Much Worse than Anticipated

Arianna Huffington recently pointed out that time and time again, the crises that we face turn out to be Much Worse than We thought it would be.

And she has a good point there.  One that is important for risk managers to contemplate.  One that we are often asked after a major loss…

Why did your risk model get that wrong?

There is a correct answer, but it is one that we can never successfully use.

In situations where major risks are being underestimated widely in the market place, the risk managers who correctly size the worst risks can run into two responses:

  1. Their firm believes their evaluation of the risk and exits the exposure as rapidly as they can.
  2. Their firm does not believe their evaluation and will only believe a risk evaluation that gives a similar (under) estimation of the risk as the rest of the market.

It is a survival of the underestimators.

And this doesn’t just apply to risk managers and risk models.  Who do you think buys a house on a flood plain?  Someone who has a clear and realistic view of the risk or someone who vastly underestimates the risk?  The underestimator will out bid the realistic every time.

So after a flood, go around to those flooded out and ask if they expected this and most will tell you that this is “much worse that we thought it would be”.

Many “emerging risks” and “black swans” are such because most people had misunderestimated the size of the risk or the likelihood.

And one way to think of it is to go back to Knight and realize that all profits are simply rewards for the uncertainties.  So when we find ourselves getting profits where we cannot figure out the uncertainty that drives the profits, maybe we should go back and figure it out.

The solution is not to curl up in a ball, nor is it to just ignore all risks that pose these potential major threats.  The solution is to take our best shot at really evaluating the risks and make our decisions, eyes wide open, to the possibility that things might just be Much Worse than Anticipated.

Maybe we need to regularly add a column to our risk reports.  To the right of the column labeled Risk.  This one labeled “Worse Case”.

Many insurers with Cat risk exposures will report the 1/250 loss potential that is the focus of rating agencies, but along side of that show a 1/500 loss potential to remind management of just how much worse it might get.

Some people complain that risk managers are just too pessimistic.  But to me this sort of practice just seems to be acting as an adult and facing our risks honestly.  Not with the intention that we stop taking risks.  Instead hoping that we stop experiencing losses that are MUCH WORSE THAN ANTICIPATED.

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Explore posts in the same categories: Black Swan, Tail Risk, Uncertainty, Unknown Risks

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2 Comments on “Much Worse than Anticipated”

  1. riskviews Says:

    From a trader’s perspective, it would be good to separate out the low frequency/high severity risks that are overestimated from those that are underestimated and find a way to by protection for the former and sell protection for the later.

    Certainly, it would be a bad business model to be in the opposite position. Insurers seem to either be long a risk or out of it completely. Banks seem to take positions on both sides, but not have any idea if they are ending up net long on the over or underestimated risks.

    Where is your organization?

  2. Eddie Says:

    Very interesting perspective. It would seem that those who do have a realistic view of certain risks are at a competitive disadvantage. It’s probably most likely to be seen with low frequency risk events, like the flood example.

    But people certainly overestimate the risk of low-frequency events too, like plane crashes. I wonder if risks are more likely to be overestimated if they’re in the context of mortal danger as opposed to financial loss. Of course, loss aversion studies show that people fear downside more than they value upside (generally), so it’s probably a much deeper topic than it appears on the surface.


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