Introduction
Geopolitical Risk has rarely been higher in the news. Conflict, populism and protectionism are all on the increase and leading to economic friction between nations and defining a new “normal” economic reality. An understanding of this risk can help us better plan for the future by implementing strategies that weight risks according to your appetite or your ability to withstand shocks on any given timescale.
This article explores the concept of Geopolitical Risk which can be considered a fundamental driver for the evolution of the global economy. We provide an overview focusing on the definition of geopolitical risk, how it can be modelled, and how it impacts balance sheets.
Defining Geopolitical Risk
Geopolitical risk can be broadly defined as the risk associated with wars, terrorist acts, trade barriers, and other actions that disrupt the normal and peaceful course of international relations. Caldara and Iacoviello's 2018 paper highlights the spectrum of geopolitical risk; encompassing armed conflicts, military tensions, trade wars, blockades, and tariffs - events that can significantly affect economic behaviour. These all impact the desire to save, to invest or to actively disrupt the economic normal and engage in physical or economic “war”.
The GPR index, introduced by Caldara and Iacoviello, provides a summary measure of global geopolitical uncertainty by analysing news coverage. It tracks the frequency of articles in 10 selected newspapers discussing geopolitical tensions from 1985. The GPRH, or historical GPR index, covers a longer historical period from 1900.
Figure 1 below shows the observed GPR and GPRH indices over time. Notable are the large increases in the GPRH index during the two World Wars. Further spikes are evident around the Korean war, the Cuban missile crisis, the Gulf War, the September 11, 2001, terrorist attacks, the Iraq invasion in 2003 and the Russian invasion of Ukraine in 2022.
Figure 1: The GPR and GPRH indices (Caldara and Iacoviello, 2018)
Impact on Insurers
Geopolitical Risk affects both sides of an insurer's balance sheet. Insurers can suffer losses directly through classes of business that insure against political risk, war, and terrorism, trade credit or contingent business interruption.
Geopolitical events also cause some asset values to fall (whilst others, may increase in times of stress). From a risk modelling perspective, whilst the trend in movements is important, we also care about volatility and in particular tail events.
Table 1 shows the observed correlations between annual changes in the GPR index and annual changes in selected financial and economic variables. Changes in the GPR index are positively correlated with changes in long-term Treasury bond yields, but essentially uncorrelated with short-term yields. The correlation of the GPR index to long-term Treasury yields is statistically significant. Changes in the GPR index are also positively correlated with inflation, credit spreads and equity volatility, and negatively correlated with equity returns, which, although smaller in magnitude and not statistically significant, is nevertheless intuitive. The analysis is quantitatively similar if one uses data from 1900 (the GPRH index) or 1985 (the recent GPR index, presented below).
| Variable | Rank Correlation |
|---|---|
| US T-Bill Rate | -0.02 |
| US 5-year Treasury Bond Yield | 0.28 |
| US 10-year Treasury Bond Yield | 0.40 |
| US Inflation Rate | 0.07 |
| US 5-year A-rated Credit Spread | 0.22 |
| S&P 500 return | -0.14 |
| VIX | 0.18 |
Table 1: Spearman correlation of annual changes in the GPR index to annual changes in selected variables
By understanding their exposure to geopolitical risk in a holistic way, insurers can reassess strategic decisions, such as the amount of business exposed to geopolitical risk or the types of assets they should be investing in. For example, an insurer may decide to cease offering insurance in high-risk areas geographically or buy additional reinsurance for certain lines of business or invest in more diversified assets. It is also interesting to note whether traditional secure assets, e.g. government bonds, are truly “low” risk for an insurer with significant exposure to geopolitical risk.
Managing Geopolitical Risk
To manage geopolitical risk effectively, insurers need a coherent model that captures the economic dynamics coherently, rather than treating risk within silos, and this is where the Proteus Scenario Generator can help. The PSG contains a broad mix of risk drivers, as well as “shock” events which impact multiple economic and financial variables simultaneously. Geopolitical Risk can now be added to this list. The GPR indices are widely accepted and provide a transparent and well-understood measure of geopolitical risk. These indices are also available broken down into sub-indices capturing more granular exposures, such as distinguishing between geopolitical threats and acts, or offering country-level breakdowns.
Driver Framework
When modelling risk – we need to consider causality and coherence. Firstly, when considering causality, the question often asked is “which comes first”, the chicken or the egg – and in the case of economic modelling, does (say) geopolitical risk drive yields, or do economic markets drive geopolitical risk. Recent events have shown the answer is not clear – all risks are co-dependent – the chicken and the egg both come first! What is clear is that whichever “event” drives change, market forces ensure all other events adjust accordingly.
Secondly, when considering coherence, it is important to consider both day-to-day stochastic volatility but also shock events that impact multiple economic and financial market series simultaneously. These shock events ensure that, as we observe in the real world, when things go wrong, they tend to go wrong together, strengthening the downside movement. (As an aside, it is interesting to note that this effect is not symmetric, upside movements are less strongly correlated). Random innovations in both the day-to-day movements, but also shock events, are calibrated together - ensuring that all economic variables move consistently with no direct reference to causality but ensuring coherence.
Conclusion
By quantifying geopolitical risk and using a coherent model, insurers can make informed strategic decisions and manage their portfolios effectively. The Proteus Scenario Generator ensures that your risk models, when fed with PSG scenarios, are sensitive to Geopolitical Risk allowing you to quantity the strategic impact on your capital. The geopolitical risk index provides a valuable tool for measuring and understanding the current geopolitical risk environment, and future integration with climate risk will further enhance the model's capabilities to capture exogenous drivers. In the future, we intend to expand the PSG to encompass further risk drivers and shock events, such as climate, natural catastrophes and more.
References
Caldara, Dario, and Matteo Iacoviello, 2018: "Measuring Geopolitical Risk." International Finance Discussion Papers No. 1222. Board of Governors of the Federal Reserve System. 1
