Elicitation & Elucidation of Risk
Preferences Working Party
2005 CAS Annual Meeting
Session C 21
Parr Schoolman / David Ruhm
Elicitation & Elucidation of Risk Preferences:
AUDIENCE QUESTIONS
•
Without looking up any information, estimate Wal-Mart’s 1999
revenue:
•
Put an upper and lower bound around your estimate, so that you
are 95% confident that your range surrounds the actual quantity:
Lower Bound________ Upper bound________
Elicitation & Elucidation of Risk Preferences:
AUDIENCE QUESTIONS
•
Linda is 31 years old, single, outspoken and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of
discrimination and social justice and she participated in antinuclear
demonstrations.
• Rank order the following 8 descriptions in terms of the probability
(likelihood) that they describe Linda:
•
•
•
•
•
•
•
•
a. Linda is a teacher in an elementary school.
b. Linda works in a bookstore and takes yoga classes.
c. Linda is active in the feminist movement.
d. Linda is a psychiatric social worker.
e. Linda is a member of the League of Women Voters.
f. Linda is a bank teller.
g. Linda is an insurance salesperson.
h. Linda is a bank teller who is active in the feminist movement.
Elicitation & Elucidation of Risk Preferences:
AUDIENCE QUESTIONS
•
You are out of town at a business meeting that runs late. As soon as you
can break away, you head to the airport to catch the last flight home. If you
miss the flight, which is scheduled to leave at 8:30 PM, you will have to stay
overnight and miss an important meeting the next day. You run into traffic
and do not get to the airport until 8:52 PM. You run to the gate, arriving
there at 8:57 PM. When you arrive, either:
(A)
(B)
You find out that the plane left on schedule at 8:30 PM, or
You see the plane depart, having left the gate at 8:55 PM.
Which is more upsetting (circle one)? A
B
Neither
Elicitation & Elucidation of Risk Preferences:
INTRODUCTION
•
Risk Management & Risk Measurement requirements
are increasing:
•
•
•
•
Sarbanes-Oxley
Rating Agency pressures
CEO Attestations of Financial Statements
Result:
•
Companies are being required to have documented Risk
Management Policies and Procedures
Elicitation & Elucidation of Risk Preferences:
PURPOSE

These requirements provide an opportunity for
management to institute a consistent viewpoint
regarding risk:


Some tradeoffs are acceptable, some are not
Some tradeoffs are preferable to others
Without a consistent policy on decisions:
 Senior management input on tradeoffs is confined to
highest level of decisions
 Unconnected, ad hoc business unit decisions
Elicitation & Elucidation of Risk Preferences:
PURPOSE
Objective
 Rational framework for making decisions
Explicit evaluations of risk vs. return
 Management risk preferences codified
 Decision consistency
 Enterprise implementation

Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Key Steps for determining a Firm’s “Risk
Policy”:
•
•
•
•
Define Risk Unambiguously
Assess Context
Determine Risk Measures
Ascertain Risk Preferences (i.e., find consensus)
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Define Risk Unambiguously
•
What do you mean by “Risk”?
•
•
•
Risk of losing money or of “missing plan”?
Reduction in accounting book value (or
income) or lost market capitalization?
Ultimate value or mark to market shortfall?
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Define Risk Unambiguously (continued)
•
What are the firms’ key risks?
•
•
•
•
•
Financial
Operational
Competitive
Strategic
For what time horizon?
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Define Risk Unambiguously (continued)

A useful risk definition is:
Specific, rather than ambiguous
 Accepted by involved parties
 As comprehensive as needed

Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Examples of heuristics that could be given
specific operating definitions:






Build in enough profit margin to insulate capital against
unexpected events and unknowable factors. (profit measure)
Don’t over-concentrate the underwritten risks. (percentile)
Do business in markets where the company has an
identifiable, durable operating advantage. (margin)
Don’t write what you don’t know. (parameter variability)
Don’t deal with untrustworthy parties. (historical data)
Avoid mass tort exposure. (exposure type’s aggregate loss)
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Risk Definition Examples:

Accident Year Total Return shortfall relative to cost of
capital
Rolling 4-quarter income shortfall relative to cost of
capital
Statutory Surplus decline over the next year
Ratings downgrade probability over the next 5 years



Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Context
•
•
•
Corporate Culture
Financial Characteristics
Perspectives of Key Decision Makers
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Context - Corporate Culture
•
•
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Age of Organization
Tenure of Current Management
Company History
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Context - Financial Characteristics
•
•
•
Financial Strength
Size of Firm
Ownership Structure
•
•
Stock vs. Mutual
Privately held vs. Public
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Context - Key Decision Makers
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Sales background vs. financial background
•
•
•
Perceived relative importance of top line
Time in career could influence risk appetite
Life vs. P&C
•
•
Life: Cognizant of persistency, investment risks
P&C: Cognizant of catastrophe, reserve risks
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Risk Measures
•
•
•
Objective
Transparent
Appropriate
•
•
•
Timeliness vs. Accuracy Trade-off
IT and Budget resource constraints
Understandable
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Risk Measures - Objectivity
•
Objective: Probability of 2005 reported net
income being negative.
•
Not too objective: Probability of very high
net losses for accident year 2005.
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Risk Measures - Transparency
•
Transparent: Probability of a net loss for the
line or segment.
•
Not so transparent: The beta of the line or
segment’s net income distribution.
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Risk Measures – Appropriateness
•
Appropriate: Short-term net income
distribution for property catastrophe lines.
•
Not that appropriate: Short-term net income
distribution for long-tail lines and lines whose
principal risk is surplus drain.
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Ascertaining Risk Preferences
•
Survey methods have been developed
for marketing
•
•
•
•
Conjoint Analysis
Quality Functional Deployment (QFD)
Multi-Attribute Utility Theory (MAUT)
Many others as noted in paper
Elicitation & Elucidation of Risk Preferences:
KEY STEPS
•
Ascertaining Risk Preferences (continued)
•
Survey methods from marketing:
•
Example: used to find out car buyers’ preferences
•
•
•
•
Younger buyers: styling, performance more important
Family buyers: space, seating, mileage more important
These are tradeoffs of desirable features
Could be used for management risk preferences
•
•
Determine acceptable tradeoffs
Isolate those risks that management considers more
important / quantify relative importance
Elicitation & Elucidation of Risk Preferences:
BIASES
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Key Biases
•
Framing – Loss (Risk Seeking) vs. Gain (Risk Averse)
•
•
•
•
Overconfidence in accuracy of estimates
More easily remembered  seems more probable
•
•
•
•
•
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An uncertain loss is preferred to a sure loss
A sure gain is preferred to an uncertain gain
Catastrophe Risk
Terrorism Risk
Asbestos
Anchoring & Adjustments
Representativeness
Regret Avoidance
Elicitation & Elucidation of Risk Preferences:
BIASES - FRAMING
Question 1:
In addition to your initial wealth,
you are given $1,000 and then have
to choose from among the
following choices:
Question 2:
In addition to your initial wealth,
you are given $2,000 and then have
to choose from among the
following choices:
A) Receive $1,000 with prob. p=.5 or
receive $0 with prob. 1-p=.5.
B) Receive $500 with probability p=1.
A) Lose $1,000 with prob. p=.5 or
lose $0 with prob. 1-p=.5.
B) Lose $500 with probability p=1.
Results:
A: 25
B: 72
Results:
A: 60
B: 35
Elicitation & Elucidation of Risk Preferences:
BIASES - FRAMING
Question 1:
You have just learned that the sole supplier of a
crucial component is going to raise prices.
Two alternative plans have been formulated
to counter the effect of the price increase.
The expected Impact is:
Plan A)If this plan is adopted, the company’s
costs will increase by $4,000,000.
Plan B) If this plan is adopted, there is a 1/3
probability that there will be no cost
increases, and a 2/3 probability that the
company’s costs will increase by $6,000,000.
Which do you prefer?
Results:
A: 36
B: 61
Question 2:
You have just learned that the sole supplier of a
crucial component is going to raise prices.
The price increase will cost the company an
additional $6,000,000 in supply costs. Two
alternative plans have been formulated to
counter the effect of the price increase with
savings in other parts of the company. The
anticipated consequences of these two plans
are:
Plan A) If this plan is adopted, the company will
save $2,000,000 in operating expenses.
Plan B) If this plan is adopted, there is a 1/3
probability that the company will save
$6,000,000 in operating expenses, and a 2/3
probability that no savings will be achieved.
Which do you prefer?
Results:
A: 84
B: 12
Elicitation & Elucidation of Risk Preferences:
BIASES - OVERCONFIDENCE
•
Without looking up any information, estimate Wal-Mart’s 1999
revenue:
•
Put an upper and lower bound around your estimate, so that you
are 95% confident that your range surrounds the actual quantity:
Lower Bound________ Upper bound________
•
23 out of 80 actuarial students’ intervals contained the actual
figure ($166.8 billion).
The actual probability that a randomly selected student’s range
contained the actual figure was 29%, far less than 95%.
•
Elicitation & Elucidation of Risk Preferences:
BIASES - REPRESENTATIVENESS
•
Linda is 31 years old, single, outspoken and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of
discrimination and social justice and she participated in antinuclear
demonstrations.
• Rank order the following 8 descriptions in terms of the probability
(likelihood) that they describe Linda:
•
•
•
•
•
•
•
•
•
a. Linda is a teacher in an elementary school.
b. Linda works in a bookstore and takes yoga classes.
c. Linda is active in the feminist movement.
d. Linda is a psychiatric social worker.
e. Linda is a member of the League of Women Voters.
f. Linda is a bank teller.
g. Linda is an insurance salesperson.
h. Linda is a bank teller who is active in the feminist movement.
52 out of 80 actuaries ranked “h” more likely than “f ”!
Elicitation & Elucidation of Risk Preferences:
BIASES – REGRET AVOIDANCE
•
You are out of town at a business meeting that runs late. As soon as you
can break away, you head to the airport to catch the last flight home. If you
miss the flight, which is scheduled to leave at 8:30 PM, you will have to stay
overnight and miss an important meeting the next day. You run into traffic
and do not get to the airport until 8:52 PM. You run to the gate, arriving
there at 8:57 PM. When you arrive, either:
(A)
(B)
You find out that the plane left on schedule at 8:30 PM, or
You see the plane depart, having left the gate at 8:55 PM.
Which is more upsetting (circle one)? A
Results: A: 3 B: 60 Neither: 16
B
Neither