Colin Wilson provides three key lessons for risk-management post-COVID-19
A decade ago I gave a series of talks on the related concepts of the price of risk, the cost of uncertainty and the value of flexibility. Recently these ideas seem to be gaining renewed currency – see John Kay and Mervyn King’s recent book Radical Uncertainty and the interview with King in the August edition of The Actuary. And, of course, the COVID-19 pandemic has caused people to reconsider some of the trade-offs we may have taken for granted. What relevant lessons can we learn from risk management concepts for the radically changed world in which we find ourselves?
Understanding risk management is key to taking successful action in the private and public sectors. Government guidance on the appraisal of policies, projects and programmes in the UK is contained in the Treasury’s Green Book. This is under review in the context of recent events and amid recognition of differences between the economics of marginal change and of transformational change – highlighted by challenges related to the climate.
Actuaries have always recognised the importance of mechanisms for handling the unexpected. We cannot just plan for ‘best estimate’ outcomes; we must also be prepared for things to turn out differently, even if such preparation increases short-term costs. Recognition of this fact has probably never been more widespread. The disruption caused by the pandemic has led many people to conclude that the UK has over-prioritised efficiency at the expense of resilience.
Price of risk
Where risks are well understood and can be easily quantified, markets are likely to develop for transferring risks between different parties. In such cases, the price of risk transfer will normally reflect the expected cost of the risk plus the cost of capital required to cover unexpected costs. If markets are efficient, it should theoretically be possible to deduce the actual degree of risk from observed market prices for risk transfer.
Cost of uncertainty
Uncertainty in a more fundamental sense arises when risk parameters cannot be quantified accurately. In such cases it may not be possible to transfer risk at a reasonable price. However, we must still recognise that things may not turn out as expected and take this into account when planning and decision-making. Theoretically, uncertainty is just as likely to lead to lower costs or greater profits as to higher costs or lower profits, but in reality there is almost always more downside risk than upside risk – perhaps due to a degree of ‘optimism bias’ in our best estimates. It is likely, then, that there will be a cost to any uncertainty, and this must be allowed for in any economic assessment.
Value of flexibility
In some cases, the degree of uncertainty is likely to be such that we can say little about the likelihood of different outcomes – what Kay and King call ‘radical uncertainty’. Here, the key is to recognise the value of keeping your options open until it is clearer what the best course of action is. This is the value of flexibility. So-called ‘real options’ theory can provide a way to quantify the value of such flexibility in simple cases where the risks are known, but in cases of radical uncertainty one may simply have to recognise that flexibility is valuable and can be worth investing in, even if the options never need to be used. Sometimes it may be worth incurring additional costs in order to obtain more data and thus reduce uncertainty. Sometimes the creation of cheap options for the future may be most cost-effective. The best choice is likely to depend on the consequences if things go wrong and we are not prepared.
Dealing with risk
Fundamentally, there are not that many different ways of dealing with risks:
- If you can isolate a risk (often called the ‘hazard’ in scientific circles), you may be able to affect who pays for incurring it, or for dealing with the consequences if it happens. For example, an insurer may accept liability for paying claims in exchange for charging an insurance premium. Alternatively, a government might pay for a disaster as ‘insurer of last resort’, perhaps charging a levy on those exposed to risk or meeting the cost through general tax revenues.
- If you understand the underlying causes of the risk, you may be able to decrease the probability of it happening (sometimes called the ‘vulnerability’). A simple example would be building flood defences to reduce the chances of a damaging flood occurring.
- If you understand the possible consequences, you may be able to reduce the impact if the risk does happen (sometimes called the ‘exposure’). This requires planning for different eventualities, with a cost-effective approach often involving contingency plans that can be scaled up according to need.
Note that the first of these actions doesn’t directly affect the overall financial impact of the risk, but rather where it falls. Nevertheless, clarity over how costs will be met, and the greater speed in making payments that normally results, can make a real difference to ultimate costs – a fact that is well known in the field of disaster risk financing.
Some or all of the approaches described above will be relevant for any risk, but the nature and magnitude of the risk will determine who is best placed to undertake the necessary actions. As the pandemic has highlighted, some risks are inherently international and call for an international response. The UN Sendai Framework for Disaster Risk Reduction calls for more countries to have strategies in place to plan for and respond to disasters, but also for increased international cooperation and more early warning mechanisms. A number of groups, such as the Centre for Disaster Protection, have started to call for an international risk watchdog.
Many risks, even individual catastrophe risks, can be managed successfully through corporations or financial institutions working separately or collaboratively. Systemic risks can be much more challenging, and only governments have the power to share risks across whole populations and potentially across time as well (ie between generations). International institutions, either governmental or corporate, are needed to share risks across different countries. Nevertheless, all stakeholders will be interested in quality research and data that helps them understand the risks and deal with them in the best way.
Whatever the magnitude and nature of the risks that need to be managed, there are three key lessons:
- Identify the price of risk. Be explicit wherever possible about who bears risks, sharing them as appropriate so that those best placed to bear the costs do so.
- Acknowledge the cost of uncertainty. Don’t just plan for the most likely outcome. The presence of risk and uncertainty may affect the best choice of action, and investing in risk reduction or impact mitigation may be beneficial.
- Exploit the value of flexibility. The fact that we don’t know what the future holds means that sometimes it will be most cost effective to invest in longer-term resilience, not just short-term cost minimisation. This may mean investing in the creation of future options, or keeping existing options open – even if they don’t end up being used.
Colin Wilson is the deputy government actuary at the Government Actuary’s Department and a former president of the IFoA