It seems that there are three approaches to how to look at the riskiness of the future when assessing risk of a specific exposure:
- Look at the “long term” frequency and severity and look at risk based upon assuming that the near term future is a “typically” risky period.
- Look at the market’s current idea of near term future riskiness. This is evident in terms of items such as implied volatility.
- Focus on “Expert Opinion” of the risk environment.
There are proponents of each approach. That is because there are strengths and weaknesses for each approach.
Long Term Approach
The long term view of risk environment will help to make sure that the company takes into account “all” of the risk that could be inherent in their risk positions. The negative of this approach is that it will in most times not represent the risk environment that will be faced in the immediate future.
The market view of risk does definitely give an immediate view of risk environment. It is thought by proponents to be the only valid approach to getting a view of that. However, the market implied risk view may be a little too short term for some purposes. And when trying to look at longer term risk environment through market implied factors, there may be very large inaccuracies that creep into the view. That is because there are other factors other than view of risk that are a part of the market implied factors that are not so large for very short term periods, but that grow to predominate with longer time periods.
Expert opinion can also reflect the current risk environment and is potentially adaptable to the desired time frame. However, the main complaint with Expert Opinion is that there is no specific way to know whether an expert opinion of the risk environment is equivalent between one point of time and another. One explanation for the uncertainty in that can be found in the changing risk attitudes that are described by the Theory of Plural Rationalities. Experts may have methods to overcome the changing waves of risk attitudes that they are personally exposed to, but it is hard to believe that they can escape that basic human cycle entirely.
Risk environment is important in setting risk strategies and adjusting risk tolerances and appetites.
Using the Long Term approach at all times and effectively ignoring the different risk environments is going to be as effective as crossing a street using long term averages for the amount of traffic.
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