take the upside of the risk rather than the downside. So going back to a rental company of only electric vehicles, what are the potential upsides, which scenario would lead to an upside risk, and how can I then plan myself accordingly. One particular case would be that no cars with combustion engine can enter a particular touristic area. It’s a possible scenario that might occur. So how I can place myself for upside risk to take advantage of it. Well, I make sure that now, I have at least some locations in that area before any possible regulation comes in. So, you need to think of scenarios that both give you the upside and the downside and when we're thinking of different events, we need to be aware that not everything that we can think of is within that list. There are black swans, events that are impossible to think of. They weren't even fathomed. For example, a pandemic is not a black swan because we know pandemic exists anyway, but and insurers, for example, have been catering for them for years now explicitly. But for example, the attack on 9/11 was clearly a black swan. Except for the people organising it. No one ever thought this was possible, or doable.

Quite right. And another thing that you have mentioned, which is interesting is that you have to understand where the laws and where the policy is going to be leading to, so, for example, in Europe at the moment, and globally there is a huge push towards doing something about climate change, something about sustainability. Whoever is thinking that you know, pre-empting that his company where it needs to be, should I be doing something rather than another. Maybe looking at the way policy is developing could also help show the direction in which one can take or otherwise a risk. But this item that you mentioned, at the end, the events know something may happen may not happen. It is a black swan? Is not a black swan? Maybe could give us some information of you know. Yes, is true, I can't ask for something which I don't know exists. So how would I go about it?

I wish I knew to be fair, and it it's actually thinking almost from a Sci-Fi reality in some cases. I mean any project, especially at a young stage, they tend to evolve and evolve and change, and that's the advantage that they have over you know, traditional industries, tradition companies. But one of the main issues that you need to be aware of, is if you've thought of a similar scenario, how can you take the upside of it? How can you take advantage of it? Limit the downside and take the upside like a free bet, in a way, or free lunch? If you want to create a stable project or a stable company or whatever it is, sustainable, and it's not really about making it more resilient, it's not about adding pro, it's not just about adding process to make it more resilient. The main aim in this another terminology is to make it anti-fragile, to make it flexible enough to be able to take new opportunities that we were not even able to think of. Now, what destroys projects or companies or what have you? Traditionally we've seen many, I know one-off risks, but there's also the strategic risk and when you look at major companies, I mean, the traditional would have been Kodak that they had the technology for digital cameras, I believe, but they said ‘Ah! Who cares?’ Or are the same with Olivetti that used to do the old typewriters and they had the market. When keyboards came along, they said, ‘Ah! We won't care’ and possibly Toyota is doing the same with Tesla. But in those scenarios, it was really a strategic decision rather than you know, an operations point of view, something external that affected. So, as we were saying, you need to look on the long run, and I mean when a black swan occurs it affects everyone.

Now, sometimes (it affects) people on a positive note sometimes on a negative note. Know, but that's why you need to be flexible enough to be able to take out the positive risks.

Interesting. And if we were to distinguish between known events and unknown events, I recall, we had you know some conversations regarding events which are known, the unknown, the known-unknown, the unknown-known. So, there are various combinations of what's known and what's unknown, and I guess this links into what you were talking about the black swan. I don't know whether you'd like to elaborate more on the combination of what's known and what's unknown and how it links to risk.

So, the thing is we're thinking about scenarios or thinking about changes in numbers, in outcomes that we might have. Some of them, as you said, they would be known something that we experienced, and we experience you know daily, monthly, or what have you. Some of them would be the known-unknown. So, we know about them, but not enough or unknown-known. So, let's say, for example, pandemics. Pandemics are in a way known-unknowns for the uninitiated, so up to four or three years ago company would have had a business contingency plan, you know, if this happens, but you know they don't really know how government will react or the policies will be, so we know about it, but we know we don't know enough. Then there are some cases in which we know we don't know anything about. I'm trying to think of a real case, what if a real meteorite falls. I guess I'm thinking really extreme events here. Then there are things that we really are black swans. We really can't even think about in a way. As you mentioned earlier as well, you need to be aware of how the market is changing. I mean, this talk sounds almost a bit aloof sadly, in a way, because, and the reason is because every industry is different, every market, not just saying catering industry, you need to understand your market per se. I mean, let's say again, I am using the takeaway shop example. If you have a takeaway shop, and one of the risks that you don't have control of it is a road been closed. If road is closed, no one's passing in front of you and no one's going to stop. But that it's in a way you know, it's not known, you don't know it will occur or how it will occur but linking it to the previous example, previous discussion, it could be an upside. It could be that you're on a side street. The main street has been closed. Everyone, one's passing through the side street. Everyone one knows about your shop now, so you never really know how these things change. So, you need to put yourself at different stages, so one of them would be ‘If the road closes, I'm ready to you know, put a few adverts on the other side’, or ‘make my online presence stronger’. The other way round. I mean you, and that way you're taking just the upside risk.

Indeed, there are many things that we need to consider when embarking on a project. If I were now to link what we have said to financial risk. What are the risks from a purely financial perspective? Do you have any examples to share with us?

I come from an insurance background and one of the cases that we are looking from – climate change – there are three forms of effect. One effect is obviously climate change will increase hurricanes and what not, so that’s ok. One of them is that we may be accused in future of not doing enough. And one of them is we might have what is called stranded asset. A stranded asset, for example in this case is, we just heard the news that in 15 years (is it?) you cannot have motor vehicles? If I'm investing in a petrol station, in a way, that's a stranded asset.

‘Assets’ is an interesting topic, and I am understanding correctly is a property, or something that you have invested in, shares perhaps. So, if a company is investing in sustainable packaging, for example, so all of the plastics that he has been using which will no longer be used, does that make them stranded assets?

It would be applied from one perspective, because it’s not an asset that lasts years, is it? I mean you are going to use it. But if they already have a contract with the supplier and now let’s say in five years’ time, the rules change, and now you need to not have plastics, he already has the contract with the supplier. So, in a way, the others are rushing in, and he has the advantage of already having that in place.

So, for example, you work in the construction industry. From the few projects that I’ve seen in construction is, that almost every construction company has a contract with a cement supplier for the next, I don’t know how many decades. And the reason is that if the cement supplier tell him ‘No, I cannot supply you, I’m over booked’, they could be the best builder in the world, and all the projects in the world, how are they going to build?

So with respect to sustainable packaging, I would not call it an asset per se, I would say that you are looking at the risk, may be your timing is a bit too early, but the thing is that if you already have a contract with the supplier for the next ‘x’ years, and once the rule comes in, everyone is rushing in, they might not be able to find but you are.

If you use the same example as to what happened with COVID-19, if you had a small online presence as a supermarket, I am talking about a local supermarket, no PAMA [a large supermarket in Malta] or anything. If you had a very rudimentary website and an email where someone can book you in, and you had deliveries for the elderly, once COVID-19 hit you were ready. But I would not call an asset per se, I would call it purely strategic.

It’s a strategic risk that you have taken at the time. Pre-empting that a shift could be required. And I guess even seeing what people are doing in other countries, because, for example, when I lived in the UK, mentioning your supermarket example, I almost never went to a big supermarket I got all my shopping delivered to me. When I came to Malta, it is a bit of a shock that I had to go and get my own foodstuffs. So, call me whatever you wish, but you know it was a rather different way of having to deal with it. So yes, having a look at what other countries are doing where they're going to in, terms of business, with would help you maybe look into the future.

I quite enjoyed what you were talking about the three, three points of insurance, just now.

So there's three issues that might affect you. I mean they are classified in three. And this is based on what the Governor of the Bank of England had said in a speech. Insurance has always been on the forefront of climate change because it affects us first. It really does - increased hurricanes, increased droughts – everything, you know, we deal with natural forces.

Lloyds of London has been talking about this for decades - not years, decades - and generally speaking we have classified the risks in three categories. And one of them has actually been the direct risks: if there are more heatwaves you have more costs in air conditioning. I mean, that's obvious costs. If you have more heatwaves there's more possible landslides so insurers can affected; the number of tornadoes has increased and there is a theory that it will increase over the years. So, there's a lot of those kinds of things going on. And that is one area. The other one is almost legal risk, and it affects even small firms. You might be operating in a way that seems OK but in in 2-3 years’ time it's illegal. And it would have been back-dated as illegal. Or maybe, if you're a public company or shareholders, deem it as illegal and because you didn't take enough decisions, enough correct decisions. So, CSR doesn't just become, you know, we just do it for the nice things, you do it for legal reasons as well.

And finally is you might have stranded assets. I mean if we're talking about the lifetime of a car usually, from an accounting perspective, is 20 years. But let’s say that we are thinking of buying some car, okay okay – a hearse – should probably lost more than 10 years. So let's say the lifetime is 30 years, given the move to electric, is there the potential of this being a stranded asset in 15 years’ time. Not one that you cannot use, but one for which there is no demand for example. And it could be even applied on shares you might own, on investments that you might currently have, including a property investment. And maybe you're building a property which reaches the current standard. In Malta we don't really look at EPC [Environmental Performance Certificate] for example but meanwhile abroad, especially in the UK, it was one of the first things you’d look at because heating costs are quite high. So maybe you should start building projects, as an individual, with a higher EPC if you want to rent them out, because you have a longer tend to look at.

Indeed, yes, the EPCs are an important way to start to classify different kinds of properties according to their energy performance.

So just to wrap up today Dominic, what take-aways can we take from this conversation? What is the essence of risk, and how should we make sure that you appreciate it right from the beginning of a project, but as you have said as well, throughout the project.

So, I would say, whether small projects, long-term projects, or what have you, you have your main estimate. This could be numerical, this could be non-numerical. You have your estimates for what you expect - think of what can deviate from those aspects; there could be natural deviation or deviation due to other outcomes, due to, how can I say, due to different scenarios. So one for each scenario, for each outcome, think whether you want how likely this and what is its effect. Next is, should you ignore it, is meaningless, and should we try to diminish? And to diminish either the effect or the likelihood of it. Should you think about transferring or is it too big that you say ‘I really don’t want to touch this’? So essentially that’s the whole aspect of it and you need to understand your business per se. It's really about understanding the industry you are in and because these could get applied much more differently. And one final thing is the truth is not absolute. So, what you might consider as low likelihood someone else could consider it as high likelihood. So, it's very important to see what others are doing as well, not to follow their mentality but to learn and to adapt.

And I guess there's always the possibility, as well, to see the upside of risk, as you have mentioned before right to see how we can harness the capacity or the possibility; the potential of this risk for an advantage.

Thank you so much Dominic for this conversation. It was enlightening and I hope our listeners have also taken some notes of how to strategically pace their risk aspects. Thank you so much for joining us today.

Thank you. Thank you for inviting me. Jeanette: This was Dominic Cortis, and you are listening to ‘The Human Agenda’. Thank you so much for joining us in this episode.

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