Systemic Risk

Insurance and Security in a Connected Age

 Overview

Systemic risk is a term that came crashing into popular discourse with the past financial crisis and since
become a key term in our vocabulary for talking about the new context of the 21st century. Systemic risk is
mounting due to the increased connectivity fostered by globalization and the information revolution, the
interdependence of massive global networks has caused systemic risk to increase exponentially in recent
years. Today it would appear that systemic risk is mounting along almost all dimensions, environmental,
technological, social and economic.

Systemic risk is the risk of a breakdown of an entire system rather than simply the failure of any individual
part. It is a product of the way the parts act & interact across the whole system to create the emergence of a
critical system state and eventual crisis.

Systemic risks take many forms; financial, as the globalization of markets and complex linkages create risk of
cascading failures; environmental degradation creates the potential for whole ecosystem collapse and
systemic changes in climate; technological, centralization of data mass automation and the Internet of Things
create mounting risk of critical cyberattacks; sociopolitical with erosion of trust in social institutions, stalling
political systems and the rise of populism.

The term "perfect storm" is often used to describe the somewhat paradoxical situation we find ourselves in
today, as systemic risk is mounting our collective capacities to cooperate and coordinate effectively through
existing institutional structures to respond to it appears to be diminishing. Risks are intensifying in scale,
scope, and frequency but the collective capacity to respond appears significantly lacking.
In the coming decade with the ongoing expansion of information networks, we will see the increasing
convergence of what in the past looked to be widely divergent domains, not just insurance and capital
markets but these will become ever more integrated with security. Whereas in the past such phenomena as
natural disasters, human security, cybersecurity, inequality, or political disruption were seen as largely
separate and distinct phenomena, as the networks of connectivity and linkages expand across and between
domains we move further into this new world of systemic risk every day.

As the connectivity proliferates we shift from a world where these vertical domains have little to do with each
other to a flat world of networks. A new understanding and approach to risk, investment, and security that is
relevant for an age of networks that span across our traditional categories and verticals is now much needed.

The modern conception of risk that emerged in the 16th century was that man was not at the mercy of some
sort of supernatural force or God, that we could use mathematical modeling, an understanding of probability
and uncertainty to realize that we were actually much more in control of our own destiny. It took a long time
for those ideas to fully pass through to industry but today we have a massive, sophisticated edifice of models
and institutions for managing risk and security.

Yet for all its great achievements this edifice is based upon a reductionist analytical conception of risk that
creates its own limitations. With our traditional linear ways of thinking, we tend to try to isolate phenomena,
searching for a cause for every effect. Yet when systems become complex linear cause and effect break
down. Because of high levels of interconnectivity, it is more the structure of the system that comes to define
how it operates and behaves rather than the properties and behavior of any of the parts.

Due to this foundations, it is unfortunate to report that our capacity to deal with mounting risk remains on
the level of dealing with these individual parts while lacking the theoretical or institutional capacities to deal
with the emergent overall macro patterns formed out of the networks of globalization through which
systemic risk travels today.

In a world of mounting systemic risks we need to be asking the question, how do we systematically combat
risk? Because this is certainly not what we do at the moment, we are incentivized to create risk and to insure
against risks, but we aren't actually systematically incentivized to find and remove them. Put succinctly, we
have a risk industry but not a de-risk industry. It would seem quite extraordinary that with the massive multi-
trillion dollar industries of insurance and security designed to reduce and manage risk almost none of our
resources are actually directed at reducing systemic risk, how could we achieve such a mismatch?

We have a security industry that is good at securing parts, creating a world of borders and boundaries, but
we do not have a resilience industry for strengthening wholes systems that is required in a world of
connectivity. Our approach to risk is a product of our linear perception of the world that is becoming
outdated as we move into this new world of complexity, where networks expand and nonlinearity becomes
the norm instead of the exception.

The financial crisis illustrates that we do not measure risk in a systematic way but a very partial way. As
systems-level crisis become more prevalent it becomes ever more apparent that we are only accounting for
risks on one level and not in a holistic fashion that would be required to actually channel resources and
capabilities towards tackling them.

What is needed is a holistic approach to asset allocation and risk management. Systems thinking is the
consideration of something in its totality, its interaction with a wide range of factors and environment. Taking
a holistic perspective to risk means factoring in all relevant metrics required to sustain the whole system and
thus mitigate systemic criticality.
Ultimately the question is how do we switch our systems from creating these externalities to solving them.
From creating negative externalities that lead to systemic risk to patterns that create positive externalities
and build systems-level resilience. We tend to think of risk in terms of loss and systemic risk as something
negative, however, if systemic risk is a multi-trillion dollar expense then solving for it is likewise a multi-trillion
dollar opportunity.

This is really a question of system-level financial innovation, so as to begin to create financial instruments and
institutions that are actually accounting for the value, resilience, and risk on the macro-level. This is still
nascent - with such things as social impact bonds or green bonds - but as the costs of systemic failures
increase it becomes more and more viable to build financial services that integrate for both utility to the
agent and value to the whole; full cost accounting and systemic risk are two sides of the same coin. Investing
in the whole to make it resilience means to create structures that push value and investment out words to a
diversity of investment vehicles; to have financial networks that engender the many channels, pathways and
diverse nodes required to sustain the whole network.

In this paper we give an outline to the nature of systemic risk, trace how it has evolved over the past decades
and how to use systems thinking, new economic financial models and new technologies to build resilience
against systemic failures across the many dimensions along which it exists today.
Understanding Systemic Risk
Section 1
Risk is the potential for loss, "a situation involving exposure to danger."1 The saying "nothing ventured nothing
gained" captures the foundations of investment. Returns are predicated on the risk of loss and thus there can be
no development without risk; the sources of risk are sources of opportunity. The risk of loss and the possibilities
of gains that are engendered in an investment, or any initiative, are two sides of the same coin.

Lionel Robbins is famous for his definition of economics as "the science which studies human behavior as a
relationship between ends and scarce means which have alternative uses."2 In this respect, economics is a
relationship between human means and ends; how we use scarce resources to achieve our valued ends.
Investment is about resource allocation into those processes that we believe will lead to the desired ends in an
optimal fashion, while risks can be seen as the set of eventualities within that environment that may lead to a
loss.

In all our activities we strive to realize the beneficial outcomes and avoid the losses; we take strategic actions to
avoid losses and we may define this as risk management. Risk management "is the identification, evaluation,
and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor,
and control the probability or impact of unfortunate events or to maximize the realization of opportunities."3

Whether we're trying to send a satellite into space or just move home, whether we are dealing with a large scale
complex project or a simple project the same basic questions apply when it comes to managing risk.4
In this process of risk management, the primary question is, what are we trying to achieve? Defining what we are
doing works to define the scope and the context; the environment within which we're having to manage risk.
The question then is what might affect the outcomes. What events or things might hinder or enable the
realization of the desired outcomes being achieved. This may be called "risk identification" finding the
uncertainties that matter and may affect outcomes.

Because not all identified risks are equally important the question then turns to the level of impact that those
events may cause, what is called "risk assessment" or "risk analytics" where we try to prioritize those things that
might affect outcomes. Typically this is done along two dimensions; how likely is it to occur and if it did then
what would be the impact.

Once this preliminary analysis is made the question is then, what can be done about that risk to avoid the
downside, minimize against it or protect ourselves? Inversely for the good risks, we could try to maximize or
exploit them, to better position ourselves to exploit them. We are trying to position ourselves within the risk
environment to minimize the downside and maximize the upside.

Once we have done this, we can then act or see how things play out, doing what we said we were going to do.
Once we have this feedback as to how the process has developed the question then is did it work? Often we
find that it does not and we might need to modify or adjust our approach in some way. The last question is, what
changed? Projects, businesses and market environments are constantly changing, we are operating in dynamic
systems and we need to stay aware of the new risks and opportunities that are constantly arising.

This same process of risk management applies from the micro-level of managing our daily activities to managing
something as complex as a decades-long energy exploration project.
"Security is an architecture, it is not something that you can put
a bandaid on it in different parts of the network and solve it”
- Tony Shakib Cisco
 Systematic vs Unsystematic Risk

Risk can be defined as systematic or unsystematic. The idea of systemic risk implies that the risk exists on the
level of a whole system or whole environment. This can be contrasted with unsystematic risk which is unique to a
specific part or section of a system.5 Unsystematic risk is also called "diversifiable risk" because it is coming from
only one part or a subset of the system it can be hedged against through investing in other nodes, i.e.
diversifying.

Connectivity is what creates the conditions for systemic risk.6 At low levels of connectivity the system is nothing
more than a set of parts. Without the pathways for effects to spread system-wide there is limited capacity to
have system-level changes. These simpler systems adhere to the models and rules of linear systems theory.7 All
complex systems have high levels of interconnectivity and interdependence between their constituent parts and
this fundamentally changes the dynamics and behavior of the system; making them nonlinear in nature.8
 Systems that are complex differ to simpler linear systems in fundamental ways,
here we can outline four key characteristics of complex systems

Emergence Nonlinearity
Interconnectivity and interdependence create the conditions in Interconnectivity creates sufficient pathways for feedback to
complex systems for emergent system-level features and become a dominant driver of change, meaning complex systems
processes not seen in simpler systems. have nonlinear dynamics.

Networks Evolutionary Dynamics

Interconnectivity creates structures and network patterns in the Without centralized coordination complex adaptive systems
system that come to have a defining effect on how the whole develop on the macro level through an evolutionary dynamic.
system works.
 Synthesis & Analysis

To understand systemic risk we have to think systemically, which means thinking in a holistic way, using what we
call synthetic thinking which is a form of reasoning that is always expanding outwards to look at a given event or
phenomenon within its broader environment or context. Synthesis is a process of reasoning whereby we put
disparate parts together to gain an understanding of the whole. With synthesis, one understands something by
looking at how the parts interrelate to form the whole and how this whole system functions within its
environment.

This is in contrast to our more traditional approach to risk management which is characterized by analytical
reductionist thinking and models. An analytical form of risk assessment is focused down on a given industry or
asset class, but a systemic perspective goes in the opposite direction expanding out in scale and horizontally
across domains. To understand systemic risk one has to consider the system's different dimensions. In terms of
scale, this means from the local level all the way up to the global level but also horizontally across domains;
political, social, economic, technological, environmental, etc.

It is important to note that analysis that focuses on one institution at a time fails to capture these systems-wide
structural patterns. Analytical risk assessment suffers from the problem that by focusing more on specific parts
and their properties we can become more removed from a perception of the whole. We assume that the forest is
nothing but a collection of trees and we go and study all of those trees in isolation assuming that if we cover
them all then we will have a complete risk profile.
This analytical approach fails to capture emergent phenomenon, that is to say, processes and structures that are
only visible at the level of the whole system. For example, by studying one horse in isolation one will never see
herd dynamics, yet herd dynamics is an important feature governing the way horses behave when taken as a
whole group.

With complex systems, context and embeddedness come to be of critical importance. With simpler linear
systems one can extract the parts and describe the response of a part to a stimulus in a linear fashion - like the
cogs in a machine that will turn in a predictable way when affected by another cog they are connected to.
Although one can study the parts of complex adaptive systems independently, its context matters in
fundamental ways.9

As the connectivity proliferates along all dimensions the risks become integrated, across geographies and
domains. What used to be isolatable events are now caught up in complex networks of interdependent
processes. Because of this complexity that is too great to compute we can only know how a system will behave
or respond to a given stimulus when taken in context and this limits the validity of an analytic risk assessment
approach that always involves aspects of isolating the given phenomenon.

As the connectivity proliferates systems-wide the risks associated with a part become more closely correlated
with the risk to the whole. This is a fundamental feature of complex systems - because they are nonlinear we
cannot simply understand the risk of a part without consideration of a risk to the whole; all nonlinear systems
have two levels to them, the micro and macro, that are interdependent.10

The biggest mistake we make in risk assessment within complex environments is the error of thinking that the
risk associated with a given asset is contained within the properties of the entity and thus we can compute a
value to the risk by primarily studying the properties of the asset. We study the risk associated with a mortgage
by looking at the holders of that mortgage and their capacity to pay, we are less inclined to look across the
industry to see how what everyone else is doing may lead to a systems-level phenomenon that leads to their
defaulting without that having anything to do with their normal capacity to repay.

In general, we look vertically, drilling down, we do not look so much horizontally and expansively. We fail to look
at the overall context and factor this into the risk assessment, this is fine in simpler environments without
systemic risk but in complex environments it creates a miss perception.

"Almost 400 years ago Rene Descartes

described a method of tackling problems by
dividing them into smaller parts, his method
of reductionism became the template to
how we think about everything, it has
enabled us to be so collectively intelligent to
build an advanced civilization, but also
collectively so stupid, to bring that
civilization ever closer to the point of
collapse… The problems that are caused by
reductionism cannot be solved by this same
way of thinking" - James Greyson, BlindSpot
 Systems Integration

Systemic risk is not a risk that is associated with any element in the network - it is an emergent phenomenon
meaning it can not be observed within a part of the system or some simple summation of the properties of the
parts, rather it is a systems-level property that relates to the integrity of the whole system.11

All complex systems have two qualitatively different levels, the whole, and the parts. The whole is the
infrastructure that provides basic overall services which the parts operate within. For example, a city needs a
shared set of public services and infrastructure - the whole - for the different organizations and residence to
operate successfully - the parts. An economy needs a shared set of standards and regulation for the businesses
to operate within. Agriculture is dependent upon an ecosystem for farms to be productive.

This infrastructure of the whole requires integrity to function.12 For example, the functioning of an ecosystem is
dependent upon the integrity of its biophysical processes. Ecological Integrity refers to the ability of an
ecosystem to support and maintain ecological processes and a diverse community of organisms. For a city to be
functional the urban infrastructure must be integrated. For public institutions to function they require integrity
operating according to a common commitment to serving the public.

Systemic risk is not a risk associated with a part in the system but is a function of the integrity of the whole. As
the integrity of the whole is reduced the system moves towards criticality and systemic risk increases. The central
component for understanding this is that of negative externalities - the way the parts are incentivized to operate
creates external effects that are depleting to the resources required to maintain the functioning of the whole.

This dynamic is famously captured in the so-called "tragedy of the commons."13 The dilemma arises when
members of a group share a common good, such as an ecosystem, where this common good is rivalrous and
non-excludable, meaning that anyone can use the resource but there is a finite amount of the resource available
and it is, therefore, prone to over-exploitation. Each agent in the system is incentivized to use more of the
commons resources because the benefits of doing so accrue to them while the cost of their actions is
externalized to the whole - thus creating a cost-benefit equation for the agents that drives them towards overuse
and eventual ecosystem collapse.

It is the structure of the game they are involved in that leads to negative externalities; depletion of the resources
required to maintain the whole infrastructure; a critical state and risks of systems failure. Systems failure happens
because the resources required to maintain the integrity of the whole system are being depleted from.

One can equally understand this as an accounting failure, where we account for the value of the parts but fail to
account for the value required to maintain the whole. A focus on a single dimension of utility value - what is of
immediate value to the agents in the system - can create negative externalities that degrade the system
infrastructure and leads to systemic risk over time. This can be seen across all kinds of complex systems, for
example eating too much sugar stimulates the body but over time degrades the infrastructure by not providing
it with the nutrients required to sustain the whole system.

The main takeaway from this holistic perspective on risk is this; we look not just at the specific issues as they
present themselves and the linear interaction of the components in the system, but how the structure of the
systems we employ create externalities that lead to systems failure over time.
"I think the overarching message now is that we need to broaden our
methods and vision involved in risk management... the importance of
looking at the system as a whole and looking at the interplay of
systems, join up the dots, take a view that isn't about silos and tunnel
vision but tries to see the totality of the situation" - Gillian Tett Financial Times
 Linearity & Nonlinearity

Risk can be classified into the two primary categories of exogenous and endogenous risk.14 With exogenous risk,
shocks to the system arrived from outside the system, like an asteroid might hit the earth. In such a market
scenario, participants may react to the shock but do not create it or really alter its magnitude of impact. In
contrast, with endogenous risk, the interaction of agents in the market alters the scope and scale and nature of
the impact. Systemic risk is a form of endogenous risk that is nonlinear in nature.

Most current financial models are based upon a conception of exogenous risk.15 However, in a complex system
as the interconnectivity increases so do the interdependencies and feedback loops, which fundamentally change
its dynamics from linear to nonlinear. It is more the network of interactions and feedback loops in the system that
determine its behavior rather than any given cause creating a given effect in a linear fashion. Risk within the
financial system is more often generated by people interacting with each other. This we would call endogenous
risk, which comes from the ancient Greek words for “growing” and “within”.16

Most of the systems we are dealing with when talking about systemic risk are complex adaptive systems for
example, financial systems, political systems or food systems. A complex adaptive system(CAS) is a special class
of complex system that has the capacity for adaptation. They consist of many elements called agents with these
agents interacting in a nonlinear fashion creating a network of connections within which agents are acting and
reacting to each other’s behavior. Other examples include, flocks of birds, social networks, the internet, microbial
ecosystems.
Events within a financial system are caused by the interaction of all the players in the market, whether financial
institutions, regulators or traders who are all pursuing their own agendas. These agents are continually acting
and reacting to each other's behavior based upon their own subjective interpretation of events; they are
changing the market in the very process of responding to it in an ongoing feedback loop.

Most of the time - because of the structure of the system and incentives - agents act in a way that
counterbalances each other's actions, thus maintaining stability and equilibrium within the system. For example,
the core supply and demand dynamic in any market is a balancing feedback loop driven by the incentive of each
actor on either side of the transaction.

These kinds of balancing negative feedback loops do not create systems-level behavior. Systems-level processes
of change happen due to the positive feedback that incentivizes all agents to take a similar action that is self-
reinforcing and self-amplifying. The best example of a positive feedback process can be seen in autocatalytic
chemical reactions. This is a chemical process where one element triggers a reaction in another which then
generates more reactions and so one. Autocatalytic processes are an example of runaway positive feedback.
Systems-level change happens when agents start behaving in a synchronized way; for example, in a crisis, the
distress of one agent triggers behavior that causes distress in others, who then further spread the stress.
“Today the network of relationships linking the human race to itself
and to the rest of the biosphere is so complex that all aspects affect
all others to an extraordinary degree. Someone should be studying
the whole system, however crudely that has to be done, because no
gluing together of partial studies of a complex nonlinear system can
give a good idea of the behavior of the whole” - Murray Gell-Mann
As the connectivity grows, we move from a linear world to a nonlinear world, which fundamentally alters the
distribution of possible states to the system. Linear processes produce normal distributions with a well defined
"normal" average state, while the greater potential for positive feedback that comes with greater connectivity
create a much higher likelihood of extreme nonlinear events and a long tail distribution - where mathematically it
does not make sense to talk about a "normal" or "average" state to the system. In a power law distribution as
we increase the number of samples we take, values will not converge to an average, they will, in fact, diverge,
with some exceptions. Asking for an average is like asking how big is a stone or how long is an average piece of
string? This loss of the law of large numbers has massive implications for how we think about and quantify risk.17

The system receives some external shock, that shock may be quite small but through some endogenous
dynamic the system amplifies that effect with a large outcome being the result, one that would not be possible
given linear models. Thus we get events in complex systems - so-called black swans - that are statistically almost
impossible within a normal distribution.18

While simpler linear systems are defined by the properties of their parts, linear causality and incremental change,
which results in normal distributions; a normal state to the system and we manage risk by focusing on those
likely events in the center of the distribution while largely excluding those possibilities that are too far from this
center.

When you move from a linear system to a nonlinear system, normal distributions start to disappear because of
the underlying dynamics driving the system behavior. The statistical outcomes are now driven by the structure of
connections and feedback loops that can amplify an outlying small event on the extreme into a huge output.
The result is that the system becomes less dominated by events in the Gaussian standard deviation.
This can be observed in our world today, as the connectivity has proliferated many forms of statistical outcomes
have gone from Gaussian to power law, for example, weather events. As professor Scott Page puts it, in linear
systems it is "the dog that wags the tail" while with complex systems "it is the tail that wags the dog.”19

"In complex systems, events far

from the median may be more
common than we think. Tools
that assume outliers to be rare
can obscure the wide variations
contained in complex systems.
In the U.S. stock market, the 10
biggest one-day moves
accounted forhalf the market
returns over the past 50 years.
Only a handful of analysts
entertained the possibility of so
many significant spikes when
they constructed their
predictive models” - HBR
As the system becomes more interconnected, this can induce greater synchronicity which can lead to a greater
capacity for system-level processes of change. More formally we call these changes in the overall structure of a
complex system a phase transition. During phase transitions the whole structure of the system changes. For
example, as ice goes to water, it is not the molecular parts that change but the whole context within which they
exist, e.g. you can crack ice but not water.

Such phase transitions within complex adaptive systems make it largely impossible to predict events the other
side of the transition because of the change in context. While linear systems are predictable in detail, nonlinear
systems are not, we can not say anything specific about the state of the parts in the future, we can only say
something general about the state of the system.

With nonlinear systems prediction in detail is extremely limited; forecasting is inherently an inexact, yet
bounded, art. Weather forecasting is but one well-known example of this as the fundamental laws governing
pressure and temperature in gases are nonlinear. For this reason, despite ample data and very powerful
computational resources, detailed, accurate long-range weather forecasting is fundamentally not possible.

Despite this, weather forecasting - as is generally the case with complex adaptive systems - is bounded in the
sense that we can make general statements about things like the average temperatures in a given season and
location. While the behavior of a machine - linear system - is predictable in detail. In a CAS, because the
elements are changeable, the relations nonlinear, and the behavior creative and emergent, the only way to know
what a complex adaptive system will do is to observe it making computer simulation a key method of
researchers.20
 Networks

We may well be reaching an inflection point in risk analytics, where the traditional, two-dimensional risk
management models that focus on single points of risk with high likelihood and severity may be increasingly
seen to be limited and need supplementing by relational data. These models are based upon a fundamental
assumption that the world they are trying to represent is relatively disconnected - thus we choose a modeling
framework that does not prioritize the capturing of relational data and patterns.

Since the last financial crisis - and the growing awareness of the importance of the interconnected nature of the
financial system that it brought - network analysis has become a more prevalent tool for trying to understand
and model systemic risk. It is now apparent that we can study the global financial system as a set of linkages of
assets and liabilities, forming vastly complex networks - there are an estimated two billion balance sheets
globally, each with thousands of entries and trillions of contracts.21 But given this vast complexity, our models to
date are not much more than illustrative, or extremely partial in their representation.

Since the crisis, there has been much talk and research on the theme of connectivity and whether it leads to
robustness or fragility. Generally, we know that complex systems can be incredibly robust and resilient, but at the
same time, they can be extremely fragile. For example, a biological organism is highly adaptive and robust to
changes in environment and component parts yet can be terminally disabled by tiny alterations to their genes or
the presence of trace amounts of toxins that disrupt structural elements or regulatory control networks.22
With respect to robustness and fragility connectivity is neutral. Peer connectivity results in the formation of
networked patterns, which result in nonlinear behavior, which means that cause and effect are no longer
correlated in a linear fashion. Given a small shock, this may propagate through a network of connections to have
a huge systemic impact but the opposite is also true, a huge impact can be absorbed without damaging the
system through a distributed set of feedback loops. Nonlinearity works in both ways, it can amplify exponentially
or dampen down exponentially. Networks do not inherently create resilience or fragility if you want either
property you have to design or manage the network to get those outcomes.

It is not a question of the degree of connectivity - the degree of overall connectivity will just tell us the potential
for nonlinear behavior - it is a question of the structure of that network, the type of shocks that it receives and
most of all the quality of the relations between the parts; the protocols and the way they interact.23

Every pathway in the system is both a pathway for the hedging of risk that can make the system more resilience
through its connectivity but it is also a potential pathway for disaster spreading. Every additional flight
connection we put on, say from Milan to Istanbul, might be a connection for trade and cultural exchange that
makes for greater solidarity between the two nations, but it might also be a pathway for a pandemic to spread.
Thus we have to understand those trade-offs and ask how do we invest in those connections that build resilience
and reduce those that can spread disaster.
"What we’ve seen in the
financial crisis and in other
areas is that most
institutions are totally unfit
for the 21st century. Even
the smartest institutions like
the IMF didn’t see the
financial crisis coming.
Navigating this new world
requires an understanding of
how it hangs together, the
new nodes and networks
and the new emergent
risks" - Ian goldin
Understanding the structure of vulnerabilities and potential pathways wherein failure can spread through a
system requires an analysis of the network that includes such questions as; how centralized or distributed is the
network? This can be interpreted from the degree distribution which tells us if there some nodes that have a very
high number of connections - the central nodes - while others only have a very few, or do all nodes have a
relatively equal number of connections making it more distributed and less critical. The "too big to fail"
phenomenon is a function of having a centralized network creating critical nodes whose failure would disrupt the
whole system. Such a network structure can be a product of a "rich get richer" dynamic to its formation, for
example, those that have more capital being able to attract greater capital investment at lower rates.

Studying the patterns of connections and pathways through which resources can travel in the system will likewise
reveal insights into its degree of criticality, we might look for bridging links whose removal would disintegrate
the entire network. For example 80% of global trade - and thus the world's supply chain - is still conducted by
sea and it travels through a very few critical points, such as the Panama Canal, but the Malacca Straits between
Indonesia and Malaysia is by far the most critical channel of approximately two miles in width through which a
huge percentage of global trade and energy travel; a critical bridging link.24

A comprehensive network analysis of the risk profile to a complex system - such as a transport network,
corporate supply chain or financial system - requires analyzing it across many different aspects. Too often models
are limited to just one or two different network structural factors. It is sobering to remember that at the end of
the day the real world is some kind of complex multidimensional set of networks that are constantly interacting
and dynamically evolving over time.
 Evolution

Without centralized control complex adaptive systems develop through an evolutionary process. This involves
the production of variety, selection, and duplication. For example in the case of financial markets, a new market
condition is given, agents create a set of strategies for investing and trading, those that are successful create
greater returns and have a greater portion of the capital to invest at the next iteration, while those strategies that
fail become less prominent. However, the act of those changing strategies changes the market environment
which then makes it possible for new strategies to be introduced and become successful, thus creating constant
coevolution between agents and structure.

With each iteration, the system starts from a new market condition where there is a possibility of high variety to
explore the new environment. As the agents explore and test different strategies to discover the rules of the new
context and get feedback about what works and does not work within that context the system moves towards a
rationalized and consistent environment where a few of those strategies prove successful. These successful
strategies will become copied by others which works to reduce the variation in the system as it becomes
organized into a new more coherent pattern. Likewise, as the system becomes more rationalized and stable with
greater synchronicity between agent states standardized protocols can form that allow for greater coupling in
the system as it becomes more tightly interconnected and interdependent.
As the system stabilizes over time a certain subset of elements that are better adapted to that environment
become selectively favored for, this reduces the diversity, increasing the homogenization of agent profiles and
strategies. While the agents become better at exploiting the specific market condition they also become
vulnerable to systemic shocks because of a reduction in variety. A system that has diversity will have some subset
of agents that are able to respond to a given change and stay successful and resilient. However, when the
system becomes homogeneous an event that one agent is not able to deal with will be the same for all others
and a small change in the environment - given the homogenization and tighter coupling - can easily spread to
the whole system and lead to collapse. Thus we can see how "stability leads to instability" the rationalization of
the market makes it more stable but that stability makes the agents more susceptible to major alterations and
thus inevitably unstable over time.

One can understand resilience in many different ways but probably the most comprehensive and advanced
model is that of a stability landscape. A stability landscape is a mathematical model representing the various
stable and unstable states that a system (such as an ecosystem or market) may occupy. The stability landscape is
based on models derived from nonlinear systems dynamics, in particular, that of state space(also called phase
space) and attractors. A state space is a 1, 2, 3 or more dimensional space that represents all the states to a
given system at any given point in time. A “basin of attraction” is a region in the state space in which the system
tends to remain cycling through unless perturbed significantly. The totality of the various basins that a system
may occupy, and the boundaries that separate them, are known as a stability landscape.
"A CAS [Complex Adaptive System] moves forward through
constant tension and balance. Fires, though destructive, are
essential to a healthy, mature forest. Competition is good for
industries. Tension, paradox, uncertainty, and anxiety are
healthy things in a CAS. In machine thinking, they are to be
avoided." - Paul Plsek
A simplified model of the stability landscape is often used in a non-technical context, where an analogy to a ball
in a bowl is made to provide a practical description. Here a ball, often representing an ecosystem, exists on a
surface where any point along the surface represents a possible state. In the simplest model, the landscape
consists of two valleys separated by a hill. When the ball is in a valley or a “domain of attraction,” it exists in a
stable state and must be perturbed to move from this state. In the absence of perturbations, the ball will always
roll downhill and therefore will tend to stay in the valley (or stable state).

These attractors within the landscape can change over time given internal or external alterations. For example,
many lakes occupy a stability landscape with essentially two basins of attraction: one that is initially wide and
deep, characterized by clear water, and a smaller one characterized by turbid water. Agricultural practices within
the larger socio-ecological system - through the application of fertilizers and manure - have gradually increased
the phosphorus content of soils in some watersheds can change this with the emergence of a new basin of
attraction while the first two are diminished.

Both exogenous and endogenous drivers can result in changes in the number of basins of attraction within the
landscape, changes in the positions of the basins within the state space, changes in the positions of the
thresholds between basins or changes in the depths of basins. Depth is a measure of how difficult it is to move
the system around within the basin, with steep sides implying more and stronger negative feedback loops where
greater perturbations or management efforts are needed to change the state of the system. Restructuring the
system changes its position within a basin relative to the edge and defines its precariousness or capacity to
move into a new basin.
The stability landscape gives us some basic model for approaching the subject of resilience in a formal fashion.
Resilience is the capacity of a system to deal with disturbance and reconfigure while undergoing change so as to
still retain essentially the same functionality and structure. This can be interpreted as the strength and number of
the negative feedback loops creating the likelihood of the system remaining in the same basin of attraction
given some perturbation.

When we ask what is the maximum amount the system can be changed before losing its ability to recover; we
are essentially talking about the width of the basin of attraction. Wide basins mean a greater number of system
states can be experienced without crossing a critical threshold. We can talk about resistance as the difficulty of
changing the system, this is then related to the topology of the attractor, deep basins of attraction mean that
greater influences are required to change the current state of the system away from the attractor. Within this
model, we can talk about the precariousness of the system - which would correlate to its current trajectory - and
how close it currently is to a limit or “threshold” which, if breached, makes recovery difficult or impossible.

It is from this stability landscape model that we can get the idea of early warning signals as to when and where a
system might be coming close to critical transition points. One such theory is that of critical slowing down which
refers to the idea that as a system approaches a critical state the recovery rate at which it returns back to its
initial equilibrium following a perturbation decreases i.e. slows down. This theory posits that in cases where a
system is close to a critical tipping point the recovery rate should decrease, thus giving us a metric that can be
empirically tested to explore how close the system is to a critical transition.

As conditions bring the system close to a critical transition, the basin of attraction of the current state of the
system shrinks and so does its resilience. At the same time, the steepness of the basin of attraction becomes
lower: this means that the same perturbation that may not flip the system will though likely take longer to
dissipate, meaning it will take longer for the system to return to its point of equilibrium when close to a tipping
point. The simplest way to measure the approach to a potential tipping point then would be to directly measure
the recovery rate at which the system returns back to its initial equilibrium state following a perturbation. In
cases where the system is close to a tipping point, the recovery rate should decrease. As such critical slowing
down offers some potential to probe the dynamics of a system in order to assess its resilience and the risk of an
upcoming regime shift.
Todays Systemic Risks
Section 2
The world we find ourselves inhabiting in the 21st century is a world of mounting systemic risks, along a
multiplicity of dimensions. At the center of this new equation is the linkage between expanding connectivity and
systemic risk. With the expansion of telecommunication networks and computerized coordination, our
economies and societies have gone from disconnected to connected within the space of just a few short
decades. The implications of this transformation are truly profound as it rewrites fundamental rules within which
our systems of social and economic organization operate today.

If we care to look into the details of almost any dimension of economic activity - transport, tourism, finance,
supply chains, commerce, manufacturing, etc - we will see a huge rise taking place in the degree of connectivity
since the early nineties. However, it is not just connectivity it is more precisely complexity - meaning more nodes,
greater connectivity and greater volumes of exchange between those nodes - it is this proliferation of complexity
that has really changed the rules of the game.

We can also note how this transformation in economic organization largely follows the rise of digital
computation and telecommunications. The expansion of the global financial system is but one good example of
this. Since around 1995 with the advent of personal computing and the World Wide Web, the average daily
volume of exchange-listed options and futures have grown at an exponential rate largely tracking the growth of
computational capacity.26

Until about 1990 flows of capital were relatively low, stable and flat and since then they have changed in orders
of magnitude and in orders of instability. This is the nature of globalization, more nodes, more connections,
more flows, which leads to greater instability. Globalization is about connectivity across borders and networks
that integrate across the whole planet, this is a much more complex, volatile and unstable context than that
created by the nation state's regulatory environment.
The global economy that we all now depend upon consists of a myriad of overlapping and intersecting networks
that we are vastly removed from understanding or properly modeling. As one trivial example of the unknown
linkages we can cite the case of the 2011 floods in Thailand caused by a monsoon which disrupted the supply
chain for computer accessories shortly thereafter computer memory was almost impossible to obtain in Swiss
stores, while disruptions to manufacturing supply chains affected regional automobile production and caused a
global shortage of hard disk drives which lasted throughout 2012.

Traditional categorizations that lead to the vertical separation of concerns and risks are no longer relevant as
domains become networked horizontally. Risks are no longer confined to one vertical or one domain but now
can spread horizontally across traditional divides. The fall of the Berlin Wall, the opening up of capital markets,
outsourcing and the expansion of supply chains, the integration of many emerging markets into the global
economy, the proliferation of connections due to telecommunications, has led to integration and convergence
between different domains.

Where as in the past such phenomena as natural disasters, human security, cybersecurity, inequality, or political
disruption were seen as largely separate and distinct phenomena. In the coming decades with the ongoing
expansion of information networks, we will see the increasing convergence of what in the past looked to be
widely divergent domains. Insurance and capital markets become more closely connected while at the same
time these will become ever more integrated with security, climate security, cybersecurity, national security, etc.

We start to see this in such phenomena as the Arab Spring. Research at NECSI discovered that a combination of
deregulated markets, commodity speculation, and food-to-fuel ethanol policies was the cause of the spike in
food prices that led to the Arab Spring. A complex set of linkages between policy, capital markets, food systems,
and political upheaval.27
"There is no better indicator of increasing
globalization than the massive and
accelerating increase in international
transactions beginning in the late 1970s.
These, in turn, have required the
construction of a complex system of
global nodes and links providing the
channels through which these can flow.
The interdependence of massive global
interactions and structures has caused
systemic risk to increase exponentially in
recent times. Tangible risks—in systems
as diverse as energy exploration and
production, electricity transmission,
computer networks, healthcare, food and
water supplies, transportation networks,
commerce, and finance—now threaten
global political, economic, and financial
systems that affect citizens of every
nation" - PIIRS Global Systemic Risk
Likewise, several studies have pointed to a link between climate change and the civil war in Syria, which started
in 2011. The direct causes of the conflict relate to popular discontent with the government, however
mishandling of a major drought in the preceding years likely fed into this discontent, while climate change
worked to increase the likelihood for such a drought.28

The proliferation of connectivity that has happened along many dimensions over the past decades has hit with a
stunning shock, the ripple effects of which a now only starting to feed through. We see this with such
phenomena as political disruption by social media, climate change, global terrorist networks or food insecurity
starting to move farther into the mainstream media over recent years.

This new world of systemic risk was brought crashing into mainstream awareness with the global financial crisis
of 2008, yet while awareness has increased our capacity to mitigate it appears as limited as ever. Since that time
systemic risk has expanded along many dimensions; technological with the rise of cybersecurity; environmental
with climate change, and social with political instability and populism.

As the connectivity has grown and global networks have expanded the sphere of stability and order offered by
industrial age organizations - within the national regulatory environment - have shrunk, the result being a world
that is an increasingly unstable place. While surely pockets of order remain within national jurisdictions the space
of networks that exist between and around this order is growing daily. Whether this is the rapidly expanding
social networks that occupy so much of our time or the offshore tax havens that slip between national
jurisdictions, the frameworks within which risk can be managed, structured and matched with responsibilities and
returns in an orderly way increasingly only exists on the micro-level while on the macro level discontinuities
create huge negative externalities and macro level imbalances - a place where multinational corporations can
profit at the expense of the planet and societies, where cybercriminals reside.
Risk exists on all levels, from individual health to the global political environment and all places in between, but
our capacity to actually create frameworks for dealing with that is very much limited in scope with huge
discontinuities between the micro level and macro level. Suffice to say that we find ourselves in a world where
the way that risk and returns are actually distributed - on the various levels - is hugely miss matched with the way
that they are born.

Walls are coming down everywhere but paradoxically this hyperconnectivity that is interconnecting us all
contains the risk of dividing us in new ways. Hyperconnectivity leads to systemic risk which threatens to divide us
all. This is because as the risk mounts and tension and fear mount, we start to fear these forces that come from
beyond our borders - be they climate change, pandemics, cyber attacks, terrorist attacks, financial crises - the
response politically is to withdraw, to try and build walls around our societies but also withdrawal from our
institutions which connect us. The UK creates a myth about independence and being able to control its own
destiny. Because people feel out of control, the future is too uncertain, it is too complex, they pull back and
become local, however, the only sustainable solution is to find new ways to understand, model and manage the
risks of global networks.29
 Environmental Risks

The long since predicted environmental crisis is now starting to become a tangible reality as environmental
factors are moving to the top of the World Economic Forum's report on Global Risk.30 These imminent specific
environmental risks sit within an ongoing fundamental transformation in the global biosphere induced by the
rapid scaling up of human economic activity since the mid-20th century.

The relationship between human economy and the supporting global biosphere has clearly entered a new
paradigm given the scale and scope of human intervention into the biophysical processes regulating Earth's
system; this new paradigm is described by the term "Anthropocene". The concept of the Anthropocene
engenders the realization that the regulation of the biosphere has shifted from being primarily determined by
ecological processes to being determined by economic factors. The intervention of human activity into
ecosystems is no longer piecemeal or incremental but instead now effects and alters whole biophysical
processes, all the way up to the planetary scale, for example altering the entire climate system or global ocean
current belts. This transformation, in turn, implies a shift from environmental risks to systemic environmental risk.

While climate change may capture the headlines the Anthropocene engenders environmental systemic risks on
every level from the risk to coastal communities from climate change all the way up to a planetary scale. The
disintegration of our ecosystems is taking place at an accelerated pace along a multiplicity of dimensions, from
overfishing, collapse of coastal ecosystems and coral reefs, to loss of topsoil, to falling groundwater levels,
drying up of rivers - over the last 25 years across China some 28000 rivers and waterways have dried up31 - loss
of biodiversity, to urban air pollution in the megacities India.
While in the past these environmental issues were largely seen as long term political considerations the level of
environmental degradation has now reached a level where it is having direct economic impacts, moving it from
the realm of policy and NGOs into the realm of economics and insurance. According to one estimate, natural
disasters caused about $340 billion in damage across the world in 2017 with insurers having to pay out a record
$138 billion.32

The economic impacts resulting from the changes to the biosphere that are underway are almost impossible to
imagine; patterns of food production will change around the planet impacting food security, climate-induced
migration into the overcrowded megacities of emerging economies, agricultural policies in Europe will change
to incorporate these environmental factors reshaping the rural economies, health care costs in India and China
may sore in the coming decade due to air and ground pollutants, while new patterns of illnesses linked to
climate change are expected to emerge as conditions change in the coming years.

To take one concrete example of these changes, we can look at alterations to air traffic due to climate change,
severe turbulence is expected to increase by several hundred percents in the crowded airspace over North
America, Europe and the North Pacific by mid-century.33

Most of the world's population lives in emerging markets - some 86 percent of the world's population in 2018 -
but these are the countries at highest risk of natural disasters as they often have lower safety net coverage.34
According to researchers at Swiss Re, an average of 80 to 100% of economic losses are uninsured and lack safety
nets in emerging markets.35 This is not merely a "protection gap" it is a huge risk that many nations around the
world live with today and for the coming decades.
"The absence of an understanding of these
networks and structures leads to the building up
of these very significant pressures over time…
whether a cyber-attack, a pandemic or a financial
crisis, we’ve found that the existing systems of
supervision and control are totally unfit for
twenty-first century purposes" - Ian goldin
 Technology

Along with environmental factors dominating the top of global risks are the risks associated with information
technology. Our technology infrastructure has always presented some form of risk, the failure of a bridge, the
derailing of a train or the collapse of a building has made safety and risk a key focus of engineering for hundreds
of years.

However, today's revolution in information technology changes the nature of these risks as connectivity across
large systems shifts the locus of risk from the failure of an individual machine or construction to the failure across
a whole network of interconnected technologies and infrastructure. We are automating and networking our
technology infrastructure and this presents risks on a whole new level of complexity and scale - systemic
technological risks similar to the scale of those presented by environmental changes.

The risk presented by the expansion of information networks are quite literally just beginning as we start to build
out an IoT infrastructure to our economies and connect up more and more devices and systems while also
automating their operations. The scale and severity of the possible risks is expanding just as fast as the networks
themselves, which are driven by network effects which means they can expand exponentially.

We move from simply the Internet of communication to the Internet of activities, our bank accounts, our front
door locks, our vehicles, airplanes, televisions, everything will be connected. In the process, we are challenged
with engineering ever more complex systems, whether we are talking of smart cities, large infrastructure
projects, smart factories or a myriad of different kinds of IoT platforms.
Every one of these devices and the connections we create is a potentially useful function but also a potential
pathway for cyberattack thus as the network expands daily so too does the speed and complexity of cyber
threats.36

According to Zurich Insurance Group's Global Risks Landscape attacks are increasing, both in prevalence and
disruptive potential. Cyber breaches recorded by businesses have almost doubled in five years, “darknet”
markets for malware products and services have seen a regrowth. The financial costs of cyber-attacks are also
rising. The cost of cybercrime to businesses over the next five years is expected to be in the order of $8 trillion, a
stunning figure that represents a large chunk of global GDP, the equivalent to the current GDP of Germany,
France and the UK combined.37

Beyond its financial cost, there is a growing trend to use cyber-attacks to target critical infrastructure and
strategic industrial sectors, raising fears that in a worst-case scenario attackers could realize a breakdown in
critical systems that keep societies functioning - telecommunications, water, electricity, finance, etc.38

Most attacks on critical and strategic systems have not been successful so far, however, the combination of
isolated successes - such as the Stuxnet virus - with a growing list of attempted attacks suggests that risks are
mounting.39

As one concrete example, we can take the Wanna Cry attack that disrupted critical and strategic infrastructure
across the world - car manufacturers, banks, government ministries, railways, telecommunications providers,
energy providers as well as hospitals - from Australia to Japan to the United States.40
The Internet is a complex system that exhibits the same kind of robustness and fragility that is a feature of all
complex systems. Far from being the single network we conceive of it as it is really a network of around 50,000
sub-networks such as that of the national telecom providers, ISPs, enterprise networks, university campuses, etc.
So for data to go from one end of the internet to the other it may go through as many as a half dozen or more
different networks, that are both competing and cooperating in routing IP packets to their correct destination.
Any one of these subnetworks can disrupt the
entire system. For example, a few years ago
China Telecom - whether by accident or intent -
started telling traffic on the internet that it was
the best way to reach ten percent of the entire
internet, it became a sort of a man-in-the-
middle attack redirecting traffic around the
world through the Chinese network without
need.41

In a similar event, Pakistan's state-owned

telecom company managed to cut YouTube off
the global Web. After receiving a censorship
order from the telecommunications ministry
directing that [Link] be blocked, the
Telecom provider - again by accident or design
we do not know - broadcast instructions
worldwide claiming to be the legitimate
destination for anyone trying to reach YouTube's range of Internet addresses. Here again, a relatively small
section of the internet managed to block global access to one of the internet's largest sites.42

One point to remember is that the global internet - upon which the whole global economy is now hugely
dependent - has not been the point of a wholesale attach so we do not know how it would fare under such
conditions.43

The emerging Internet of Things presents huge systemic risks going forward. The very virtue of the internet, the
fact that it is an open network where anyone or thing can be connected to exchange information is also part of
its vulnerability, as it makes it easy to connect insecure devices that are vulnerable to being recruited into what
are called botnets, virtual armies of anywhere from 10s of thousands to millions of interconnected endpoints -
anything from a personal computer to a network of smart light bulbs - under the command and control of a
single attacker who can direct them at a single target to bring it down.

We are now populating our world with an endless array of connected devices and systems often without thinking
about the consequences of that. A picture display, that someone decides to put Linux on and have it send image
to a cloud service, may sound cool but it is just one more vulnerable device out there and what happens when
the producer goes out of business and stops pushing updates, the picture frame sits there getting more and
more vulnerable to being harnessed for attack. Each device and system connected is a vulnerability and we
rarely can see the potential long term consequences of its existence or imagine the ways that it may be used in
the future for malicious ends. Deloitte Cyber Risk estimates that globally 35% of internet users have at least one
unprotected device vulnerable to such exploitation.44 We can note here the kind of tragedy of the commons
dynamic creating systemic risk through the negative externality of people not properly securing their devices.
"By 2020 $3 trillion a year will
be lost to cybercrime"
- WEF Report
Artificial intelligence is again a growing threat. When we embed automated logic and adaptive capacity in all
these technologies around us we do not really know how they will interact as a whole network. Early signs of the
challenges presented by having algorithms automate the control of critical networks can be seen in today's
financial markets with algorithmic trading.

The Flash Crash of 2010 - where stock indexes collapsed and then rebounded very rapidly - is thought to be one
such event of this kind as regulators found that high-frequency traders exacerbated price declines. As securities
trading has become a more heavily computerized industry driven by black box algorithms across global
networks, the propensity for glitches, errors and even flash crashes has risen.45

The emergence of flash crashes is a good illustration of our lack of understanding to the workings of our global
financial systems. As the CFA Institute notes "Flash crashes are the sources of increasing concern among
financial market practitioners and regulators because pinpointing their causes is difficult."46

Flash crashes have become a more regular occurrence. There have been thousands of mini flash crashes, moving
a market by a relatively small amount, but also more major incidents. Phenomena such as these are early signals
as to what may happen to many other forms of critical infrastructure as they become automated, operating
through machine-to-machine ecosystems where we have little understanding as to how the system might
respond to a given non-normal event because of the unknown network of interactions between the unknown
logic of smart systems.

Machine learning algorithms learn, this may be useful information that they acquire but equally it might not. The
objectives that they learn might diverge from the interest of society, or have negative externalities on broader
society. As automated systems take over more and more of the basic control functions of our critical
infrastructure this becomes an ever greater threat. In the case of finance the space previously occupied by bank
traders - with a degree of intuition and broader awareness - has been colonized by algorithmic traders, with a
very narrow form of "intelligence." Such a narrow form of awareness can easily have negative externalities for
the broader systems they operate in.

With a growing confluence of factors leading to systemic technological risk - the centralization of data within
data centers; the expansion of telecommunication networks connecting up more and more partially secure
devices and systems; the introduction of automated "smart" systems into complex networks - we are certainly
living dangerously when it comes to the risks posed by the development of our IT infrastructure, and these risks
are not diminishing they are mounting daily as we build out these global IT networks and automate them.
 Economic Risks

The systemic risks hidden in our economic networks take many forms, the most publicized and infamous of
which are the risks of a global financial crisis. However, beneath this are the risks created by the expansion of the
long and complicated supply chains created by the last wave of globalization and the growing dependency of
the world's population on this formal economic system given the growth of the global middle class.

The systemic risk to the global financial system has become a much-debated topic but aside from adding
additional layers of regulation and requiring banks to hold more reserves, little has been done about the
underlying complexities of the issue.

Asset size is clearly an important component of systemic importance, but it is not the only component. To
address the issue in the holistic fashion required one must incorporate many more factors; issues such as an
institution’s leverage, geographic footprint, interconnectedness, the nature and complexity of products,
incentive structures, and the degree of substitutability of operations. In practice, however, regulators focus
heavily on the use of financial institutions’ book asset values as a proxy for their systemic importance, in part
because book asset values are easily obtainable.47

The current analysis is focused on where we have data, large financial institutions and banks in particular
because of their regulation, but this blinds us to the many other areas of relevance. For example, we have almost
no data about the workings of hedge funds, or as noted above the combined workings of algorithmic trading.
Beyond this, our data and knowledge is also limited when it comes to such phenomena as dark pools, shadow
banking or informal economies in emerging markets.48
Globally, shadow banking assets have continued to grow. The Financial Stability Board maintains shadow
banking assets that pose risks to the financial system grew 7.6 percent to $45 trillion by 2016, the most recent
year it has assessed.49

If we are to ever hope to mitigate and build resilience to systemic financial risks we will need to understand and
model the system in a much more comprehensive fashion. Finance, in general, remains heavily dependent upon
linear models - while nonlinear networked models are still a novelty - which can not be expected to represent
the complexity of the system they try to represent.

Currently the kinds of models and the amount and type of data required to represent the global financial system
in a holistic way - as would be required to identify and mitigate systemic risk - is significantly absent. All we can
say is the next global financial crisis will happen when it happens, but it will unlikely look like the last one. It may
come from emerging markets where the financial institutions are much less developed, it may come from
algorithmic trading, cyber attack, shadow banking in some form, or some combination of all.

The nature of our modern industrial economies means that the more affluent we become the more we affect
others. If you are a poor peasant, what you do has little impact on the rest of the world beyond your indigenous
locality, what you eat, what you consume, how you do it. However, as you get wealthier, you become more and
more connected through our industrial infrastructure, what you do increasingly affects others in far off places.
The OECD estimates that the size of the “global middle class” will increase from 1.8 billion in 2009 to 3.2 billion
by 2020 and 4.9 billion by 2030, eg within the space of two decades, we are connecting an additional 3 billion
people into the global economy of exchange.50 This adds not just greater connectivity and interdependencies
between more people and systems but also greater stress on the environment.
As a function of this more and more people are becoming more and more dependent upon a complex network
that forms our globalized supply chain. Up until the globalization of supply chains in the nineteen-nineties, it is
safe to say that most of the world was dependent upon resources largely derived from their indigenous locality
but today and going forward, possibly for the first time in history, this may no longer be the case.

One of the reasons that companies got very enthusiastic about the globalization of their supply chains in the 80s
and 90s was that it gave them a chance to source materials and sub-products component parts more cheaply.
While at the same time we were kind of hoping that a global market meant we were actually more stable
because there was more than one point to source from. However, as events have unfolded over the last decade
companies are now starting to find out the uncertainties and risks of maintaining a long complex supply chain in
a volatile world, they create multiple points of failure.51

Of course, it is not just the companies that are dependent on these supply chains, it is increasingly the whole
world which creates another dimension of systemic risk - again this is only mounting as the supporting
ecosystem becomes more degraded and fragile.
"All around the world, we are seeing a gradual raising of awareness of the
lessened legitimacy of traditional hierarchical power structures and
decision making. Many of the Western world’s governments are losing
legitimacy, and people are facing a set of complex conditions that are
coming at them faster than they know how to adapt” - Jon Husband
 Sociopolitical Risks

As the tectonic plates - of technological, environmental, economic and cultural transformation - continue to shift
under societies feet issues related to identity and community continue to drive political dislocation in many
countries and these issues are increasingly fueling nationalism, populism and cross border tensions.

The bonds that held modern societies together for the past hundred years or so is starting to unravel along
many dimensions, whether we are talking about a sense of national identity and solidarity, stable middle-class
jobs, trust in a shared set of institutions and political leaders, etc. Exploring all such profound issues are beyond
the scope of this paper, here we will just touch on two, the issue of inequality and the erosion of trust in
institutions.

The issue of inequality is but one example of mounting social dislocation. As the 2018 World Inequality report
notes "We show that income inequality has increased in nearly all world regions in recent decades but at
different speeds.”52 Stunning facts from Oxfam, such as 26 people owning the same wealth as the 3.8 billion
people who make up the poorest of humanity, are illustrative of the huge social divides that exist as we move
further into this world of globalization.53

There is clearly nothing wrong with inequality per se, it is a natural phenomenon given people's different skills,
capabilities, propensity for work and risk-taking. What is a problem is structural inequality, which is to say social
structures and dynamics that selectively favor some people over others. The rich get richer effect is a good
example of a structural dynamic that generates exaggerated inequalities, where wealth accrues to those that
already have wealth. For example, bankers lending capital to those who already have large capital bases as
opposed to those businesses and individuals that have none. This is a form of systemic inequality because it is
built into the structure of the system, over time it leads to divergence and criticality.54

Rising income inequality in many countries across the world polarizes those societies and makes it harder to get
consensus on issues that need collective agreement and action. People of different wealth brackets live in very
different worlds and when those differences in wealth are too great they can start to tear apart the shared
experience of people that is required for a sense of social cohesion and solidarity

"When there is trust in the room that's like a hard floor, do you realize how high
you can jump off a hard floor, when there is no trust in the room it is like a sandy
beach, you can't jump anywhere"- Thomas Friedman

Modern societies are interlinked by vast institutional networks of interdependence that function through an
invisible but critical web of trust between counterparties. We are so dependent on these networks of trust that it
is not until it becomes breached or eroded that we begin to recognize it.

Today the foundational substrate upon which our industrial age social institutions are based is being eroded.
Within developed economies trust in critical institutions is at a very low level, trust in the large bureaucratic
institutions that support our modern society is dangerously lacking.55
With each new shock we face the incapacity of these institutions to respond to the complex issues created by
this new context of connectivity becomes more apparent and with that people lose trust and credibility in them.
This was first illustrated with the financial crisis, where a huge loss of societal trust happened within Western
economies due to the publicly funded subsidizing of the very financial institutions that caused the failure.

Almost everything we know about the emerging information age points to the fact that the context is changing
in a way that does not favor these kinds of vertical centralized bureaucratic systems. As a function of this, our
capacities to coordinate and successfully operationalize people and resources through these institutional
structures that we have used for the past one hundred years plus is diminishing.

The Secretary-General of the OECD Angel Gurria spells this out when he notes that this loss of trust in
institutions "is the greatest challenge we have, it is a legacy of the crisis... we lost trust, this is trust in everything
we built in hundred years, in precedence, in prime ministers, in ministers, in parties, in parliaments and of course
trust in multinational organizations, in multinational corporations, or multinational organizations like ours, trust in
the banking system, etc. trust in democracy itself... so basically you have a very very serious problem of trust."56

Unfortunately, most of our thinking about how to deal with this is about going backward. As Mr. Gurria goes on
to say "The way to recover it [trust] is by getting back, the growth, by getting back the jobs, good quality jobs"
however "back" does not appear to be where we are going to.

This loss of capacity to effectively organize and coordinate ourselves through existing large institutional
structures is of critical importance to the current risk equation as it works to paralyze our capacities to actually
respond both in the short term, towards mitigating immediate crises and hazards, but also in the long term to
build up resilience to the kinds of inevitable shocks societies and economies face in the coming years.
Moving Forward
Section 3
Today we find ourselves in a situation where we are lacking in many aspects the capacities to actually deal with
the risks we face on a macro-level. We lack the basic models required to understand the kinds of complex
networks that now run our economies and upon which we all depend. As the complexity proliferates our
understanding of the world around us and the systems we depend upon is shifting from the realm of known
knowns and known unknowns, into the world of unknown unknowns.

Our incapacity to respond to and learn how to manage the complexity of the systems we have created means
we increasingly live in a world where we have limited capacity to define and realize desired outcomes. We have
created systems of incredible complexity that are able to produce all the things that we like - from mobile
phones to cheap holidays in the sun - but our incapacity to evolve the capabilities to actually manage that
complexity has resulted in ever-shrinking islands of centralized systems within which we can effect change and
ever growing complex networks wherein we have limited capacity to effect desirable outcomes.

Whether we are talking of the global biosphere, the operations of the hedge fund industry or the workings of
socio-political networks we do not have the models and the right data nor are we able to match them in the
right ways to have a conception of how these networks really work - we lack the kinds of institutional structures
required to manage complex global networks on their different levels and across different dimensions and thus
lack some chance of "managing" them.

We need to stop thinking of these issues as being "out there" and that they will somehow fit into the existing
institutional infrastructure of a bye-gone era. Issues like climate change, global cybersecurity, financial instability
are wicked problems, they are not isolated events that can be dealt with in a traditional linear fashion but are
instead emergent dysfunctionalities within complex systems and the real issue is our incapacity to manage
complexity, to change our management methods - be they risk management or otherwise - to a nonlinear
networked approach.
Without the right models or the institutional structures we can - as politicians and leaders - only pretend that we
know what we are doing while really we are just waiting for the next disaster to happen. This is the unfortunate
reality of the world we find ourselves in given the changes that have taken place and our limited capacity to
evolve new ways of responding to those changes.

As the connectivity proliferates we shift from a world where these vertical domains had little to do with each
other to a "flat world" of networks. A new understanding of risk, investment, insurance, and security is now
needed that is relevant for an age of networks that span across our traditional categories and verticals creating
systems-level risks.

This new approach to mitigating risks and re-imagining insurance needs to start with a paradigm shift in our
thinking that is as fundamental as the changes that have taken place. If our understanding and models of this
new world are not matched then we will surely not be successful from the outset. As the nature of the risks has
shifted from parts to whole systems so to our perception of how to respond to that has to shift from parts to the
whole. In more concrete terms this means shifting from a centralized focus on the securing of a given asset to a
decentralized investment in the whole.

Shifting the locus of security and insurance from defending against the losses to a given asset to firstly investing
in the whole system so as to build resilience. Risk management in an age of systemic risk is not just about
avoiding losses to the parts, once we have the connectivity and the emergence of systems-level risk a new
dimension is now added and it becomes as much about investment in the whole to create resilience. Whereas in
the past we were able to take the whole as a given, as a constant and simply focus on the risk of loss to the
parts, in an age of systemic risk this needs to shift to incorporate a new dimension, that of investment in the
whole.
As such the best solution to systemic risk is not risk management, it is actually investment. What we do is we
focus our investment on centralized solutions and this depletes resources from the networks around them
leading to systemic risk and the emergence of failures over time. The counterbalance to that is not to increase
security and insurance of the parts but instead to create structures and vehicles of investment that account for
and channel resources into building the resilience of the whole network.

With the expansion of connectivity along all dimensions in the coming years, we face a massive process of
convergence, where industry boundaries and sectors will become blurred and redefined. While today's markets
are dominated by closed organizations this is rapidly starting to give way to networks, platforms, and
ecosystems. Today's vertical conception of risk and security will start to give way to a new vision, a networked
approach.
 Full Cost Accounting

In a connected world, the centralized approach of fortifying a given centralized system becomes less effective.
When businesses become networked into ecosystems interconnected and interdependent across large networks
when individual products become integrated into service systems where many different products and
organizations have to interoperate, we start to shift more into a world of trust in the networks that we form part
of.

As the world becomes connected the risk shifts from things to networks and the focus on our defense has to
likewise shift from the securing of things to building the value and resilience of the networks that our products,
services, and livelihoods depend upon. Building resilience across the whole system means building frameworks
that channel resources out through those distributed networks instead of concentrating it inwards to fortify
centralized nodes.

Unlike closed systems that are defined by fixed structures, networks are dynamic, they are about the exchange
of resources and value, to understand risk in a world of networks it needs to be conceived of in terms of the
exchange of value. To integrate the various forms of risk, social, economic, technological, environmental, we
have to understand the value inherent in each of these kinds of networks, that enables them to function and
maintain resilience. For example within society, trust is a kind of value that is captured in the concept of social
capital, but the same is true for the resources required to maintain any network, natural capital for an ecosystem,
economic capital for private organizations or technical capital, the technology infrastructure required to operate
our economies.
What has changed today is that - because we have degraded the intrinsic value of many of these systems to
such a low level - we are starting to recognize the value inherent in these whole networks and how that directly
impacts our utility as individuals and as organizations.

For example, the degradation of the environment - the whole system - is now costing insurance companies large
sums of money - individual utility. When individuals and organization experience the direct lost of utility this
creates new opportunities to channel their losses into new forms of economic and financial investment structures
that work to strengthen whole networks.

Traditionally there has been a strong divide between narrow for-profit investment and a more holistic form of
investment - the divide between the world of for-profit enterprises and NGOs - but as these factors become
more interconnected they become integrated and the differences between the two starts to diminish. This is all
being gradually reflected in the evolution of finance and economics through such phenomena as ethical
investing, green bonds, or ESG metrics.

"What we are doing with natural capital accounting and evaluation is in

my view really the biggest thing happening to business today why is it
so big?... We are moving beyond mere corporate responsibility and we
are moving into the space of corporate sustainability.
- Peter Von Der Gaag Natural Capital Coalition
In the early years of the new millennium, the major part of the investment market still accepted the historical
assumption that ethically directed investments were by their nature likely to reduce financial return, however,
today there is a clear convergence between financial ROI and overall metrics of value within many enterprises.

The idea of ethical investing did not make much sense to people until recently, what prevailed was the idea that
investing was only to make money and that was it, a single dimension of assessment to one's investment.
However, by the year two thousand, this was starting to change as analysts were becoming more positive
towards these ESG companies and by now it has fully turned.

The dialogue is opened up and people now realize that when you are examining a company you need to know
as much as you possibly can about that company and environmental issues, employee issues, how that
organization is dealing with the communities in which it operates these are all now seen as important to
determine how that company is going to perform financially over the long term.

A growing focus of consumers and investors alike is now on the issue of sustainability, they want their
investments to deliver a positive societal impact, it has to be both a good business opportunity and an
opportunity to do good. As of 2019, there are some 23 trillion dollars invested with some form of ESG in is a
market that has experienced double-digit growth over the past years.57 Pressures are now coming from
fundamental key stakeholders of the companies, whether they are customers or investors or their own
employees.

The implication of these changes in how we define and measure value to incorporate a wider set of metrics
creates a growing potential to build alternative economic structures that systematically channel resources into
building resilience and mitigate systemic shocks.
 Investment

Insurance and investment are starting to converge in new ways and this interaction is critical to responding to
systemic risk and reinventing insurance in an age of connectivity. As a recent report by Marsh entitled "The
Growing Importance of Alternative Capital in the Commercial Insurance Market" notes "over the past decade,
the insurance industry has evolved from simply a method of financing risk, to a source of opportunity for
investors." they go on to note in the paper "the relationship that developed between reinsurance and
alternative capital is a symbiotic one."58

The key to tackling systemic risk hinges around the question of how do we actually build financial frameworks
that channel resources into developing the different forms of capital within networks require to maintain their
resilience and functionality. This involves the convergence of alternative capital with a holistic approach to
insurance.

This approach works by valuing the costs associated with systemic risks, and rewarding capital investments that
work to build the resilience within different networks that mitigate that risk, thus attracting and channeling
alternative investment classes in the right direction towards the required sources. There is no lack of money in
the global capital markets but there is a lack of innovation in realizing the full potential of those investments
along the multiple dimensions required. We are very good - maybe too good - at innovating inside the box
creating new complex structured products that slice and dice risk and returns in new aways across existing asset
classes, what we are not so good at is innovating outside the box to create new instruments that connect
investment with risk in the new ways that are required given the changing context.
An investment is a choice and an action, it has real implication in the real world whether you are buying barrels
of oil from Saudi Aramco or investing in a wind turbine farm in Thailand no investment of any size exists within a
vacuum, investments always have more than one effect. When we extrapolate this out to the global capital
markets the effect of the way those investment vehicles are structured and modeled on the macro-level has the
scale and capacity to respond to the scale and severity of the systemic risks faced by societies and the insurance
industry across multiple dimensions.

The often missing piece in this equation is that risk is an opportunity, the question is though how do we start to
see it as such and not only that but build a new system of organization, products, and services that actually deal
with it as such. For every single risk of any kind, there is a loss of value to someone, somewhere at some time,
thus by solving for that risk, we can capture some or all of that value. By identifying that point of loss it can be
packaged into an investment opportunity. By simply thinking differently we can look around us and not see risks
and destruction but opportunity, this simple change in mentality can set us on course to move from worry and
fear to active problem-solving.

Just as the wise investor of any asset will deduct the risk associated with it from its overall value, so too our
world is full of undervalued assets because of the systemic risk looming over their head, by working to solve
those potential risks we are working to increase the value of the assets around us and that increase in value
should flow to those who work to do this.

Typically it is cheaper to invest now rather than face the rising costs of future disasters, however, we often do not
do this because of the time delay. More often we stay operating risky processes because they are profitable in
the short run while the costs may be externalized out to the future. The challenge is to link future costs of risk
with current returns of an investment vehicle.
The current mounting systemic risk is a function of externalities, one of the primary kinds of externality is that
that exists over time. We externalize costs to the future hoping they will not happen, the question is how do we
better link future costs with current returns so that we factor them into the investment equation that we make
now - better linking current incentives to future outcomes to reduce future risks.
 Behavioral Factors

The key challenge of the 21st century is how do we move from operating within systems that inherently create
negative externalities which aggregate up to systemic risk and crises on the macro-level, to patterns and
structures of organization that have positive externalities, synergies that combine to form new levels of emergent
organization that actually mitigate and solve for those systemic risks; that do not just channel resources in the
new directions required but actually channel the structure of actions in new ways.

The answer to this is incentives, looking at and better understanding and designing the "games" that people
play, the narratives that we employ that create the motives and incentives towards certain behaviors - better
using game theory model analysis and alter the subjective experience of individuals, the subjective narratives
and incentives.

To understand what really drives people and the real outcomes that we get one has to switch to a subjective
model first. This means understanding how people really see the world from their subjective perspective, the
stories they employ and the set of incentives they find themselves within because it is this combination that
defines to a large extent how they act.

To get a grasp on how people really behave - because most of the risks we face are created in one way or
another by the choices people make - one has to look at the full set of socio-psychological factors. What are the
dominant narratives within an organization, do people have direct skin in the game that will incentivize them
towards making the right decisions.
This means an analysis of organizational structures, are they compartmentalized with great intermediation, where
there is a great opportunity for people to game the system and externalize risk from one part of the organization
to another. Does the assessment of vulnerabilities turn into real outcomes or just procedures where people tick
boxes? Often safety and risk mitigation is a tick-the-box and spreadsheet exercise but how can it be built into
the day-to-day workflow rather than an additional exercise stuck on the end. Solutions can be found by looking
at human behavior, psychology and incentives, as such each one of these questions requires an ethnographic
look at how the organization functions in practice not in theory.

A focus on behavioral factors means opening up and exposing the models that individuals and organizations
use. We should not forget that the future that we perceive only exists within our imagination, it is shaped by not
only the stories that we tell but also our emotional state. The equation of how individuals, organizations an even
whole industries deal with uncertainty in decision making is a key part of how risk is managed. How do we build
uncertainty into decision making? How do we work with decision-makers throughout the organization to capture
that uncertainty, to make them think about it, to challenge their biases? On a psychological level, a key part of
managing risk well is about uncertainty, how we embed uncertainties into our decision-making process, the more
we can do this the more we can refrain from externalizing the costs of it to the future.
 Resilience

A key part of this changing paradigm is the shift from a mentality of resistance to one of resilience. When we
invest in security we typically invest in prevention of some kind because it is tangible and visible, we build walls
to protect things because you can see this protection, it has a strong presence and demonstrates the
commitment on the behalf of the leaders.

Building walls is instinctive to us when it comes to security, what did the Japanese do after the Fukushima
accident? They build a 20-foot wall. Resistance is big business, trillions of dollars are spent on resistance by the
security industries, while the resilience industry does not really exist yet.

Resistance as a strategy means using some form of a regulatory system to try to limit the number of possible
eventualities and maintain only a limited number of responses. In order to try and reduce the number of possible
outcomes to some small subset that is conducive to the system, we have to try and control the environment. The
farther we go down this path of resistance the more we are trying to control the system and environment to
reduce the possible outcomes. This is done through linearizing the system, removing any nonlinearity that is
inherently uncontrollable.

In contrast, the strategy of resilience hinges around adaptation; ensuring the system has a sufficient diversity of
components to generate the appropriate response when required and ensuring the distributed competency of
the whole system. Whereas resistance will try to remove all disturbances, adaptation comes with a recognition of
the importance of disturbance in testing the system, in order to maintain the competency of the system’s
components, because without control over its environment, the diversity and effectiveness of its constituent
components is the only thing that is going to ensure its preservation.
"We as societies - and this is a universal trait - we always put most of
our resources on resistance. I would suggest to you that 99% of what
we invest we invest in resistance measures all over the world”
- Meir Elran, Institute for National Security Studies
As an example, we may think about how the human body develops its adaptive capacity to antigens. The
immune system develops by encountering interventions from antigens, having to develop the appropriate
responses and then retaining a copy of those for future application, in so doing it uses these environmental
perturbations to build up resilience over time.

A resistance approach follows naturally from a linear way of thinking because it focuses on specific cause and
effect dynamics, a resilience approach is less common because it requires a more nonlinear way of looking at
things, resilience is the distributed capacity embedded across a whole network. When systems become complex
they become nonlinear, meaning an approach that is predicated upon identifying and controlling for linear cause
and effect dynamics becomes less effective. Instead of investing the resources in building a big wall while not
thinking about how the system behavior itself may create the problem in the first place, we switch this around to
look at the whole system and ask how the distributed way the system is structured and behaves creates the risk,
in such a scenario walls and barriers appear less relevant.
The Evolution Of Insurance
Section 4
Insurance is a massive industry that has historically not had a lot of incentives for innovation, leaving it today
primed for disruption. Until very recently not many entrepreneurs have taken on insurance but today a
confluence of technologies is bringing the barriers to entry down and making this multi-trillion dollar industry
ripe for change.

Insurance today is an industry residing a top of a bureaucratic centralized opaque business model - the very kind
of business model that is most susceptible to today's exponential disruptions. The industry is largely unspoiled
by the kinds of innovations we have seen in other domains over the past decades. The Fortune 500 is made up
of almost 10% of insurance companies. With their average age of over 100 years, the incumbents are vestiges of
the Industrial Revolution. Their corporate structure and business rules appear normalized for the world of the
1900s rather than the 2000s.59

The confluence of new technologies - from big data, advanced analytics, blockchain, and IoT - is today the
catalyst for huge changes in an industry that much needs it. Datafication - the conversion of more and more
aspects of our world into a data format that can be quantified, analyze modeled and processed for insight via
algorithms - can shift insurance from static, opaque and slow to be real-time, transparent and automated.

Emerging decentralized technologies are now letting us rethink how whole industries and sectors of the
economy work. By allowing us to automate intermediary activities and connect people peer-to-peer a new space
for insurance startups is opening the “long tail” of insurance.

Already we can see the future of insurance in chatbots to manage interaction with customers, apps that will
insure you for a few hours while you borrow your friend's car, image recognition software to identify the laptop
you wish to insure with a click of a button or peer-to-peer insurance.
On top of this substrate of data and automation, new business models will emerge, no longer centralized,
manual and transactional, but now automated subscriptions that are customized for each specific circumstance.
They will include aspects of evolutionary psychology but also behavioral economics and game theory, social
networks and social impact. This combination of data, automation, decentralized networks, new business models
and new ways of assessing risk along multiple dimensions could be a harbinger of true transformation in
insurance. Insurance could expand radically to become true managers of risk along the multiple dimensions
outlined in the previous sections.

"I think what is next are more porous organizations where the
boundaries of the firm are not as clearly delineated and that is going to
force companies that are used to being vertically integrated managing
many parts of the value chain to think more about how to create value
within a network" - Alex Tapscott
 Risk Management Platforms

The insurance industry consists of many millions of contractual agreements that specify how much a buyer pays
in premiums and how much an insurance company pays under what circumstances. There’s an investor on one
side; on the other side is a customer paying a premium, providing the income stream.

To achieve economies of scale the model is centralized, typically with a large bureaucratic organization in the
middle, that aggregates the required capital, specifies the contract of risk and payment under various
circumstances while organizing all the operations.

This model has multiple issues of misalignment of incentives though. Every dollar an insurance company does
not pay out in a claim goes directly to the company's bottom line. Like all other businesses they are incentivized
to maximize the net revenue meaning they are at least partially incentives in the opposite direction from how we
would wish them to be. This is one of the reasons why today's insurance industry has to be so regulated because
the incentives are inherently misaligned.

The key structural change that will come about - as is taking place in other industries - will be the platformization
of insurance; using a substrate of an information platform to create fluid two-sided markets, that reduce the
need for the traditional bureaucratic centralized entity. Technology is used to connect the providers of capital
with those that need insurance and algorithms used to automate the coordination, the rules of the exchange,
terms, condition of contractual agreements and financial transaction.
As an illustration, we can look at what happened to the advertising industry with the rise of the web. In essence,
companies like Google and Facebook "platformized" advertising. While advertisers were buying big media
campaigns and banner ads, Google broke every single search word down into its own little market and sold the
words via market exchange to the highest bidder. They created a liquid and fluid two-sided market, getting rid
of the middle-man and automating the process radically reduced barriers to entry so that today anyone can
purchase a keyword and advertise at a very low cost.

This is the atomization of advertising — by breaking everything down into the smallest possible unit, it’s easy for
buyers to purchase what they want when they want it, and they can specify in fairly sophisticated ways how much
they are willing to pay for various words under various conditions.

The implementation of algorithmic coordination along with the peer connectivity brought about by the internet
and telecommunications has this same platformization effect on all industries and will over time reshape the
basic structure of the Insurance industry to being one that is mediated via real-time algorithmically coordinated
information networks. The result of the digital transformation across industries is this shift from the industry
being dominated by a few large centralized entities to something that looks much more like an ecosystem of
many interacting agents, where the barriers to entry along many dimensions are reduced - because of
automation and connectivity - so that anyone can connect in and deliver a service receiving value in exchange,
eg today's on-demand economy.

Today in insurance we can start to see a platform model emerging which allows anybody to build their own
insurance products; which allows for anybody with the data source to supply their data and earn value from that;
which allows users to build insurance products using the templates native to the platform; which allows for
anyone to provide capital by investing in an insurance product and receive the revenue streams from that; which
allows for anybody to build a risk model and to sell this risk model to the members of the ecosystem.
Just as the internet has transform communication by being an open network with a defined set of protocols for
exchange that enables anyone to connect and exchange information with peers, so to the internet will have the
same effect on insurance. With the advent of today's decentralized web technologies startups will build new
protocols and open standards that create platforms upon which any kind of risk could be converted into a
structured product and made available for anyone to provide the underwriting for; for anyone to provide data or
any other resources required to manage risk.

This opening up of insurance has the effect of making insurance look much more like capital markets, where
products are traded publicly, dynamically access based upon current information available to the market, while a
huge army of analysts and financial media channels feed in information with the price of the asset being defined
minute by minute for anyone in the world to see. Similar to insurance-linked securities decentralized risk pools
can effectively take the role of reinsurance, with investors earning passive income. New products could be
assembled, modeled, tested, collateralized, and securitized in real-time to meet the needs of various investors.
 Blockchain

A key enabling technology here is blockchain as it provides a secure record of value without the need for
centralized authority. Blockchains can be best thought of as a new kind of decentralized computer as they
network a set of individual autonomous computers and incentivize them towards providing a single common
computing environment - similar to today's cloud computers but in a decentralized fashion.

On top of these networks of computers can be stored any records of value - likewise, logic can be executed. In
the world of decentralized technologies what are today companies will become quite literally replaced by a
software system.

A blockchain can be used as an open, trusted and anonymous repository of data where anyone can contribute
data and have it stored in their own wallet so that only they have access and can grant access to others as
required; individuals can then earn revenue by providing their data.

The workings of the network can be automated via a smart contract. Smart contracts are typically small bits of
logic that can be run on top of a blockchain. They can be used to automate contractual agreements running
them on the same decentralized computer. These kinds of networks greatly strengthen and extend the capacity
to create mutual insurance as there is no one in the center. Because blockchains are secure trusted records of
value it makes it possible for people to easily set up their own insurance systems or a group of people to
underwrite themselves.
In order to determine the validity of data added into the blockchain "oracles" could be used. The primary task
of oracles is to provide a valuable source of input data. They are third-party information sources that have the
sole function of supplying data to the network. Oracles provide external data and trigger smart contract
executions when predefined conditions are met. Such conditions could be any data like a weather pattern,
payment completion, or change in stock prices, etc.

These oracles can provide trusted sources of data based upon different criteria, they may be coming from a
trusted third party, such as Bloomberg for stock prices, they may come from a physical technology, such as some
sensor or they may use some kind of prediction market that incentives a mass of people to provide information
that is accurate - because they will receive a payoff if they provide information that correlates with the outcome.

Using blockchain-based accounting and smart contracts for products, insurance against hurricane damage, flight
delays, crypto wallets loss, and more could be fully automated. The time to market for creating a new insurance
company is currently years but in a world of decentralized technologies, one may be able to set up an insurance
company in an afternoon.60

"The concept of tiny insurance tokens explodes the industry, from

monolithic paper contracts to agile smart contracts that are infinitely
adjustable both to buyers and sellers” - David Siegel
Like finance, insurance is an information processing activity. However traditionally in insurance, we only really
capture data at two points, point of sale and point of claim with a huge data vacuum in between. There is a
massive dark, foggy space where we have no data just left guessing about. Take for example the supply chains
for the world's goods which house multiple forms of nefarious activities, from slavery to bribery and
discrimination, each one of these is a point of tension and weakness waiting to be surfaced as a crisis - whether
it be a crumbling sweatshop in Bangladesh, corrupt organic certificates in Kenya or WV's false emissions
reporting.

We live in a world of black box data, proprietary data sets with extremely low utility, typically getting used by
one person for one or two functions. Very few people look at the data set and they look at it in one specific
context with limited access to other's data, creating poor feedback loops. This data is not being used on mass,
being analyzed by hundreds of thousands of people who could be analyzing and connecting it in a multiplicity of
ways.

The revolution in data sources that is underway is a true paradigm shift, if this data could be opened up it would
truly revolutionalize the scope of our capacities to deal with risk. White box data allows for a multiplicity of
advantages, no lock-in, transparency, widespread usage as public access makes it usable in a multiplicity of ways
that the owner of a closed data set couldn't even imagine. Open data can now be monetized on a blockchain,
thus the value to the creator can follow not from locking it down but from opening it up.

Real-time data sources allow for personalized insurance adapted to the context of the end user. For example,
logistics firms managing large shipments can gather sensor data to inform insurers on the status of shipments.
Greater market intelligence gathered via these sensors and connected products allow insurance firms to offer
personalized premiums.
To take our capacity to deal with risk to another level requires not only open data but also accessible data
visualizations to build end-user awareness to real-time risks on various scales.

When data is exposed to people they can see the real costs of their actions with respect to the risks they are
taking, by exposing the data we start to close the feedback loops and create self-correcting self-balancing
systems that do not drive towards critical states.
 Insurance-As-A-Service

The insurance industry has long monetized the promise to protect customers should an extreme event take
place but with constant data capture, they can now promise avoidance of such extreme events in the first place.

In a world of real-time data, insurance can shift from the static product based model into a dynamic real-time
service model - from pushing out standardized products based upon past data to streaming services based on
real-time information. From buying a once off fixed solution to subscribing to insurance based upon preferences
and current needs.

In a world of big data, insurance can be a tool for building resilience by placing the cost of an activity in the
hands of the person who takes it, at the time they take it. Drive too fast and your insurance will go up, while at
the same time that this incentivizes the person to take less risk personally it also reduces the negative
externalities of their risks. We can start to pay not for compensation once an event has happened but instead for
events not to happen in the first place.

In the U.K., Marmalade fits a black box behind the car dashboard of young drivers, providing them with
feedback and education to improve their driving habits over time. Telematics enables insurers to assess your risk
based on your driving habits rather than the driving habits of young drivers in general. If the data shows that one
has been driving safely over the course of the first year, the premium at renewal will reflect this.
 Insurance Token

As insurance shifts to a platform model, it becomes more of a service network mediated by a market of
automated value exchange. The underlying distributed ledger technology makes it possible to record, track and
exchange this value in a greatly more efficient way than with the traditional financial system.

As platforms evolve they will go from today's platforms that are still mediated by centralized a computing
infrastructure and financial service providers to a decentralized computing and decentralized exchange of value
that removes bottlenecks. By having a digital token we can capture the unique value that is within a given
ecosystem/economy and facilitate investment and growth; better aligning the interests of participants.

A key question is how do we create structures of incentives that switch the core dynamic from one of negative
externalities creating systemic risks to one where agents are incentivized to identify situations of risk, resolve
them and build systemic resilience. This is the same for cybercrime as it is for capital markets, as for water
security.

We do not just want to put today's insurance industry on steroids by digitizing it, we need to also expand its
capacities so that it is more holistic in its capacity to manage risks of all kind, not just insurance for the loss of
parts but to create a network that builds resilience against systemic risk. To do this value has to be channeled in
a decentralized fashion; our system of risk management has to channel investments into the maintenance of
whole networks, not just the parts.
 Full Cost Accountin

This next generation of information technology enables some very novel features in that they enable us to
compute things at a network level rather than just at an individual level. Because we can use them as public
repositories of data that no one owns and have transparent algorithms running on them computing anonymous
data they can work to compute information about whole systems, eg society at large. This becomes very
important when coupled with big data as it allows us to compute and reason about risks to a whole system. For
example, a smart city or a regional agricultural area might employ open data for its sensors, which could be
moved to a blockchain for computing risks to that whole area - information that would then be available for
anyone to use in building risk mitigation plans.

This capacity revealed by the combination of big data and blockchains becomes particularly important when it
comes to building economies and financial systems that better account for the whole, i.e. full cost accounting.
Just as we today have things like green bonds and social impact bonds we can also have risk mitigation
instruments. Today we spend trillions on security, insurance, and disaster relief, a token market system could be
used to switch this whole dynamic from paying to fix the pieces, to channeling investment to the whole network
so that we don't get systemic risk and failure in the first place. This is done by tokenizing the current costs of
failures and security, people then earn tokens for actions that mitigate these risks. Just as today we create an
economy around carbon so too we could create economies around any risk.
g

When coupled with a digital tokens model one could earn token for taking any action that reduces risk, a whole
parallel economy is created where people are incentivized to reduce risk not just for themselves but for the
whole system.

Just as Plastic Bank62 tokenized the collection of plastic to reduce this environmental hazard, so too we can
tokenize any form of negative externality that creates systemic risk. This is because those systemic risks have a
cost at some time to some set of people, thus we can flip this around and turn the reduction of that risk into an
asset and tokenize it. The way to systematically reduce systemic risk is to create the financial instruments that
place the cost of negative externalities leading to systemic risk in the hands of those who take them and
incentivize them not to by giving them tokens to reduce those negative externalities.

Token economies can be complemented and strengthened through behavioral economics and gamification that
deals with the softer psychological aspects that do not require explicit concrete incentives.
Conclusion
As we have tried to illustrate in this paper, systemic risk is systemic and thus requires a systemic response. In this
respect our traditional ways of thinking often fail us, analytical reasoning leads us back to seeing a set of
independent phenomena, that we then try and tackle in isolation through traditional linear methods. What is
needed instead is recognition to the changes that hyper-connectivity has brought about as it marks a shift from
discrete parts to whole networks. The days of systems that are designed to create negative externalities that can
be pushed out to the future while we patch over current issues is coming to an end; as that future is here now.
What is needed today are systems of security and insurance that are wholistic in the sense that they build in all
relevant factors; refactoring in the externalities.

This is no longer a dream, a future potential or niche market, as the cost of whole systems failure and collapse -
whether that be a financial crisis, ecosystems collapse, or failure of technology infrastructure - is becoming ever
more tangible to the utility of actors, both organizations and the general public. This means there is now the
opportunity to build economies that factor in this value to the whole system and work to create positive
externalities that build resilience on the macro-level.

Doing this however requires the use of data and new technologies, so that we can not only capture in a data
format all the resources required to maintain the system in a sustainable fashion, but also track the activities that
add or subtract from that. We then make this transparent and build “games" or “economies" that account for
this so as to ensure the maintenance of the critical resources, whether that be natural capital required to
maintain an ecosystem or the social capital to avoid conflict. By taking this holistic approach insurance could be
a powerful system for not just protecting against discrete events that involve loss but rather building resilience to
make sure such events don’t happen in the first place.
 Curated by Joss Colcheste
Contribution by Gaya Branderhorst
A Systems Innovation Publicatio
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