Enterprise Risk Management

The black swan

Dealing with the highly improbable is a key ERM strategy

By Michael J. Moody, MBA, ARM

Some readers may be tempted to believe that this article is going to be about an unlucky swan that happens to find itself somewhere along the Gulf Coast. A coast, as of this writing, that is being pelted with the remains of what some experts have estimated to be in the range of 30,000 barrels to 50,000 barrels of crude oil per day. The events that have led to this disastrous situation started on April 21 with the explosion and sinking of BP’s oil platform, Deepwater Horizon, as well as the deaths of 11 workers. In addition, the explosion set off a chain reaction to what is already being tagged as the “greatest ecological disaster of all time.”

As of this writing, some experts are suggesting that the oil flow will continue until sometime around Christmas 2010—six months from now. The effects on flora and fauna will be massive and will worsen day by the day. Just where it will spread is a topic of debate, since no one knows for sure. Without question this has been yet another major failure of risk management and begs the question, just how effective is risk management, when you have tangible evidence of failures such as this.

The black swan

Well, if that is what you were thinking this article was going to be about, you are incorrect (although the oil spill itself may be considered a type of black swan event). The black swan to be discussed here deals with the systemic risks that are typically associated with major disruptions within the financial industry. These risks are presented by organizations that are frequently called “too big to fail.” This is a concept that has recently been popularized in two books by Nassim Nicholas Taleb, a former securities trader. In the first book, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and the follow-up, The Black Swan: The Impact of the Highly Improbable, Taleb talks about the role of large, improbable losses on society.

The concept of the “Black Swan,” grew out of Taleb’s market observations and is a reference to a 17th century philosophical thought experiment. At that point in time, European people had seen only white swans. Thus, their assumption that “all swans were white” had become a touchstone and was long used as a standard example of a scientific truth. Most people gave little thought to the chance of finding a black swan. The odds, notes Taleb, were considered to be impossible to calculate. However, this “truth,” was quickly turned upside down when in 1697 some explorers found a black swan in Australia.

In his second book, Taleb states that in order for an event to be considered “highly improbable,” it must have three primary characteristics:

• It must be unpredictable.

• It must carry a massive impact.

• After the fact, observers will concoct an explanation that makes it appear less random and more predictable, than it was.

Taleb, who gave one of the keynote addresses at the recent Risk and Insurance Management Society (RIMS) convention in Boston, provided some additional insight into the black swan concept and its effect on society. But, he is far from the only expert providing com­ments about the “too big to fail” concept. In fact, since the financial meltdown, Tabel’s comments seem especially cogent, particularly this one—“after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was.” Recently this topic has been debated far and wide. There has been more time, money, energy, and “Monday morning” quarterbacking spent on this issue than on how Boston could have lost the NBA Championship.

More to the point

Many risk professionals believe that Taleb’s three characteristics are right on point. But what does this mean for ERM? First, let’s look at characteristic one: “It is unpredictable”; ergo, it is not possible to calculate and or properly model systemic risks given this definition. He believes that really big events are rare and thus unpre­dictable, and trying to predict them is for the most part counterproductive. He points out that, “History does not crawl, it jumps.” These types of events, Taleb notes, don’t fit our standard bell curve of predictability, but rather represent a “wilder,” more extremist view. For his part, Taleb’s views are much more tied to the randomness that these outlier events represent.

As any observer of actuarial science can attest, we use history to predict future events. However, many times, this approach has proven to be a poor predictor of systemic risks. That is not to say that we should not continue to emphasize state-of- the-art modeling techniques to assist in estimating the probability of loss. However, it does appear that we may be placing too much emphasis on certain aspects of the modeling, especially when consider­ing low-probability-of-loss events—the black swans.

The irony of the recent financial crisis is not so much that bankers, investors, and even regulators did not foresee that certain events in the financial markets would occur. But, rather, it was how the individual risk elements, when combined, would react. Some experts believe that this was the true tragedy of the financial meltdown. Individually, the events would not have been as damaging, but when combined, the results were catastrophic.

According to Tabel, when combined, it carried “a massive impact.” And as has been observed by many pundits, and just as Tabel states, we all should have seen this coming.

So what should be done?

Clearly, systemic risks or black swans do represent a situation that every organization must come to grips with. However, it is questionable just how helpful probability-type analysis can be in these situations, even with the most sophisticated modeling techniques. Given the chaos that these events can precipitate, it is all the more important to at least identify all risks that could wreak this kind of devastation on a single organization or society as a whole.

Once identified, the organizations involved should focus their risk management efforts on better manag­ing the consequences that one of these low-probability, high-impact events can cause. The effect of the Deepwater Horizon explosion is an excellent case in point. Had proper loss mitigation strategies been fully implemented, the effects of this event would have been bad, but nowhere close to what will become the “worst, man-made environmental event” to have occurred.

Risk managers are just beginning to learn about systemic risks. As of yet, these unique types of risk are not yet well understood, and this continues to create obvious difficulties in interpreting data and dealing with the associated risks. Tabel set out several key principles with regard to the black swans. Among the more important ones are:

• What is fragile should break early while it is still small.

• People who drive a school bus blindfolded should never be given a new bus.

• Don’t let someone making an “incentive” bonus manage a nuclear plant—or your financial risks.

• Only Ponzi schemes should depend on confidence.

Tabel has provided an excellent introduction to the concept of systemic risks or, as he calls them, “The Black Swans.” He has recently updated the original work with a book titled The Black Swan: Second Edition: The Impact of Highly Improbable. This generally updates the original concepts and includes a new section, “On Robustness and Fragility.” This is a book that should be read by any risk management professional, or anyone involved with the insurance industry. Tabel has a good writing style and knows how to drive his points home.

Conclusion

In conclusion, there appears to be little that can be done to accurately predict systemic risk events. However, this puts much more emphasis on a comprehensive risk identification and loss mitigation program. Providing much better early warning systems that signal potential problems is good; however, having taken proactive mitigation steps is great. The old adage that “an ounce of prevention is worth a pound of cure,” has never been more true. This is at the heart of how a successful enterprise risk management (ERM) strategy should perform.

The author
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF), an independent consulting firm with the primary goal of actively promoting the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.