Risk Management Reports

June 2001
Volume 28, Number 6
 

Parable of the River

Last month three students of risk management traded emails on the critical starting point of this discipline: how we define our terms. Margaret Davis, of Scotland's Glasgow Caledonian University took issue with two retired codgers, Shaun Wilkinson, the former risk manager of New Zealand's Fletcher Challenge Ltd., and me. With academic care and patience Margaret tried to convince Shaun and me that the meaning of risk is confined to the possible downside of events. We applied our years of experience to argue that it must necessarily involve the potential for both gain and harm. Neither side budged even though we find agree than we disagree. I thought about her challenge and developed a parable that illustrates the Wilkinson-Kloman point more clearly.

Once upon a time, a man came to a river. It was a quarter mile wide, with a fast-moving current in its center, tumbling into dangerous rapids about a mile downstream. His guidebook warned of piranha both upstream and downstream but not at his location. He could cross the river easily by walking ten miles downstream to a bridge. Should he swim across or take the bridge?

Here is a classic case of decision-making under uncertainty. The man must weigh his potential rewards with his potential penalties. Yet both rewards and penalties are contingent on his circumstances at a particular time. Consider three scenarios. One: he is on a leisurely vacation, with more than two weeks left. Two: He's at the end of his vacation, with two hours to catch a home-bound plane at the airport just over the river. The next flight is three days later. His boss will certainly dock his pay if he returns to work late and may even dismiss him! Three: he's just escaped from a local jail, where he was tortured and condemned to life imprisonment. He can hear the pursuing hounds baying in the distance. Across the river is another country, no extradition treaty, and freedom. If he takes the bridge he will almost certainly be caught.

His risk decision must be based on his balance of both reward and harm related to the particular time and circumstances. In the first scenario, he'll detour to the bridge. In the second, the bridge is a probable choice. In the third, there is no question that he must swim.

What is this man had a corporate staff to advise him? Legal counsel notes that crossing to the other country other than by the bridge will constitute illegal entry. Arrest is certain if he swims. Internal Audit argues that he should wait two days until proper controls can be constructed. Human Resources is concerned about the potential loss of a key man. Safety panics: an injury, or worse yet death, would ruin the safety lost-time record and bring in safety and health inspectors and regulators. The Insurance Manager reports good and bad news. The good news is that he's covered by Workers' Compensation and Group Life Insurance. The bad news is that any injury or death would damage the loss-premium ratio, bringing higher premiums next year. He too advises against swimming.

 

By focusing only on the downside none of these "risk managers" clearly appreciates the whole picture!

Extend this parable to a corporate example. A company can invest in a new technology in a new country, guaranteeing a return on equity exceeding 100% for at least the next four years. But the new country (entirely hypothetical!) is prone to earthquakes where the plant must be built. Power outages are common every afternoon. And extremists oppose both the siting of the plant and its potential product. The country is highly litigious. Class action lawsuits are certain at the first sign of any product fault. A decision must be made immediately as competitors will establish themselves in less than a year if the company fails to act.

Again the circumstances affect the decision. Scenario One: the company has reported a comfortable ROE of 12% for the past three years, its stock is steady, and strategists and external analysts consider its prospects good to excellent. Scenario Two: the company's ROE is poor (less than 5% for the past three years), the shareholders and stock analysts are concerned, and some key people are leaving. Scenario Three: the company has reported losses the past three years, cash will run out in less than two years, and it needs a quick and public turn-around to save itself and its jobs.

In the first case, the company weighs the pros and cons and considers the new investment as a joint-venture with another organization. In the second it might seek a merger with a larger company with more cash and a stronger bottom line. In the third, it will probably raise as much cash as it can and go for the risky investment. After all it's somebody else's money!

The moral to these two parables is that any decision made under uncertainty and risk must include the likelihood of both rewards and penalties, plus the timing and circumstances. Any risk decision that considers only one side of the equation, be it upside or downside, is incomplete and potentially damaging. To separate the positive rewards, tangible and intangible, from the potential penalties is not risk management.

Yes, Margaret, there is a Santa Claus in risk. Perhaps, in this never-ending discussion of the meaning of risk, we should acknowledge what Les Davidow, Susan Carr and David Wield wrote last summer, ". . .risk debates express contending visions of how society should be organized." A view of risk as a negative corresponds to the pessimistic view of Man as a flawed creature requiring extensive religious or governmental regulation and a continual skeptical view of his actions. I subscribe to the more optimistic view. Man is a creature capable of great good so long as he has freedom of action. For thousands of years we have endured these antiphonal views of Man so why should we complain if we have two similar views of risk?

The dream is to find the open channel. What, then, is the meaning of it all? . . . . I think we must frankly admit that we do not know.

Richard P. Feynman, The Meaning of It All, Helix Books, Reading, MA 1998

Copyright H. Felix Kloman and Seawrack Press, Inc.

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