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The Actuary The magazine of the Institute & Faculty of Actuaries


Strategic risks can affect an organisation’s achievement of its main objectives, or even its survival. The word ‘risk’ is used here not only in the negative sense of a threat, but also in the positive sense of an opportunity. For the past two years I have belonged to the steering group for STRATrisk, a project that aims to help company boards and similar bodies in the public sector to better manage their strategic risks. STRATrisk, which is sponsored by the actuarial and civil engineering professions, has a research grant from the Department of Trade and Industry and receives input from Bath and Bristol universities. Its findings will appear later this year, but some interesting conclusions are emerging already.
While some strategic risks can be foreseen and mitigated, many are clouded in uncertainty. To manage its strategic risks, an organisation needs:
– a good understanding by the board of the nature of risk and uncertainty;
– a diversity of experience on the board;
– the board itself devoting the necessary time to strategic risk, despite other commitments;
– identification by the board of the organisation’s principal objectives a list of up to, say, ten ‘key strategic risks’ which the board will manage itself;
– establishment of a comprehensive and properly resourced risk-management system throughout the organisation, to cover all risks (strategic, project, and operational);
– a programme to address any cultural or communication issues necessary to get full participation and involvement by all the organisation’s staff; and
– the introduction of appropriate risk-management tools, including horizon scanning, concept mapping, and pattern recognition in the case of strategic risks, and risk analysis and management for projects (RAMP) in the case of project risks.
Risk management does not mean, of course, that all risks should be eliminated. On the contrary, most organisations need to take risks in order to achieve their objectives. These risks should be identified as far as possible and appropriate actions taken, where it is financially sensible to do so, to minimise threats and maximise opportunities.

Project risk
Unfortunately many organisations embark on projects without thinking them through properly. RAMP has a vital role to play in this area, and the British government recommends it for use in appraising its own projects.
Although RAMP was first published as long ago as 1998, and in essence has remained unchanged since then, the RAMP handbook has been updated to include a significant amount of new background material. The RAMP Working Party is the main vehicle for the collaborative effort between the actuarial and civil engineering professions and I have been privileged to lead it from the outset. Set out below is a brief reminder of the purpose of RAMP, followed by an update on the latest edition of the RAMP handbook, which is due to be published in September 2005.

The purpose of RAMP
RAMP is a simple logical framework, which ensures that the complexities of managing project risks and assessing the financial implications of risk are carried out in the right order, without forgetting important steps. The methodology can be used not only for projects which involve the construction and operation of a physical asset, but also for projects such as launching a new product line, acquiring a business, or introducing a new computer system. RAMP links in with suitable investment models to provide a method for valuing risk, usually on a ‘net present value’ basis, and helps to ensure good decision-making. When the project commences, the plans for responding to the various risks are taken fully into account in the project control process.

Certainty and uncertainty
The new edition of the RAMP handbook will incorporate some significant changes, with more attention being devoted to general uncertainty, upside risks (or ‘opportunities’), risk efficiency, and decision criteria.
Uncertainty is defined in the new handbook as ‘incomplete knowledge of the future’. All uncertainty has to be judged subjectively, in the light of one’s own prior knowledge and experience, and different people may perceive different degrees of uncertainty about a given project, even if they have the same information about it. There are three main levels of certainty:
– ‘certain’ those things we think we know for certain, for example, that our project has planning permission. But even this ‘certain’ knowledge may be wrong a hidden procedural defect might invalidate our planning permission;
– ‘partially known’, either ‘variable’ or ‘fuzzy’ variable uncertainty is expected to follow a definable probability distribution, so it is possible to predict the likelihood of a specified range of outcomes, whereas fuzziness indicates a lack of precision, though the approximate knowledge we have may suffice for managing the risks involved;
– ‘unknown’ where there is no knowledge.
These distinctions may sound academic but they are of crucial importance when allowing for uncertainty in the project appraisal.
Can uncertainty be managed effectively? The handbook suggests that it can and proposes steps to mitigate its worst effects. This will overcome the tendency for project appraisals to restrict themselves to variable or fuzzy risks, just because these can be treated mathematically, while ignoring the big but unquantifiable risks associated with greater levels of uncertainty.

Risk efficiency
Risk efficiency is newly defined in the handbook. It is an important objective for any risk management process and is achieved when we reach the point, in devising responses to both downside risks and opportunities, beyond which we believe that the marginal cost of introducing an additional response would exceed the utility to the sponsor of the resulting risk reduction or opportunity increase. The process will usually involve trial and error to find the right set of risk responses.

It may seem obvious, but a biased project appraisal is worthless. Unfortunately, the evidence suggests that many past appraisals in the public sector have been biased, either by accident or design. For example, insufficient care may have been devoted to the identification or analysis of risks, or worse key risks may have been accidentally or deliberately omitted. Incorrect assumptions that certain risks were independent of each other may have concealed the true likelihood of ‘chain reactions’ of adverse events. The likelihood of disasters occurring may have been underestimated because of inadequate past experience. Cashflows may have been biased towards optimism. To eliminate such bias the handbook proposes some very useful steps that can be taken in practice.
One way of dealing with expected bias is to allow for it specifically in the project appraisal. The Treasury recommends in its Green Book that, instead of a proper risk-analysis process, expected bias can be managed by making an adjustment, known as ‘optimism bias’, which increases the estimated ‘likely’ capital cost of a project by a percentage designed to reflect the degree of bias that has been observed in similar public sector projects in the past. This procedure has several serious disadvantages and hopefully, as RAMP becomes more generally applied in the public sector, staff become more experienced in its use, and independent checks of project appraisals are routinely made, the need to apply optimism bias adjustments will gradually disappear.

Major infrastructure projects
The handbook now summarises an impressive body of evidence, which strongly suggests that there have been significant errors in estimating and managing the risks involved in major infrastructure projects. Too much attention has been paid to the asset-creation phase of the project and not enough to the crucial need to create a viable ongoing business. The handbook suggests that, for transport infrastructure projects, there should be a radical change of approach, including adaptation of the project development process to serve the commercial needs of the project, its sponsors, and its investors. There needs to be a ‘reality check’ on the traffic forecasts produced by sophisticated models, by analysing the actual experience of comparable projects and introducing independent checking of the parameters used in the appraisal. Flexibility should be built into the asset design and the project as a whole, even at extra cost, so that the project can respond effectively to changing circumstances for many years.
If, as is likely, a considerable amount of infrastructure will be constructed in the world over the next 20 years, it is of vital importance to banks and investors that the serious problems experienced in the past do not recur. We hope that the new edition of the handbook, even more than its predecessors, will help readers to make correct allowances for risk and uncertainty, and to find the right package of risk responses.

A role for actuaries
Actuaries can help an organisation to develop a clear focus on its strategic risks. They can also assist with the practical implementation of RAMP, by helping to develop suitable procedures and methods, or by independently checking the appraisals of individual projects.

Further information
The Institute will hold a relevant half-day seminar on the morning of Wednesday 23 November. It should be of interest to many actuaries, as it will demonstrate significant new business opportunities for members of the profession.