A Safety Net for Global Capitalism: Inside Munich Re, the World's Risk Center

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To discover accumulations, despite all of the challenges, and to protect its bottom line, Munich Re employs, in addition to mathematicians, risk analysts and scientists, another group consisting of people like Christian Bendel. Bendel, an engineer, is what one would call a foot soldier at Munich Re. His job is to come to grips with the impossible through experience and visual inspection.

Bendel has a background in construction. He has built bridges in Croatia and the Philippines, and these days he spends much of his time traveling in Africa and the Gulf States. He doesn't look like he gets much sleep.

Bendel's task is to gather on-site impressions of possible and impossible risks. He uses empirical methods and visual inspection. Bendel knows how to work with concrete on the top floor of an 800-meter (2,624-foot) building, and he also knows that construction workers have a tendency to connect sprinkler systems at the end of a project, which explains why so many buildings have been destroyed by fire shortly before completion.

One of Bendel's colleagues is extremely familiar with the world's computer chip factories, another specializes in fish farms in Latin America and a third is practically at home on oil rigs. There are specialists in tunnel building, deep drilling, the construction of nuclear power plants and new developments in heart transplantation. In the age of outsourcing, employing an expert on fish farms in Latin America seems like an anachronism. But Munich Re is willing to pay for this luxury, because management believes that this is the only way to detect remote but potentially costly risks.

For example, in 1973, 37 years ago, this approach enabled Munich Re to offer an early warning against the risks of possible climate change. Or in 2008, two years before the eruption of Iceland's Eyjafjallajökull volcano, an employee completed an analysis of the possible effects of a volcanic eruption on international aviation.

Keeping Track of the World's Risks

What all of these experts have in common is the bottom-up, inductive method with which they approach the unknown, which means drawing general conclusions on the basis of isolated incidents. But the opposite approach also works, at least most of the time.

As the "chief risk officer" at Munich Re, Joachim Oechslin's job is to maintain an overview of the world's risks for the company and to ensure that its employees' understanding and assessment of these risks is constantly improving. A financial mathematician, he applies general data to individual scenarios. At 40, Oechslin, a Swiss national and amateur mountain climber, is surprisingly young to be in such a senior position at a company like Munich Re.

Oechslin is particularly interested in a very specific type of risk that is as important to his employer's bottom line as accumulations. He is partly responsible for Munich Re AG's financial investments and the company's overall investment strategy. A major presence on Germany's DAX stock index of blue chip companies, Munich Re's investment portfolio is worth €180 billion ($229 billion).

Oechslin knows that he can rely on his data and his computers, and that the scenarios they spit out are among the world's most sophisticated. He knows that the combined computing power of Munich Re is used to support him in his work. The company analyzes the daily fluctuations on the world's stock markets as intensively as it does the readings on seismographs. But Oechslin also knows that people are the key factor. A person calibrates the programs, determines which risks are assessed in what way, what is and isn't acceptable, and decides which risk levels are acceptable when making investments. But if the people performing these tasks are too greedy, all of the programs and scenarios become worthless.

'We Learned Our Lessons from the 2001 Losses'

Munich Re made this painful experience itself at the end of the New Economy boom. At the time, about 20 percent of its financial investments were in stocks, making the crash an expensive -- and humiliating -- proposition. The global risk center had allowed itself to become caught up in an atmosphere of greed and, like most others, had believed that the boom would never end and that the bubble would continue to grow forever. The company's professional pessimists had suddenly mutated into optimists, even though they, of all people, should have known better.

But then, when the heyday of mathematicians in the financial world began, when the risks posed by obscure credit securities were downplayed, and when bankers around the globe relying too heavily on computers ended up taking dangerous risks, the pessimists at Munich Re decided to hold onto their billions and not to blow their investments on fly-by-night credit bets. When they analyzed many of the obscure new financial instruments that investment banks were touting as low-risk, high-return investments, the collateralized debt obligations (CDOs) and the credit default swaps (CDSs), they generally concluded that the risks were in fact too high.

When these securities fell apart like bad checks, and when the global economy slid into recession and many companies posted losses, Munich Re reported a profit of about €1.6 billion, which increased to €2.5 billion in 2009.

There were scenarios in Oechslin's department that predicted an abrupt end to the boom, but it wasn't the scenarios that were primarily responsible for the profits of the past year. It was something else. "We had simply learned our lessons from the 2001 losses," says Oechslin. After the end of the Internet hysteria, Munich Re drastically reduced the percentage of its capital invested in stocks, from 20 to 2.5 percent, while at the same time increasing the share of fixed-interest government bonds to about 40 percent. This reduced the risk, as well as the opportunity to achieve massive returns during the boom years.

It was not a victory of mathematics or of data gathering, but one of reason in an era of greed, an admission of one's own limits. At the time, the hot shots at the investment banks amused themselves to no end over their overly conservative counterparts at Munich Re. Today Munich Re wins accolades for its restraint, while its shareholders are eagerly awaiting the results of a new project. The goal of the project under development in Oechslin's department, more comprehensive than any other project before it, is to redefine the limits of knowledge by developing a global risk model. In addition to specifying the major risks in the world, it also seeks to identify their interactions and make them predictable.

Work on the project has been underway for more than two years, and results are expected next year. When that happens, Oechslin and his team hope that life on Earth will become a little more predictable.

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• Part 1: Inside Munich Re, the World's Risk Center
• Part 2: Like A Game of Dice
• Part 3: An Authority on Fate
• Part 4: Possible and Impossible Risks