A black swan event is an extraordinarily rare eventuality that brings a catastrophic impact. black swan events, so-named due to the dark pigment being an uncommon trait in swans, are usually discussed in the context of financial preparedness and resilience.
It’s the coined term that thrust author Nassim Nicholas Taleb into prominence through his best-selling title The Black Swan: The Impact of the Highly Improbable .
How rare is a black swan event? Well, to take a cue from their namesake, real black swans occur approximately 1 in every 500,000 swan births. This translates well to real life; these events are so infrequent that forecasters cannot foresee their specific occurrence.
However, this doesn’t mean that wise management teams cannot anticipate or protect against obscure disasters that may befall a business. They just have to approach risk management with their eyes wide open to the fact that bad things can happen which aren’t even conceivable. These are also called ‘unknown unknowns’.
Examples of black swan events include:
- The current Covid-19 pandemic
- The post-9/11 grounding of flights
- The 2014 volcanic eruption of Eyjafjallajökull in Iceland in 2010, which grounded European airlines for weeks
- The ‘flash crash’ in 2010, which saw $ trillion US dollars wiped off the value of stocks on the NYSE stock exchange in the space of a few minutes.
Businesses, traders or investors who are highly leveraged and need everything to succeed are very vulnerable to black swan events.
How to protect your business against black swan events:
Financial resilience through cash buffers
Much like the way an individual should aim to have 3 – 6 months of salary in emergency savings to pay for unexpected expenses or the loss of income, a business can weather a short term event by having sufficient cash to fund losses or demanding expenditure for a short period.
Cash can be conserved through:
- Financing new investment or acquisitions through the issuance of debt rather than running down all cash reserves
- Cutting spending on research and development
Naturally, some of these solutions are short termistic and will erode the longer-term growth prospects of a company. Sustainable options include setting a sensible dividend level, and not being too aggressive in drawing cash to the centre from foreign subsidiaries of an international group.
Unutilized lines of credit
Cautious corporations establish access to short term cash which is contractually assured, but underutilised. A corporation may agree on a revolving credit facility with a bank or syndicate for many multiples of the sum the business requires to manage day-to-day working capital requirements.
This untapped borrowing capacity can be drawn down in a time of severe need. Rather than having to turn to financial institutions in with a weak negotiating and peak credit risk, these facilities can be arranged for years in advance, with interest rates that reflect the strong standing of the company prior to turbulence.
Broad insurance cover
Insurance is an ideal tool against black swan events. General insurance policies cover the long tail of claims, regardless of how obscure. Some exceptions exist, such as Critical Illness personal cover which specifically names a finite list of injuries or diseases which are covered. The remainder of policies are designed to capture any event which requires compensation rather than forcing the policyholder to define the event in advance.
Lloyds of London built its reputation providing insurance against all manner of accidents such as the loss of ships at sea, to a singer losing their voice.
Mistakes can take many forms. Professional Indemnity Insurance could cover for losses, legal fees and damages paid as a result of a huge range of professional mistakes, including negligence.
With a combination of natural resilience (cash reserves), additional lines of credit and insurance policies that could take the edge off a wide range of costs, there are positive steps that businesses take to protect themselves against the invisible threat of unpredictable black swan events.