Uncommon Sense

The funny thing about this risk management stuff is that everyone is supposedly doing it already. In business, from the solo practitioner or individual employee, to the department manager, to the chief executive, everyone has their internal compass as to what they should be doing or avoiding, or what specific result would constitute failure or success. Most people call this common sense.

Find XBut common sense can be surprisingly uncommon and inconsistently applied. Modern principles of risk management emphasize the importance of laying things out explicitly, in advance, taking actions that are consistent with these objectives, then monitoring progress and making adjustments over time. Sometimes the actions need to be adjusted, but sometimes the objectives do too. Even the most well thought out plan and risk management strategy will need to be changed eventually. Here is where we can easily slip off into abstract philosophical ruminations or highly technical risk management methodologies that would be virtually impossible for most business people to implement. I’m more of a pragmatist so let’s just start with the idea of questioning our assumptions, which is the bedrock of a sound risk management strategy.

 

Fragile or unrealistically precise assumptions are very dangerous things, and can lead well- intentioned business people astray. A simple example that I have seen repeatedly is the assumption that a new company can make a lot of money by entering a very large and mature market, if they can just eke out a tiny market share. It’s so tempting – surely we can get at least 0.5% market share, and with a $100 billion market, that’s $500 million in sales for us. Yes, there are large start-up costs, but once we break in, our profit can be $50 million annually in five years! This siren song is always accompanied by detailed financial projections, under baseline assumptions and stress tests. Ostensibly, this is good risk management practice, as the assumptions are explicit. But all too often I’ve seen these assumptions insufficiently justified, the stress tests not broad or severe enough, and the risks inadequately addressed.

 

This is where the actuary – the quantitatively astute skeptic and businessperson – can be invaluable. The actuary recognizes that market share is a function of how you distinguish yourself relative to competitors, and this is amenable to quantitative and qualitative analysis. The actuary needs evidence for assumptions, and can trace them back to specific operational actions or broader business conditions. The actuary recognizes that numerical assumptions should only be considered as placeholders for a range of possible outcomes, not an exact prediction; deviations can be multiples of the original assumption, not just plus or minus 20%. The actuary recognizes that these deviations represent risks to the business and should be managed attentively, not hoped away. And here’s the best part: the actuary is equipped to help manage these risks, sometimes through operational actions, sometimes through investment transactions, and sometimes through insurance transactions. Common sense meets modern risk management – now that is a powerful combination.


Don't Be Fooled by Forecasting

One of the things that I have always loved about mathematics, particularly in my quickly receding undergraduate days, is that there is almost always a right answer.  At least for the problems posed in math classes.  Usually the answer could be determined exactly.  Sometimes, you could only approximate it, and if you couldn’t do that, you could often at least prove that it exists.  And every now and then, you’d just have to take solace in the fact that you could prove that there is no solution.  At least that’s something.  That type of certainty is comforting to the young and idealistic, and to those who limit themselves to tidy categories of problems.

The passage of time and accumulation of experience has broadened my perspective.  While I still enjoy finding an exact and correct answer when the opportunity for that luxury presents itself (balancing the checkbook, reviewing my kids’ homework, etc.), I have come to recognize that these situations are not the norm in the real world.  All of us, including, and perhaps especially, actuaries – highly trained professionals in the fields of mathematics and finance, engineers of the insurance industry, and Jedi knights of the risk management profession – are surrounded by intractable problems.  By intractable, I don’t mean that these problems cannot be solved, at least partially.  I mean that they are not amenable to an exact and correct solution that can be determined in advance.

All too often, when the mainstream media mentions the actuarial profession, a trite description like “the folks who set your insurance rates” or “the folks who predict your life expectancy” is often used.  The inference, often quite direct, is that actuaries are capable of predicting the future.  Actuaries naturally scoff at this characterization, as we know that it is absurd, but I think that a fair number of us secretly enjoy the mystical powers that are ascribed to us.  All of which contributes to a general notion that actuaries and other mathematical and financial wizzes are capable of predicting the future and eliminating risks.

The good news is that we cannot.  No one can.

Why is this good news?  It is good news because risk is the flip side of opportunity.  A business without risks is impossible, whether we care to admit it or not.  And even if it was possible, it would be a business without opportunity for gains.  The gains that businesses earn from opportunities are in compensation for the risk of losses.  Moreover, a business can be characterized as a decision, explicit or implicit, to participate in certain types of risks.

Which risks, and to what extent?  Those are the real questions.  Any entrepreneur or business leader understands this intuitively.  The actuary’s role is to plumb the depths of these questions, determine and implement answers that are appropriate for the business given its risk appetite, and review, learn, and modify over time.  Historically, much of the work of actuaries has centered around management of specific risks in the insurance industry, but there is no reason for this limitation prospectively.  Business risks are all around us – materials supply, delivery logistics, financial liquidity, competitive analysis, customer behavior, and the list goes on.  Actuaries can help evaluate and manage these risks, even if they can never be fully eliminated.  Actuaries can identify the cost-benefit trade-offs that are central to the risk management process for any business.  And perhaps most importantly, actuaries can help identify and manage the other risks – the ones that are very subtle, perhaps possibilities that we have never wanted to see or consider before.

The job of the actuary is to see the world as it is, and help manage business opportunities and risks realistically.  The job is not to do exhaustive calculations for their own sake, or impart a false sense of precision to complex financial projections, or just “run the model”.  The job is to think and do, sometimes with the aid of rigorous mathematical and financial techniques, but avoid being fooled about what is and what can never be.  Can your business use this?