A few comments on a recent paper entitled “Not up in the air. Risk-management lessons from the volcanic ash cloud”, pubished by economists.com on April 20th
Apr 27th, 2010
A few phrases from the paper named Risk-management lessons from the volcanic ash cloud are copied below in italics, then commented:
…Conventional thinking about risk management holds that risks are mainly local and routine—that it is possible to list all the negative events that could happen, determine their probability based on past experience…
Risk-management lessons from the volcanic ash cloud
Two common wrong behaviors are indicated in the phrase above:
1) risks to be included in a risk assessment are not mainly local and routine and should derive from a very wide spectrum hazard identification phase. It is true, however, that many corporations, many international agencies fail to perform proper hazard identification using various excuses as pointed our earlier in this blog.
By NASA image by Jeff Schmaltz, MODIS Rapid Response Team at NASA GSFC. Caption by Michon Scott.
2) at Riskope, we have been teaching for years that “future does not equal past”…especially in this world of dynamic climate and societal changes. Typically insurers work in this obsolete and WRONG actuarial way. That is using statistics and, oh what a surprise, some end up bankrupt.
They then calculate what economists call “expected loss”, the probability multiplied by the cost if it happens. If the probability of a very disturbing large-scale event is set very low, then the expected loss may be insignificant. That gives a false sense of security. That leads managers to assume that this type of risk is manageable with the same resources as more “normal” ones.
We will not delve in the intricacies of technical lingo. However we rather point out that there is only one valid approach to understand if a risk is truly significant. It is the COMPARISON BETWEEN EACH SCENARIO’S RISK or “expected loss” and THE TOLERANCE THRESHOLD.
Again, managers relying on improper methods and measurements will most certainly fail to manage properly….sounds familiar, doesn’t it?
Pointing at the wrong culprit
So, at the end of the day some of the statements in the referenced paper pointing at “generalized difficulties to handle some risk scenarios” are correct. However that is not because the problem is insoluble It is rather because companies (and their managers) refuse to look at the world with the proper instruments! From what I read, it seems that unfortunately some academic personalities also refuse to see that rational and scientific approaches exist. They allow to shed a light in this area of management.
Low probability events are furthermore often confused with unforeseeable events…and this is the area where we at Riskope have been working a lot with our industrial clients as of late.
Foreseeability
We think the discussion on foreseeability warrants a little more explanations.
Foreseeability indeed requires the definition of a threshold likelihood. For example a tornado in Salt Lake city was unforeseeable, by scientific consensus, until one happened. From that moment on, if not repeated, it became a foreseeable, but very low probability/likelihood event.
From our research on these matters we conclude that the scientific community has defined the threshold value of foreseeability. It lies somewhere between one in hundred thousand and one in a million. Thirty years ago we demonstrated that the probability of failure resulting by code design in many countries, for a variety of civil structures, floats around those values. However, economists and financial experts seem to dare say that a phenomenon that:
- happens with various magnitudes seventeeen times in two hundred years, and
- happened with very significant magnitude seventy years ago and again in 2008-2009
is unforeseeable. They have even invented a nice wording for it. They call it a black swan…!!
Force Majeure considerations
So, it is of critical importance for business management and survival to spell our what Force Majeure is. That requires the definition of what is foreseeable vs unforeseeable. That goes through the definition of the threshold values of probability and magnitude. It is not “chatting about it” and putting together some nice decision making committees that will take decision based on “nothing” or close to “nothing”!
Why are we talking about Force Majeure now? Simply because Force Majeure will become a very critical issue in the close and medium term for any business entity.
At first sight it seems that the FM clause is written for the benefit of one side only. For example, to allow insurances to avoid paying. Some homeowners insurance policies state for example that wind shear is an act of nature but a tornado is an act of God and is not covered. or to exit a contract…(an audacious yet inventive attempt at utilizing the inherent ambiguity of “Force Majeure” occurred in the USA. Donald Trump argued that the current financial crisis qualifies as a “Force Majeure” event. This would excuse him making payments on a real estate loan. Trump, Donald et al –v- Deutsche Bank Trust et al, New York Supreme Court, Queens, 026841/2008).
What parties really want to do
In many other cases, however, in the aftermath of a catastrophic event, both parties may want to resume operations and rebound. That is finding a win/win situation rather than losing time in litigation. Many of our clients are fully aware that no Business Interruption insurance will, for example, cover the market share they lose if they are not servicing their clientele around the world.
But the more difficult cases arise precisely when one party to the contract claims performance is impossible. The other party generally maintains that performance is possible, but just at a greater expense to the opposing party.
Here the optimization takes the form of a “Best Practice” per-negotiated set of parameters. Its purpose is to allow both companies to take well balanced and sustainable remediation measures. That in turn will allow both parties to resume contractual obligations in the best possible manner. That is without the distraction by potential litigation.
Tagged with: balance, business, catastrophe, committee, contracts, decision, Financial, Force, global, insurance, interruption, law, lawyers, Majeure, market, premium, risk, share, tolerance
Category: Consequences, Hazard, Risk analysis, Risk management, Tolerance/Acceptability
You’ve done it once again! Great writing.
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Franco