The title of this post is adapted from a comment made by the CRO of Fidelity Investments, who wrote:
“Corporate leaders recognise that over the long term, the only alternative to risk management is crisis management. And crisis management is much more expensive, time-consuming, and painful.”
Summarised from : Kloman, Felix. “A short history of risk management: 1900-2002”. Risk Management Reports, 2002
Risk management is the idea that a logical, disciplined approach to the uncertainties of the future is possible and necessary in order to live with these uncertainties productively and efficiently. Prior to the advent of risk management, faith and luck were the two pillars for managing the future. Events have causes. Believing in luck obscures the causes.
The great conflicts (e.g., World War 2), the great disasters, (e.g., Chernobyl) all affected and contributed to the development of risk management. But the most significant milestones are from personal events:
1900: The Galveston Texas flooding changes the nature of weather prediction worldwide.
1905-1912: Workers’ compensation laws introduced in the US from inception in Germany, introduces pension and shifts personal responsibility to business and government.
1920: BP forms Tanker Insurance Company, Ltd, which becomes one of the first captive insurance companies. Today there are 5000 such companies with $214 billion investable assets. (Captive insurance companies are companies formed to finance the risks of their parent companies)
1921: John Maynard Keynes publishes ‘A Treatise on Probability’ which emphasises the importance of relative perception (over numbers?) and judgment when determining probabilities.
1926: Von Neumann begins publishing papers on games strategy showing that a goal of not losing is superior to a strategy focused on winning.
1933: The US Congress passes the Glass-Steagall Act, which slowed the development of financial institutions and fragmented risk management. Also caused the split between financial and insurance risks. Revoked in 1999.
1952: Markowitz’s paper ‘Portfolio Selection’ published, which explores return and variance, which led to many of the sophisticated measures of financial risk in current use.
1956: Russell Gallagher’s paper ‘Risk Management: A New Phase of Cost Control’ published. Philadelphia becomes focal point of new ‘risk management’ thinking. Snider argues that the ‘professional insurance manager should be a risk manager’. Herbert Denenberg picks up writings of Henri Fayol, using them to explore risk management.
1962: Massey Ferguson develops the idea of ‘cost-of-risk’, comparing sums of self-funded losses, insurance premiums, loss control costs, and administration costs to revenues, assets and equity. Moves insurance risk management thinking away from insurance, but fails to cover all forms of financial and political risk. Rachel Carson’s ‘Silent Spring’ is published, leading to the formation of the EPA and Green movement.
1965: Ralph Nader’s ‘Unsafe at Any Speed’ is published which gives rise to the consumer movement. Caveat emptor changes to caveat vendor, leading to stiff product and work safety regulations. Rise of punitive damages in American courts.
1966: Insurance Institute of America issues the first examination for ‘Associate in Risk Management’
1972: Kenneth Arrow Nobel Prize winner imagines a perfect world where every uncertainty is insurable. Concludes our knowledge is always incomplete. We are best prepared for risk by accepting its potential as stimulant and penalty.
1973: Geneva Association is formed. Two years later begins linking risk management, insurance and economics. The association provides intellectual stimulus for the developing discipline. Scholes and Black publish paper on option valuation, opening up the field of derivatives.
1974: Gustav Hamilton creates a ‘risk management circle’ which graphically describes the interaction of all elements of the process, from assessment and control to financing and communications.
1975: American Society of Insurance Management changes name to Risk & Insurance Management Society (RIMS), signalling shift towards risk management and by end of the century has 3500 corporate members.
1976: Fortune magazine publishes ‘The Risk Management Revolution”, suggesting coordination of risk management functions within an organisation, and also suggesting board responsibility for organisational policy and oversight.
1980: Society for Risk Analysis formed in Washington. Its journal Risk Analysis published. Makes terms ‘risk assessment’ and ‘risk management’ well known in legislatures on both sides of Atlantic.
1983: William Ruckelshaus’s speech on ‘Science, Risk and Public Policy” brings risk management to the national political agenda.
1986: The Institute of Risk Management (IRM) begins in London. A few years later begins education program looking at all facets of risk management, issuing the designation “Fellow of the Institute of Risk Management”. US Congress passes Risk Retention Act. Risk retention groups begin.
1987: Black Monday. Vernon Grose publishes ‘Managing Risk’, one of the best ever primers on risk assessment and management.
1990: UN starts IDNDR, International Decade for Natural Disaster Reduction. Efforts end with publication of Natural Disaster Magazine, presenting a synopsis on nature of hazards and challenges for the 21st century.
1992: Cadbury Committee in UK issues report suggesting that governing boards are responsible for setting and accepting oversight for risk management policy. Successor committees in the UK (Hempel, and Turnbull) and in other countries establish a new and broader mandate for organisational risk management.
British Petroleum turns insurance world topsy-turvy with decision not to insure operations in excess of $10 million. Decision was based on academic study by Neil Doherty of the University of Pennsylvania and Clifford Smith of University of Rochester.
1995: AS/NZS 4360:1995 standard first published. First Risk Management Standard. Nick Leeson in Singapore topples Barings. Revives interest in operational risk management.
1996: Global Association of Risk Professionals start. Operating through the internet, it becomes the largest RM association in the world. Focused on financial risk.
Risk management popularised and becomes a bestseller through Peter Bernstein’s ‘Against the Gods’.
2000: Y2K bug fails to materialise, mainly because of massive fix effort. A big success for risk management.
2001: Sept 11. Collapse of Enron reinvigorates risk management.
Summary of “Facts and Fears: Understanding Perceived Risk”, a study of risk perception conducted by Slovic, Fischhoff, and Lichtenstein.
Perception of risk refers to the acceptance that there is in fact a risk. Acceptability of risk refers to how much the risk can be tolerated; to what level it should be controlled.
INVOLUNTARINESS
New research suggests that the accepted views on catastrophic loss may need to be revised. A current, popular view, based on a hypothesis forwarded by Starr (1969), says that people tend to demand stricter standards against hazards brought on by involuntary risks (involuntary risks are risks one does not take by choice). This hypothesis says that risks that are involuntary are perceived to be less tolerable.
Slovic, et. al's study did not intentionally seek to address Starr's hypothesis, but the findings provided an interesting test of it. Their new study seems to suggest that in addition to voluntariness, a host of other factors such as knowledge, controllability, etc. need to be factored into risk standards.
Their study further tends to the notion that it may not be involuntariness per se that drive the call for stricter results, but other conditions closely associated with involuntariness, such as catastrophic results. Involuntary hazards tend to include large-scale catastrophic events such as nuclear power, terrorism, bio-chemical threats.
Levels of acceptability of risk correlates positively with perceived benefits of the risk, in fact more strongly than voluntariness.
CATASTROPHIC POTENTIAL
The study suggests that it is the (perceived) potential for massive loss, rather than involuntariness, that could be the driving force to risk perception and acceptability.
CONCLUSIONS
Further conclusions. The authors conclude that the public can make gross mistakes in perceptions of risk, but then so do experts, so public opinion ought not to be excluded from risk decisions. It is much better to involve the public in risk matters for the purpose of increasing their knowledge in the longer term and also because their cooperation is needed for risk management undertakings to succeed.
