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«The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial ...»

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Risk Analysis and Risk Management

Financial

in an Uncertain World

Institutions

Center by

Howard Kunreuther

02-08

The Wharton Financial Institutions Center

The Wharton Financial Institutions Center provides a multi-disciplinary research approach to

the problems and opportunities facing the financial services industry in its search for

competitive excellence. The Center's research focuses on the issues related to managing risk

at the firm level as well as ways to improve productivity and performance.

The Center fosters the development of a community of faculty, visiting scholars and Ph.D.

candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence.

Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest.

Franklin Allen Richard J. Herring Co-Director Co-Director The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation Risk Analysis and Risk Management in an Uncertain World Howard Kunreuther** Center for Risk Management and Decision Processes The Wharton School University of Pennsylvania Philadelphia, PA 19107 Visiting Research Scientist Columbia University Paper for Distinguished Achievement Award Society for Risk Analysis Annual Meeting Seattle, Washington December 4, 2001 (To be published in Risk Analysis) * My thanks to Robert Chen, Baruch Fischhoff, Robin Gregory and Paul Slovic for comments on an earlier version of this paper as well as two anonymous referees. Support for this research under the U.S. Environmental Protection Agency’s Cooperative Agreement C R 826583 with the University of Pennsylvania as well as the Wharton Risk Management and Decision Processes Center and the Columbia University Earth Institute is gratefully acknowledged.

1

ABSTRACT

The tragic attacks of September 11th and the recent bioterrorist threats have raised a set of issues regarding how we deal with events where there is considerable ambiguity and uncertainty on the likelihood of their occurrence and their potential consequences. This paper discusses how one can link the tools of risk assessment and our knowledge of risk perception to develop risk management options for dealing with extreme events. In particular it suggests ways that the expertise of members from the Society for Risk Analysis can apply their talents to the risks associated with terrorism and discusses the changing roles of the public and private sectors in dealing with extreme events.

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I am honored to receive the Distingushed Achievement Award from the Society for Risk Analysis (SRA). SRA is a unique organization because its membership is drawn from the physical and biological sciences, engineering and the social sciences. I have learned a great deal over the years from interacting with researchers and practitioners associated with SRA.

The tragic attacks of September 11th and the recent bioterrorist threats have raised a set of issues regarding how we deal with events where there is considerable ambiguity and uncertainty on the likelihood of their occurrence and their potential consequences.

The following questions should be addressed if we are going to be able to develop

meaningful strategies for dealing with these extreme events:

• How can we link the tools of risk assessment and our knowledge of risk perception to develop risk management options that are likely to be successfully implemented?

• What is the changing role of the public and private sectors in dealing with these risks?

• How can we utilize lessons from dealing with past extreme events in helping to plan for the future?

I believe SRA can help develop strategies for coping with the fallout from these unprecedented events. This paper will address the challenges and opportunities for SRA to play this leadership role. Rather than referencing the wide range of relevant papers that have appeared in Risk Analysis and other journals on the topics discussed here, I have listed a selected set of recent books and papers, many of which provide a comprehensive list of relevant references to the topics discussed in this paper.

–  –  –

One of the cornerstones of SRAs success has been the many contributions that the membership has made to the area of risk assessment ranging from early studies of fault and event trees for nuclear power to National Academy studies on understanding risk. (2)

2.1 Nature of the Field The field of risk assessment encompasses studies that estimate of the chances of a specific set of events occurring and/or their potential consequences. For those like myself who are users rather than creators of risk assessments and vulnerability studies, we need to appreciate that most of these published papers represent the tips of an iceberga 10 page article in Risk Analysis characterizing the likelihood of a nuclear power accident often represents the culmination of person-months or years of study which reflect the collection and analyses of volumes of data.





Scientists and engineers need to provide the users of these data not only a picture of what we know regarding the nature of a particular risk and the degree of uncertainty surrounding these estimates while being sensitive to their role as assessors of these estimates. Experts in the field need to take special care not to provide these estimates through the filter of their values.

It is not uncommon for the public to hear Expert 1 say that there is “nothing to worry about regarding a particular risk” while at the same time learning from Expert 2 that “this risk should be on your radar screen”. There may be many different reactions to these conflicting reports. One layperson may decide that they cannot rely on the judgment of any expert. Another individual may decide to focus on the expert supporting his or her 1 See Haimes(1) for a comprehensive summary of recent work in risk assessment.

–  –  –

there is a degree of consensus on the nature of the risk.

2.2 Use of Exceedance Probability (EP) Curves One way to capture what experts know and do not know about a particular risk is to construct an exceedance probability (EP) curve. An EP curve specifies the probabilities that certain level of losses will be exceeded. The losses can be measured in terms of dollars of damage, fatalities, illness or some other unit of analysis.

To illustrate with a specific example, suppose one was interested in constructing an EP curve for dollar losses to homes in Seattle from an earthquake. Using probabilistic risk assessment, one combines the set of events that could produce a given dollar loss an then determines the resulting probabilities of exceeding losses of different magnitudes.

Based on these estimates, one can construct the mean EP depicted in Figure 1. By its nature, the EP curve inherently incorporates uncertainty in the probability of an event occurring and the magnitude of dollar losses. This uncertainty is reflected in the 5% and 95% confidence interval curves in the figure.

–  –  –

events is the degree of uncertainty regarding both probability and outcomes. As everyone is aware by now, it is a lot easier to construct an EP curve for natural disasters and chemical accidents than it is for terrorist activities. But even for these more predictable accidents or disasters, there may be considerable uncertainty regarding both the likelihood of the occurrence of certain risks and the resulting damage. For low probability-high consequence risks, the spread between the three curves depicted in Figure 1 shows the degree of indeterminacy of these events. This should increase the credibility of the experts producing these figures.

The EP curve can serve as an important element for evaluating a set of risk management tools. It puts pressure on experts to state the assumptions on which they are basing their estimates of the likelihood of certain events occurring and the resulting consequences. The graphical depiction of risk is likely to be an unfamiliar frame of reference for many people. However, this group may come to appreciate the importance of presenting information in this form, if they are convinced that the analysis is based on a set of logical sound assumptions. In fact, EP curves, such as those depicted in Figure 1, should enable the general public to gain a better understanding of why experts may disagree and why there is so much ambiguity surrounding estimates of some risks and much less uncertainty on others.

Here are a few questions to ponder with respect to the uncertainties associated with

the following extreme events:

• What are the chances that Seattle will have an earthquake of Magnitude 7.0 or greater next year and what will be the resulting damage and indirect losses?

–  –  –

United States and what would be the resulting impacts?

• What is the probability that an airplane will crash into the Sears Tower in the next year and how serious would the consequences be?

• What are the chances that there will be a terrorist-induced smallpox epidemic in the United States in the next five years and how many people would be affected When experts are asked to answer these questions they are likely to respond by asking for more precise information to help define the event. Take the question related to the chances of an earthquake of Magnitude 7.0 or greater in Seattle. The experts will

normally require more precise information for defining the event. They are likely to ask:

“What is the geographic area that defines Seattle?” “What do you mean by next year (i.e.

starting today or January 1, 2003)? What is an indirect loss?2 In order to obtain more accurate and useful risk assessments laypersons need to set the terms of the analysis so that experts know what to do and users know what they have received.3

3. RISK PERCEPTION AND CHOICE UNDER UNCERTAINTY4

Traditional risk assessment focuses on losses that are often measured in monetary units. Risk perception is concerned with the psychological and emotional factors that have been shown to have an enormous impact on behavior. In a set of path- breaking studies begun in the 1970s, Paul Slovic, Baruch Fischhoff and other psychologists began measuring laypersons’ concerns about different types of risks.

2 My thanks to Robin Gregory who suggested that one needs to pose these types of questions when addressing issues of risk assessment.

3 For a more detailed discussion of the interaction between laypersons and experts see (2) and Fischhoff(2a) 4 See Slovic (3) for a comprehensive summary of recent work in risk perception.

–  –  –

knowledge and were also highly dreaded were perceived as being the most risky. For some technologies, such as nuclear power, and activities such as storing radioactive waste, there was a wide disparity between the general citizenry and the experts’ view of the risk. The general finding that laypersons see the world differently from the scientific community also raised a set of questions as to the nature of the decision-making process for dealing with risks. This section explores how recent research on risk perception has broadened the nature of the risk assessment process and has increased our understanding of choice under uncertainty.

3.1 Impact of Stigma and Social Amplification of Risk For a long time the scientific community felt it was appropriate to ignore the public’s perception of the risk if it differed significantly from their own estimates. The public did not believe the experts’ figures because they were not communicated very well, the assumptions on which they were based were not well stated and there was little understanding as to why experts disagreed with each other.

The situation has changed in recent years where there is increased sympathy for including these psychological and emotional factors as part of the risk assessment process. Recent studies have confirmed this view by showing that the public will assiduously avoid certain activities because they are perceived to be unduly dangerous.

More specifically, there is a stigma associated with technologies, places and products because public perceives them to be hazardous.5 In many of these situations the scientific evidence suggests that there is no reason to be concerned about these risks.6 5 The ancient Greeks used the word stigma to refer to a mark placed on an individual to signify infamy or disgrace, thus suggesting that the person posed a risk to society.

6 See (Flynn et al 2001)(4). for recent studies on the impact of stigma on risk perception.

–  –  –

carcinogenic, although there is limited, if any, scientific evidence to support this position.

Take yourself back to 1989 when the public was panicked about eating apples that contained the chemical Alar. The assertion that Alar was carcinogenic was based upon animal studies that were considered suspect because the doses used had been so large as to be acutely toxic. Moreover, there was no evidence from epidemiological studies showing Alar to be a human carcinogen. Yet these scientific findings were not communicated to the public so that it was alarmed at the prospect of being exposed to Alar.

The strong reaction by the public to Alar also illustrates another phenomenon that is well-documented in the literature, the social amplification of risk and how its relationship to stigma. (5) Stimulated by media reporting, the public’s perception of the risk is often amplified in ways that are difficult to explain if one was focusing on the standard elements of any technical risk assessment---probability times direct losses.



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