Contingencies Online - July/August 2009

Risk by Any Other Name
RISK HAS MANY MEANINgS. In the financial realm, risk has come
to represent volatility over a recent period—especially the fluctuations of
prices around a given path—but not the uncertainty associated with the
path itself. Real risk can exist in this context, when such a fluctuation has
an adverse effect. But often this misses the effect of the uncertainty as-
sociated with the path itself, which is usually of far greater significance.

Banks have at times not given adequate attention to path uncertainty because of their reliance on short-term hedging programs and on the assumption that they will be able to unwind all open positions without a significant loss during a specified short period. But as we’ve seen recently, this approach doesn’t always work. To base an entire industry upon such an assumption, particularly an industry upon which the economy is so dependent, represents a significant systemic risk. I remember a Society of Actuaries panel where I asked a participant whether there was risk other than volatility. He responded by claiming that volatility alone defines risk. I couldn’t then and still cannot agree with this answer.

Volatility usually arises because of random or short-term conditions or perceptions (primarily, process risk), partly as a consequence of the stochastic nature of the processes involved. Uncertainty arises when you don’t know what the expected value is (parameter or model risk) or the extent of its skewed distribution, often a result of incomplete knowledge. While gambling involves simple volatility, insurance and other financial services contain several elements of uncertainty. That’s one reason why an insurer puts together a portfolio of risks—to reduce the effect of volatility by taking advantage of the law of large numbers.

The need to reduce uncertainty is a fundamental reason the financial services industry exists. Insurance and banking enable people and entities to more efficiently undertake their lives or ventures of an uncertain or risky nature. Uncertainty is the raison d’être of insurance, as it seeks to deal with adverse financial

consequences. It’s a significant reason why people and entities save for a future event and borrow money in the hope of making more. But uncertainty also has to be considered by the financial services industry to ensure that it can fulfill the promises it makes to its customers.

I just read an article bemoaning the fact that companies and governments continue to ignore certain recurring hazards to the industry. In some cases, people’s memories are too short. Many of those responsible for governance still don’t recognize the costs associated with possible adverse scenarios, despite warnings by their own risk managers. Even when risk managers are not ignored, management may not be prepared to pay the cost to hedge against every possible risky scenario, especially extreme ones. But in so doing, it must recognize the bet it’s taking and be prepared for the consequences if it loses the bet.

It’s likely that inadequate anticipation of risky scenarios will lead to adverse consequences. You can be lucky for a while,

but some of those scenarios will inevitably catch up to you. If uncertainty isn’t respected or if mitigation efforts aren’t taken, all the money spent on risk management will be thrown away. Insurance, one of those techniques, can be used in many cases to reduce the uncertainties. While entrepreneurs can take advantage of favorable fluctuations, it’s easy to become blind to the potential downside. Misplaced optimism is particularly common at the top of a bubble.

Why do smart people continue to make decisions that in hindsight are incorrect? Is it because of poorly designed incentive compensation programs? An inadequate emphasis on risk management? Or is it because of the sometimes false assurance that current best practice will always be sufficient?

When things are going well, the advice of an actuary or risk manager (often, one and the same) is frequently ignored. When losses arise, actuaries and risk managers suddenly have everyone’s ear. What’s necessary is adequate attention to risk management throughout the cycle.

A sound financial system can thrive only with effective safety valves or mitigation techniques and with independent regulators who set the rules or principles by which the participants play. Based on historical experience, there’s a need for oversight of the management of uncertainty, ensuring that underlying needs are addressed in a manner that doesn’t end up in even more uncertainty. Society cannot afford to neglect both consumer protection and counterparty management oversight. But regulatory control also has to be reviewed on a regular basis to ensure that it doesn’t stifle constructive innovation, while reducing both systemic and entity-specific uncertainty.