Where to Draw the Line

“The unprecedented scale of the earthquake and tsunami that struck Japan, frankly speaking, were among many things that happened that had not been anticipated under our disaster management contingency plans.”  Japanese Chief Cabinet Secretary Yukio Edano.

In the past 30 days, there have been 10 earthquakes of magnitude 6 or higher.  In the past 100 years, there have been over 80 earthquakes magnitude 8.0 or greater.  The Japanese are reputed to be the most prepared for earthquakes.  And also to experience the most earthquakes of any settled region on the globe.  By some counts, Japan experiences 10% of all earthquakes that are on land and 20% of all severe earthquakes.

But where should they, or anyone making risk management decisions, draw the line in preparation?

In other words, what amount of safety are you willing to pay for in advance and what magnitude of loss event are you willing to say that you will have to live with the consequences.

That amount is your risk tolerance.  You will do what you need to do to manage the risk – but only up to a certain point.

That is because too much security is too expensive, too disruptive.

You are willing to tolerate the larger loss events because you believe them to be sufficiently rare.

In New Zealand,  that cost/risk trade off thinking allowed them to set a standard for retrofitting of existing structures of 1/3 of the standard for new buildings.  But, they also allowed 20 years transition.  Not as much of an issue now.  Many of the older buildings, at least in Christchurch are gone.

But experience changes our view of frequency.  We actually change the loss distribution curve in our minds that is used for decision making.

Risk managers need to be aware of these shifts.  We need to recognize them.  We want to say that these shifts represent shifts in risk appetite.  But we need to also realize that they represent changes in risk perception.  When our models do not move as risk perception moves, the models lose fundamental credibility.

In addition, when modelers do things like what some of the cat modeling firms are doing right now, that is moving the model frequency when people’s risk perceptions are not moving at all, they also lose credibility for that.

So perhaps you want scientists and mathematicians creating the basic models, but someone who is familiar with the psychology of risk needs to learn an effective way to integrate those changes in risk perceptions (or lack thereof) with changes in models (or lack thereof).

The idea of moving risk appetite and tolerance up and down as management gets more or less comfortable with the model estimations of risk might work.  But you are still then left with the issue of model credibility.

What is really needed is a way to combine the science/math with the psychology.

Market consistent models come the closest to accomplishing that.  The pure math/science folks see the herding aspect of market psychology as a miscalibration of the model.  But they are just misunderstanding what is being done.  What is needed is an ability to create adjustments to risk calculations that are applied to non-traded risks that allow for the combination of science & math analysis of the risk with the emotional component.

Then the models will accurately reflect how and where management wants to draw the line.

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Explore posts in the same categories: Assumptions, Black Swan, Enterprise Risk Management, Risk, risk assessment, Risk Limits, Tail Risk

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