A New Era of Risk Management?

The quality of risk management has mostly fallen for the past few decades. There are signs of change for the better.

Risk management is a broad field; many kinds of risk must be managed. Risk is usually defined in terms of probability and cost of a potential loss. Risk management, then, is the identification, assessment and prioritization of risks and the application of resources to reduce the probability and/or cost of the loss.

The earliest and most accessible example of risk management is insurance, first documented in about 1770 BC in the Code of Hammurabi (e.g., rules 23, 24, and 48). The Code addresses both risk mitigation, through threats and penalties, and minimizing loss to victims, through risk pooling and insurance payouts.

Golden Gate BridgeInsurance was the first example of risk management getting serious about risk assessment. Both the frequentist and quantified subjective risk measurement approaches (see recent posts on belief in probability) emerged from actuarial science developed by the insurance industry.

Risk assessment, through its close relatives, decision analysis and operations research, got another boost from World War II. Big names like Alan Turing, John Von Neumann, Ian Fleming (later James Bond author) and teams at MIT, Columbia University and Bletchley Park put quantitative risk analyses of several flavors on the map.

Today, “risk management” applies to security guard services, portfolio management, terrorism and more. Oddly, much of what is called risk management involves no risk assessment at all, and is therefore inconsistent with the above definition of risk management, paraphrased from Wikipedia.

Most risk assessment involves quantification of some sort. Actuarial science and the probabilistic risk analyses used in aircraft design are probably the “hardest” of the hard risk measurement approaches, Here, “hard” means the numbers used in the analyses come from measurements of real world values like auto accidents, lightning strikes, cancer rates, and the historical failure rates of computer chips, valves and motors. “Softer” analyses, still mathematically rigorous, involve quantified subjective judgments in tools like Monte Carlo analyses and Bayesian belief networks. As the code breakers and submarine hunters of WWII found, trained experts using calibrated expert opinions can surprise everyone, even themselves.

A much softer, yet still quantified (barely), approach to risk management using expert opinion is the risk matrix familiar to most people: on a scale of 1 to 4, rate the following risks…, etc. It’s been shown to be truly worse than useless in many cases, for a variety of reasons by many researchers. Yet it remains the core of risk analysis in many areas of business and government, across many types of risk (reputation, credit, project, financial and safety). Finally, some of what is called risk management involves no quantification, ordering, or classifying. Call it expert intuition or qualitative audit.

These soft categories of risk management most arouse the ire of independent and small-firm risk analysts. Common criticisms by these analysts include:

1. “Risk management” has become jargonized and often involves no real risk analysis.
2. Quantification of risk in some spheres is plagued by garbage-in-garbage-out. Frequency-based models are taken as gospel, and believed merely because they look scientific (e.g., Fukushima).
3. Quantified/frequentist risk analyses are not used in cases where historical data and a sound basis for them actually exists (e.g., pharmaceutical manufacture).
4. Big consultancies used their existing relationships to sell unsound (fluff) risk methods, squeezing out analysts with sound methods (accused of Arthur Anderson, McKinsey, Bain, KPMG).
5. Quantitative risk analyses of subjective type commonly don’t involve training or calibration of those giving expert opinions, thereby resulting in incoherent (in the Bayesian sense) belief systems.
6. Groupthink and bad management override rational input into risk assessment (subprime mortgage, space shuttle Challenger).
7. Risk management is equated with regulatory compliance (banking operations, hospital medicine, pharmaceuticals, side-effect of Sarbanes-Oxley).
8. Some professionals refuse to accept any formal approach to risk management (medical practitioners and hospitals).

While these criticisms may involve some degree of sour grapes, they have considerable merit in my view, and partially explain the decline in quality of risk management. I’ve worked in risk analysis involving uranium processing, nuclear weapons handling, commercial and military aviation, pharmaceutical manufacture, closed-circuit scuba design, and mountaineering. If the above complaints are valid in these circles – and they are –  it’s easy to believe they plague areas where softer risk methods reign.

Several books and scores of papers specifically address the problems of simple risk-score matrices, often dressed up in fancy clothes to look rigorous. The approach has been shown to have dangerous flaws by many analysts and scholars, e.g., Tony Cox, Sam SavageDouglas Hubbard, and Laura-Diana Radu. Cox shows examples where risk matrices assign higher qualitative ratings to quantitatively smaller risks. He shows that risks with negatively correlated frequencies and severities can result in risk-matrix decisions that are worse than random decisions. Also, such methods are obviously very prone to range compression errors. Most interestingly, in my experience, the stratification (highly likely, somewhat likely, moderately likely, etc.) inherent in risk matrices assume common interpretation of terms across a group. Many tests (e.g., Kahneman & Tversky and Budescu, Broomell, Por) show that large differences in the way people understand such phrases dramatically affect their judgments of risk. Thus risk matrices create the illusion of communication and agreement where neither are present.

Nevertheless, the risk matrix has been institutionalized. It is embraced by government (MIL-STD-882), standards bodies (ISO 31000), and professional societies (Project Management Institute (PMI), ISACA/COBIT). Hubbard’s opponents argue that if risk matrices are so bad, why do so many people use them – an odd argument, to say the least. ISO 31000, in my view, isn’t a complete write-off. In places, it rationally addresses risk as something that can be managed through reduction of likelihood, reduction of consequences, risk sharing, and risk transfer. But elsewhere it redefines risk as mere uncertainty, thereby reintroducing the positive/negative risk mess created by economist Frank Knight a century ago. Worse, from my perspective, like the guidelines of PMI and ISACA, it gives credence to structure in the guise of knowledge and to process posing as strategy. In short, it sets up a lot of wickets which, once navigated, give a sense that risk has been managed when in fact it may have been merely discussed.

A small benefit of the subprime mortgage meltdown of 2008 was that it became obvious that the financial risk management revolution of the 1990s was a farce, exposing a need for deep structural changes. I don’t follow financial risk analysis closely enough to know whether that’s happened. But the negative example made public by the housing collapse has created enough anxiety in other disciplines to cause some welcome reappraisals.

There is surprising and welcome activity in nuclear energy. Several organizations involved in nuclear power generation have acknowledged that we’ve lost competency in this area, and have recently identified paths to address the challenges. The Nuclear Energy Institute recently noted that while Fukushima is seen as evidence that probabilistic risk analysis (PRA) doesn’t work, if Japan had actually embraced PRA, the high risk of tsunami-induced disaster would have been immediately apparent. Late last year the Nuclear Energy Institute submitted two drafts to the U.S. Nuclear Regulatory Commission addressing lost ground in PRA and identifying a substantive path forward: Reclaiming the Promise of Risk-Informed Decision-Making and Restoring Risk-Informed Regulation. These documents acknowledge that the promise of PRA has been stunted by distrust of the method, focus on compliance instead of science, external audits by unqualified teams, and the above-mentioned Fukushima fallacy.

Likewise, the FDA, often criticized for over-regulating and over-reach – confusing efficacy with safety – has shown improvement in recent years. It has revised its decades-old process validation guidance to focus more on verification, scientific evidence and risk analysis tools rather than validation and documentation. The FDA’s ICH Q9 (Quality Risk Management) guidelines discuss risk, risk analysis and risk management in terms familiar to practitioners of “hard” risk analysis, even covering fault tree analysis (the “hardest” form of PRA) in some detail. The ASTM E2500 standard moves these concepts further forward. Similarly, the FDA’s recent guidelines on mobile health devices seem to accept that the FDA’s reach should not exceed its grasp in the domain of smart phones loaded with health apps. Reading between the lines, I take it that after years of fostering the notion that risk management equals regulatory compliance, the FDA realized that it must push drug safety far down into the ranks of the drug makers in the same way the FAA did with aircraft makers (with obvious success) in the late 1960s. Fostering a culture of safety rather than one of compliance distributes the work of providing safety and reduces the need for regulators to anticipate every possible failure of every step of every process in every drug firm.

This is real progress. There may yet be hope for financial risk management.

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  1. #1 by pkostek on February 14, 2014 - 11:52 am

    Reblogged this on Pkostek’s Blog.

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