VIEW 7 Systemic risk: Complex adaptive systems

7. Systemic risk: Complex adaptive systems

In this year’s Davos meeting of the World Economic Forum (View #4) the top two threats to the global economy were deemed to be climate change and cyber-attacks. Climate change from a coverage perspective translates into property insurance. So, let’s compare and contrast these two types of risk: natural catastrophes and cyber catastrophes. John Foster, in a paper published in
the Cambridge Journal of Economics in 2005 (vol 29, 873-892), developed a scheme for describing orders of complexity which has four levels as follows:

7. Systemic risk: Complex adaptive systems

First order complex systems:
These are systems with purely physical components. A tornado, for example, is a complex structure that requires sophisticated non-linear mathematics to model its flow. A supercomputer can crunch the numbers in a natural catastrophe model to estimate the damage caused when a tornado hits a set of buildings in a specific place. But the tornado and the buildings are both physical structures, so this problem is only of first order complexity.

Second order complex systems:
Second order complexity shifts from the physical to the biological realm. In these systems, there is the extra element of adaption as Darwinian evolution becomes a factor. So, a tornado will not become stronger as a result of buildings becoming stronger, but a beaver’s teeth will evolve over time to deal with bigger trees.

7. Systemic risk: Complex adaptive systems

Third order complex systems:
Third order complex systems are one step more adaptive as they involve creativity rather than just natural selection. The adaption is directed by an intelligence that actively tries to change the environment to benefit itself. Humans first using tools marked a transition point from second order to third order complexity. Second order systems progress under the influence of feedback loops. In third order systems, there is a feedforward effect too: an ability to actively create a different future by design.

Fourth order complex systems:
In fourth order systems, there are two intelligences rather than one. The environment is one of anticipatory change. The protagonist and the opponent are trying to predict the other’s moves before they have even happened and retaliating in advance of that. All markets are fourth order complex, where the secret to success is not to figure out what something is worth but how your opponent will value it instead. You are not judging a beauty contest, you are judging the judges of a beauty contest.

The cyber realm is fourth order complex, with hackers anticipating defensive responses and vice versa. So, the key difference between cyber risk and natural catastrophe risk is that the former is fourth order complex while the latter is only first order complex.