Challenges of Applied Risk Management

by

Ralph L. Keeney Fuqua School of Business

Duke University

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What is Applied Risk Management

Applied Risk Management is making decisions about risks. It involves

• Identifying and analyzing risks• Identifying and evaluating alternatives to deal with these risks

• Choosing alternatives to manage risks

• Communicating about the decision.ARM uses models and analyses

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Objectives of the Presentation

• Raise a few general issues about analysis

• Outline applied risk management• Suggest important aspects of the art of applying risk management

• Stimulate some thought (hopefully)

• Have some fun!

Why Bother to Make Decisions?

•Your decisions are the only way that you can purposefully influence anything.

•Anything includes the quality of your life, your family, your organization, your country, or your world is through the decisions you make. •Everything else just happens.

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True or False

It is reasonably likely that a moderate to large hurricane will cause significant damage to the Mid-Atlantic region sometime in the foreseeable future.

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Please Define the Following

• reasonably likely• moderate to large hurricane

• significant damage • the Mid-Atlantic region • the foreseeable future.

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True or False

•It is reasonably likely that there will be a moderate to large earthquake in the San Francisco Bay Area in the near future.

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Please Define the Following

• Reasonably likely

• Moderate to large earthquake

• San Francisco Bay Area

• Near future

Why Build a Model and Do Analysis?

•The real problem is too complex to understand all of its parts and their relationships. •A model is a simplification of the problem.•The model must address the complexities of the problem in order to provide insights about them.•You can analyze the model to produce insights relevant to the real problem.

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Complexities of Risk Decisions

• Multitude of impacts (multiple objectives)– Some intangible impacts (hard to measure) – Requires multiple disciplines– Long-term impacts

• Uncertainties about impacts – These are ‘factual’ uncertainties – Professional judgments required

• Several Stakeholders• Values are crucial

– Aggregation of impacts is necessary – Policy (value) judgments required – Some vexing value tradeoffs

• Unclear decision process and decision-makers

• Need to justify decisions

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Decision Analysis Addresses the

Complexities Inherent in ARM

• A formalization of common sense applied to decision problems.

• A philosophy, articulated by logical axioms, and the techniques and procedures, based upon those axioms, for analyzing complexities inherent in decision problems.

• Decision analysis is prescriptive vs. descriptive.

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Keys to Effective Decision Making

• Work on the right decision problem

• Specify your objectives• Create imaginative alternatives• Understand the consequences• Grapple with your tradeoffs• Clarify your uncertainties• Account for your risk tolerance• Consider linked decisions

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Elements of Decisions• Problem• Objectives• Alternatives• Consequences• Tradeoffs

• Uncertainty• Risk Tolerance• Linked Decisions

Iteration among the elements is crucial in analysis

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Problem

• Given a decision problem … then …• Initial problem statement (frame)• Reframed with objectives and alternatives

• What is the “risk”• Who is/are the decision-maker(s)• Who are the stakeholders

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Problem Examples

• Nuclear Repository: best site or portfolio of three

• New Orleans Levees: build a new levee, how high to build, how strong to build

• How to effectively communicate about a hurricane approaching Florida

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Objectives

• Objectives state what you want to achieve by making a decision

• Define objectives using a verb and an object– Minimize environmental degradation– Limit loss of life– Minimize property damage

• Objectives are elicited from individuals

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Ex: Choosing a Dissertation Topic

1. ________________________________________________________2. ________________________________________________________3. ________________________________________________________4. ________________________________________________________5. ________________________________________________________6. ________________________________________________________7. ________________________________________________________8. ________________________________________________________9. ________________________________________________________10. ________________________________________________________11. ________________________________________________________12. ________________________________________________________13. ________________________________________________________14. ________________________________________________________15. ________________________________________________________16. ________________________________________________________

Suppose you have identified ten potential dissertation topics and now have to pick one. Write down all the objectives that matter to you in selecting a dissertation topic.

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Categories to Stimulate Dissertation Objectives

Academic Objectives While A StudentA. ____________________________B. ____________________________C. ____________________________D. ____________________________E. ____________________________F. ____________________________

Academic Objectives After GraduatingA. ____________________________B. ____________________________C. ____________________________D. ____________________________E. ____________________________F. ____________________________

We would like you to think a bit harder about the objectives that matter when selecting a dissertation topic. Below you will find four categories of objectives. Many dissertation objectives will fall into one of these four categories. Consider each category and list any additional objectives that matter to you that you did not list previously.

Personal Objectives While A StudentA. ____________________________B. ____________________________C. ____________________________D. ____________________________E. ____________________________F. ____________________________

Personal Objectives After GraduatingA. ____________________________B. ____________________________C. ____________________________D. ____________________________E. ____________________________F. ____________________________

AA. ____________________________AB. ____________________________AC. ____________________________

AD. ____________________________AE. ____________________________AF. ____________________________

OTHER (any other overlooked criteria that are relevant to deciding on dissertation topic)

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Dissertation Study

Is a topic acceptable to faculty for my doctorate

Is of interest to a faculty member that I want to serve as my advisor

Leads to multiple publishable papers Is of interest to me/maintains my

interest Can be scoped/is tractable Uses methods generalizable to other

domains Is interdisciplinary in

nature/combines different areas Utilizes my academic strengths Does not require lots of data

gathering Does not require a lot of data

analysis Provides opportunity to improve my

writing skills Addresses issues involving

collaboration between public and private sectors

Provides opportunity for sufficient quantitative analysis

Allows for personal time during ‘dissertation years’

Is of interest to the research/academic community

Is enjoyable to do Helps me develop myself academically

Helps me build a coherent future research program

Helps me balance my career and personal life

Causes me to learn skills that will be applicable to future research

Prepares me as an independent researcher Improves ability to write research

proposals for funding Puts me in control of the dissertation

process (e.g., content, timing) Is innovative/pursues a new idea/novel Is insightful/has results that weren’t

obvious prior to my work Is relevant to real-world applications/is

implementable Will help people/organizations make better

decisions Addresses problems that are important Influences the work of others Stimulates discussion with colleagues Leads to potentially fundable future

research Provides basis for further research Opens new areas of research after the

dissertation Results in an interesting job talk paper Provides opportunities to work with top

scholars

Check all objectives that are important to your choice of a dissertation topic.

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Dissertation Study Results

self-generated objectives:

7.1 average unaided, 4.5 additional with categories

relevant objectives: 21.3 average

recognized objectives:

9.3 average

importance: self-generated average 7.7

recognized objectives average 7.2

bogus objective average 2.1

baseline objective average 4.2

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Identifying Objectives

• From decision makers and stakeholders

• Get a complete set of objectives

• Distinguish between fundamental objectives and means objectives (max wind speed over land vs. fatalities)

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Identifying Objectives Requires Work

• Individuals miss many objectives– Experimental results– Real-world decisions

• Devices to stimulate thinking– Wish list– Generic (health and safety, environmental, social, economic)

– Use alternatives– Ask why?

• Involve multiple individuals

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Alternatives

• Need to create alternatives• Creative alternatives are needed• Use objectives to stimulate thinking about alternatives (NYFD study)

• Iterate through decision analysis steps– Delete poorer alternatives– Embellish/change others

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Exercise

•What are the objectives?•What are some alternatives?

Problem: Effective Communication about an Approaching Hurricane

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Consequences

• Need to measure objectives– Natural scales– Constructed scales– Proxy measures

• Use models, data, and information to describe consequences

• Most time, effort, and cost of analysis involves building the model and collecting the data

• Consequences are uncertain

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Ghost Dance Fault

• What is the probability that the Ghost Dance fault is active?

• What is the definition of active?

• What is the Ghost Dance Fault?

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Implications for Applications

• Unambiguously clarify terms• Quantify uncertainties• Quantify consequences (or fully and completely describe them)

• Develop clearly defined measurement scales

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“Get the Data First”

• Usually a bad idea• The objectives, alternatives, and tradeoffs indicate what data and information is desired

• Much of the ‘data’ collected first may turn out to be irrelevant

• Ex: Auburn Dam Reservoir Induced Seismicity

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Tradeoffs

• Minimizing the risk is not the objective

• Construct an objective function• There are multiple objectives and these must be ‘balanced’ using value tradeoffs (i.e. even swaps)

• Risk tolerance is also relevant• Value judgments are required to do this

Tradeoffs - What is More Important

In cleaning up hazardous waste sites, rank the following in order of importance (1 is most important):

___ Economic costs of the clean-up

___ Human illness caused by the hazard

___ Damage caused to the natural environment (i.e. flora and fauna)

Decisions Based on Values

Most common error: which objective is most important

In cleaning up hazardous waste sites, check the alternative that you prefer:

___ Alternative A which costs $1 billion and 20 people nationwide subsequently get very ill for 1 week each.

___ Alternative B which costs $2 billion and 10 people nationwide subsequently get very ill for 1 week each.

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Uncertainty

• Uncertainty is the lack of complete knowledge of what is or what might occur

• Probability quantifies uncertainty (coin flip)

• Because of uncertainty, you won’t know what consequences you will get until after deciding

• What are some decisions without uncertainties?

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Risk Profile: Introduction

• What are the key uncertainties?• What are the possible outcomes of these uncertainties?

• What are the probabilities of occurrence of each possible outcome?

• What are the consequences of each outcome?

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A Perspective on Analysis

• People make decisions• The model is not the real world, so answers for the model are not answers to the problem

• No analysis ever makes a decision• Analysis, done well, can provide insight to make good (or better) decisions

• Good analysis includes sensitivity analyses

• Analysis and insights provide a basis for communicating

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On Objective Analysis• There is no objective analysis• The foundation of any analysis

is based on subjective judgments– Problem– Objectives– Alternatives– Data and Information Sources

• Foundation is common sense• Analysis can be systematic,

honest, justifiable, consistent, understandable

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Summary Points

• The problem drives the analysis• The objectives and alternatives define the analysis

• Include all that is important to the problem

• The standard for what you should do and how you should do it is common sense