Are Formal Risk Assessment of Any Use

By Jablonowski, Mark | Risk Management, August 2002 | Go to article overview

Are Formal Risk Assessment of Any Use


Jablonowski, Mark, Risk Management


The stakes for risk management decisions are higher than ever and thus these decisions need to be supported by a higher level of detail. Determining that appropriate level of detail is

a matter of understanding and grappling with the uncertainties of probability that inevitably challenge the risk management profession. We need to be able to critically assess the applicability and credibility of all sources of risk management information-from the numbers (the base of all risk analysis) to the intuitive powers of the risk decision makers.

A Lack of Data

To make sound judgments based on statistics, we need data. The more data the better. For most organizations, however, data on individual exposures is scarce. This is especially true for severe, yet infrequent events, which involve the most difficult and costly decisions.

The results of statistical study on losses for any particular exposure boil down to a chart like that shown in Figure 1. A probability number, here expressed as a percentage, is associated with various loss potentials. Likelihood is typically shown as a probability of exceeding a given annual aggregate loss.

The numbers are derived in various ways. The most common method matches theoretical equations with observed loss data. The fewer data points there are, the more possible mathematical equations fit the data. Yet only one true equation exists. Which one is correct? The choice is based on which equation minimizes the difference between its theoretical predictions and the actual data. If the actual data is subject to random fluctuations, however, the chance that the selected equation fits the true underlying loss distribution is slim.

We can take the analysis one step further and calculate the likelihood that the probability we come up with is true-our statistical confidence intervals. Unfortunately, this can lead to an infinite regression of probabilities on probabilities, and it assumes certain theoretical conditions. In this fast-moving and complex world, we can never be sure of such assumptions.

Loss prediction precision fades at exactly that point where we need to make significant decisions. How reliable is a decision based on a number developed in a system so dependent on possibly flawed theoretical ideas? To effectively use formal risk assessments, we must understand the numbers, any uncertainties surrounding them and what we can do about those uncertainties.

Actuarial Limitations: The Ten Percent Rule

While we might specify probabilities accurately for frequent events, accuracy falls off as the frequency of loss decreases. Likewise, as the potential losses increase, we become less sure of the probability of exceeding these amounts. Estimates involve picking one of the many theoretical models that predict future loss, but that choice, beyond a certain point, becomes arbitrary (see Figure 2).

The probability number associated with a particular loss amount could be the result of a range of modeling options. The problem is compounded when the fitted models are used to extrapolate beyond observed data. Such data deficiencies mean that the results of statistical risk assessments can be highly inaccurate for losses where predicted probability falls below ten percent.

In the study shown in Figure 1, aggregate losses for our hypothetical firm are predicted to exceed $6.6 million 10 percent of the time (or once every ten years). So losses will be under $6.6 million 90 percent of the time. Results at higher thresholds-5 percent or 1 percent-are highly questionable, regardless of the skill of the statistician. This means that if we are concerned about losses exceeding $8 million, or we want a comfort level in excess of 90 percent with our risk financing decisions, extra caution should be used.

This problem manifests itself when we are dealing with more sophisticated risk management and risk financing issues, beyond buying insurance or selecting a maintenance deductible. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Are Formal Risk Assessment of Any Use
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.