The True Nature of Risk & the Value of Risk Management

by futurist Richard Worzel, C.F.A.

An unusual report was just published by insurance company RSA, which essentially stands for “Royal and Sun Alliance”, based in London, England. RSA is celebrating its 300th anniversary, and decided to do a report on the past 300 years of dealing with risk (which is what an insurance company does), and look into the future of risk as well. There are some interesting insights on modern society and the world in this report, and it also inspired some further thoughts on the true nature of risk that seem worth pursuing. But first, let me draw some highlights from the report.

First, RSA deals with countries around the world, and so surveyed consumers in many of their principal countries about the concerns that weigh most heavily on their minds. The countries covered are somewhat quirky, because they represent the countries in which RSA does business. Hence, Canada is discussed, but not the U.S.; Sweden is involved, but not Germany; China’s there, but Japan isn’t, and so on. Despite this ­– or perhaps because of this – it produces some interesting insights, especially as RSA’s roots are in the United Kingdom, and some UK statistics go back more than 300 years.

Insights from the Past

The first insight is that the world is, on average, a much less risky place than it once was. Intellectually we know that, but emotionally we tend to believe that our generation is the one that is balanced on a knife-edge. We point to the threats of nuclear war, terrorist attacks, climate change, not to mention crime in the streets and AIDS, and conclude that we are living in perilous times. Yet, if you look at simple survival statistics, and compare them with England in 1760, it’s clear how far we have come:

	Infant Mortality per 1000 live births	Life expectancy (in years) at birth
England, 1760	174	34.2
Bangladesh, 2007	56	66
Madagascar, 2007	76	60
Nepal, 2007	59	66
U.K., 2007	5	79

Source: RSA report, “300 years of risk: Past, Present and Future”, December 2010.

Even the most dangerous of Third World countries today are far superior to one of the best countries of the 18th century, and that reflects another intriguing difference: the importance of knowledge. Much of the increase in life expectancy and decrease in infant mortality has come from a vastly improved understanding of infection, disease, and the way the body works, and therefore, how to treat infants and people generally to improve their chances of survival. As a result, even though the desperately poor in today’s world often lack adequate medical care or access to drugs, they are still vastly better off than people were 300 years ago.

The Institutionalization of Risk Management

A related insight is that we have institutionalized risk management in today’s world, which was largely lacking in earlier times. Benjamin Franklin, in his autobiography, discusses the creation of one of the first fire departments in America in the 1730s. In today’s world we would be shocked to find a city of any significance without a corps of professional fire fighters. And although there have been public and private guardians against theft and violence since ancient times, the first professional force devoted to preventing theft and violence was established in 1800 in Glasgow, Scotland.

Likewise, while the concept of insurance has been around for centuries, if not longer, the extent and sophistication of insurance today has been vastly expanded to include the default of corporations, national governments, protection for farmers against specific kinds of weather (too much or not enough rain, for instance), and even against the ultimate costs of a disaster that has already occurred.

Yet, ameliorating risk, and institutionalizing risk management have not eliminated risk – nor our feelings of being threatened.

Today’s Perception of Risk

One of the principal focuses of the RSA report is on what characterizes the feelings of risk in various different countries. What I found of greatest interest was not the specific things that people felt were threats in the various countries surveyed so much as the nature of the differences from one country to another. Let me summarize the top three risks from each of the countries surveyed (countries listed in alphabetical order):

	Top Risk	2nd Risk	3rd Risk
Argentina	Illegal drugs	Corruption in government	Burglary of your home
Canada	Rising cost of living	Climate change	Damage to the natural environment
China	Earthquakes	Unsafe ingredients in food	Cancer
Poland	Drink driving	Speeding traffic / dangerous drivers	Rising cost of living
Sweden	Damage to the natural environment	Climate change	Cancer
United Arab Emirates	Rising cost of living	Speeding traffic / dangerous drivers	Corruption in government
United Kingdom	Anti social behaviour	Rising cost of living	Terrorist attack

Ibid.

Just comparing the first two countries – Argentina and Canada – is revealing in terms of societal differences. In Argentina, there’s a clear concern about risks that should be managed by good government: drugs, corruption, and burglary. In Canada, the threats are more abstract (although still very real): inflation, climate change, and environmental degradation. There is also a sensitivity to financial concerns in most of the countries, which reflects the recent concerns resulting from the Great Recession of the past couple of years (although these are not evident in China or Argentina, probably for different reasons).

It’s clear, then, that our perception of risk is related to our direct, personal experience. And I would add that the real risks we run may be very different from the risks we think we are running. The perfect example of that is the belief in America (and elsewhere, such as Spain, Ireland, and the U.K.) in the mid-2000s that owning a home with a large mortgage was virtually risk-free (“safe as houses”) when in fact, it turned out to be extraordinarily risky. Likewise, the securities issued by the major banks based on the housing markets, being securitized loans, asset-backed securities and the like, were viewed as being AAA credits when, after-the-fact, it was clear that they were nothing of the sort.

But risk is not just a matter of perception. Reality will frequently intrude in ways we’d hadn’t thought of, and for which we are unprepared. In turn, this means that our thinking on risk management, if it is to be helpful, must be much broader than everyday thinking would indicate. We should be thinking about risks that are not obvious from our own experiences.

Managing Risks

There are fundamentally three kinds of risks: those we’re familiar with; those we don’t normally encounter but can imagine; and those we have not imagined. Inevitably the risks we tend work hardest on managing fall into the first category. And by definition, it would seem that we cannot manage risks that are beyond our imagination (which is not entirely true, as we’ll get to in a moment). But let’s focus on the first two categories of risk for the moment.

If you live in Canada, you don’t tend to spend a lot of time worrying about hurricanes or earthquakes, even though Canada has experienced both. They are not part of the normal range of expected risks, so Canadians don’t focus on them very much. If they do happen, they tend to be extraordinary and so tend to be shrugged off as a fluke. Yet, this is actually a good example of how not to manage risks. Canada has experienced hurricanes, and has incurred a great deal of damage when they do occur. A number of lives were lost in 1954 in Toronto when hurricane Hazel blew through town. And the city of Vancouver, on Canada’s west coast, will one day experience a devastating earthquake of a type that people tend to expect in California, and for the same reason: moving tectonic plates. Because an event is unusual does not mean you shouldn’t prepare for it.

Moreover, this kind of conscious mistake becomes almost systematic in the corporate world, and the highest profile set of mistakes of this type in recent memory are the risks that investment banks took in securitized assets prior to the financial panic of 2008. Estimates were made of how probable (or improbable) certain kinds of risks were in financial assets and markets, based on economic theories popular before the crash. Yet, most of these models assumed that financial risks were distributed normally, that is, according to a Gaussian distribution model, even though it had been known since the early 1970s that financial assets do not follow a Gaussian distribution. Why, then, did the financial modelers use a normal distribution? They did it because Gaussian distribution systems have certain very nice properties that make it simple to forecast the probability of future events. In other words, it was convenient, not accurate. And the traders and executives that relied on the models created by their theorists never took the time to understand the shortcomings of the models they were using. The result from this (plus other, similar misconceptions and mistakes) gave rise to what have been called “black swan” events. And since such events were calculated as happening only once in 10,000 years or 10,000 centuries, managers assumed they were impossible.

Another aspect of this mis-estimation of risk amounts to gambling: I know that if this black swan event occurs, it will bankrupt us, but the potential rewards are so tempting that I will bet that I can win big before I go bust – and that I will be smart enough to quit while I’m ahead. This fallacy is the one that made Las Vegas rich, at least before the real estate bust.

So here we have two common mistakes in managing risk: assuming that because something happens infrequently, it is a fluke, and can be ignored. And assuming that you’ll be the lucky one that wins, and therefore press ahead, ignoring the risk.

Dealing with Unimagined Risks

Now let’s look at how to deal with unimaginable risks. It would seem, by definition, that we can’t deal with risks we can’t imagine, yet there are techniques that do just this. Principal among these are what are known as wild card scenarios. A wild card is a low probability event, which, if it occurs, has dramatic consequences. Hence, the terrorist attacks of 9/11 were such a wild card. Ironically, these attacks shouldn’t have been a wild card at all. They were, instead, a mistake made by underestimating the risk, which is another way of saying “overconfidence.” There had been successful terrorist attacks on American targets abroad, an almost successful car bomb attack on the World Trade Center (which actually fed the sense of overconfidence), and a successful (if that’s the word) terrorist attack within the United States in Oklahoma City by an American. Yet, these became “black swans” in the sense that people decided that they hadn’t actually seen what they had seen, or that they were flukes, and could therefore be ignored.

So, how do you expect the unexpected? Fundamentally, you ask seemingly simple questions, and then keep following the answers, wherever they take you. Let me give you an example.

Royal Dutch Shell is one of the most successful non-governmental practitioners of scenario planning, and has had a number of well-documented successes. One of these was their anticipation of the collapse of the Soviet Union before just about anyone else could conceive of such a thing. Indeed, they were rumored to have contacted the CIA to try to warn them that they, Shell, expected a Soviet collapse was imminent, only to be pooh-poohed by the CIA. It was too unlikely, said the Agency. It was a black swan, and nobody has ever seen a black swan.

What Royal Dutch Shell is reputed to have done to arrive at this conclusion is instructive. They were, not surprisingly, interested in the price of oil, and asked the classic wild card question: What could have a dramatic effect on the price of oil that we’re not currently thinking about? One of the answers was: the price of oil could soar if one of the major oil producing countries were to experience some kind of major disruption. They then went through the list of major oil producing countries, and for each one asked: What might cause this oil producing country’s oil production to change radically, up or down? When they got to the Soviet Union, they decided that an economic collapse of the Soviet Union could cause a collapse of their state-run oil production. As a result, they started looking for signs indicating a possible economic collapse. And when they started seeing such signs, they raised their expectations of the risk of a big hike in the price of oil.

Following this line of questioning led to one of the great intelligence coups of modern times. Doing this takes intellectual discipline, but more than that, it takes a willingness to ask uncomfortable questions.

What Are the Risks Ahead?

So what risks are we facing now, in the second decade of the 21st Century? I will be dealing with these issues in a series of blogs over the next few weeks, but a partial list would include:

• A trade war

• Renewed financial crisis

• Climate change provoking major shifts in weather patterns

• Nuclear, biological, or chemical terrorist attacks

• A radical improvement in our standard of living brought on by computers & automation. (Not all wild cards are negative.)

This is just a sampling of some of the risks that few organizations are actually thinking about right now. There are many others, including wild cards that I, or others, haven’t thought about. And you could spend a potentially infinite amount of time thinking about risks and contingency plans, which is clearly unmanageable. Yet, making a systematic assessment of the real potential risks out there, how likely they are, and how harmful or beneficial they could be is a critical issue in today’s management.

Even though we may be living in an age where infant mortality is lower than at any time in history, and life expectancy greater, there are risks that can be critical to your well-being, both as an organization, and to you personally. Because of the speed with which the world is changing, not approaching risk management in a systematic way would be like driving down a superhighway wearing a blindfold. It’s a risk not worth taking.

© Copyright, IF Research, January 2011.