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.
BRIAN A. JACKSON, 3d BRAINEd / SHuttERStOCK, BONOtOM StudIO
SAM GUTTERMAN is director
and consulting actuary with
PricewaterhouseCoopers llP in Chicago.