Hurricane Sandy Re-Raises the Psychology of Black Swan Events
How the management should protect the organization from the rare but serious occurrence.
Why don’t so many companies and individuals buy flood insurance (as just one example of inexplicable behavior in terms of basic risk management)?
The 2012 Mega Storm event in New York and New Jersey exposed a common problem with “black swans.” A black swan is an atypical event whose occurrence is unlikely and whose effect is much greater than ordinary events that occur constantly (1). Risk managers have always worried about severity vs. frequency. The severe event, although rare, is the most important. However, wrong psychology and incentives make non-risk managers focus more on frequency. This is understandable; however, it is a mistake.
Really frequent loss events are a cost of doing business. They are not even insurable on a basis that makes business sense. This is the fallacy of the dollar trade. An insurance company will be happy to accept your premium dollars as long as the premium is at least 165% of the average annual loss. Somewhat frequent losses receive the most attention from CEOs and CFOs. These are losses that don’t happen every day, but do happen enough and cost enough to be a concern. These are the losses that your insurance broker will make sure are covered, and these are the areas where your loss control efforts will be directed.
What about truly serious events? These are not managed unless there is a focused risk management culture. This is where many companies are exposed. This is the area where the events that bring companies to their knees take place. Business owners and managers have a way of letting go of worrying about the rare but severe event, except for a vague concern about it in the back of their minds.
Why did this happened?
First, there are some psychological phenomena that cause us to misjudge. We judge the probability of an event occurring in the future by how easily we can remember it (the “availability bias”), or by the date it occurred (the “hindsight bias”). The “bystander apathy effect” allows us to rule out worry in a group if no one else in the group raises it. Another example is the “Induction Problem”. With inductive reasoning we project into the future based on events we have observed in the past. If it hasn’t happened to us, we assume it won’t.
Then sometimes there are perverse incentives at work. Your broker’s incentives are geared toward ignoring severe risk. Brokers must change policies and must have satisfied customers. They can’t get bogged down in what seems like irrelevant talk about events that hardly ever happen. They cannot be expected to criticize the terms and conditions of their own product, except with respect to losses that they know are going to occur in the short term, which they emphasize in their proposals. Finally, black swans happen so rarely that if it happens and they lose a customer, it’s just one!
The insurance products described in that article epitomize the “don’t worry, it will never happen” syndrome. This is not an opportunity for runners; This is the structure of the insurance market.
CFOs can also get caught up in short-term thinking because they are too busy or may plan to be with the company for a short time. For Owners: Make sure your incentives are organized so that your CFO is in tune with severe risk as well as somewhat prevalent risk. The more thoughtful CFOs, or those encouraged by their bosses, are just as busy, but they know they can and should outsource risk management.
Owners, the CFO should have the same thought process as you about the long-term survival of the business.
Handling gravity is not that difficult; However, you do need a culture of risk management. Severe events don’t happen suddenly without warning. It just seems that way because low volume signals are not recognized or acted upon. There is a lot of apparent noise in the operations of any organization. Some of it is just that: pure noise. But, some of that is not noise at all, but weak signals of trouble brewing. Being aware enough to see the difference is the essence of serious risk management.
The first puff of smoke is a warning sign that something bad is about to happen. We know that smoke precedes fire and not many of us are ignorant of it. Similarly, other things are constantly going wrong in an organization and there are many weak signals showing up like smoke. Busy executives push them aside until they are severe enough to care. Sometimes then it is too late. Mindfulness is the word used by so-called “High Reliability Organizations” (HRO) (2) to describe the ability to distinguish weak important signals from unimportant ones.
Here’s another phenomenon: Safety rules have been instituted in companies around the world. These are the rules of OSHA, other government agencies, insurance companies, and loss control experts. These rules almost always require layoffs and safety margins in all operations. But disasters happen anyway. Why? In practice, margins are not always fully respected; there are traps for the sake of speed and cost, but usually nothing happens. If the cheating on tolerances caused a mess every time, the cheating would stop. The few times disaster strikes, something else is at stake.
The workers know that they can protect themselves a little, they know that the margins are there and they wax them without any negative effect. But sometimes, in the same job, another margin is shaved; and maybe a third. The defects are additive and / or multiplicative and the cumulative effect is a disaster. For example, despite strong safety oversight, cranes continue to collapse. For discussion purposes, assume three safety factors: a weight capacity in the material being lifted, a level base, and low wind speed. Slightly exceeding the limit on any of these can be tolerated, but all three at the same time will cause the collapse.
Two (at least two) HRO principles would be applied to this situation to analyze the confluence of risks, the combination of risk factors, which otherwise goes unnoticed. Management’s “sensitivity to operations” would result in a risk management presence at the ground level (“operations level”); and “deference to experience” would make the risk management point of view the dominant point of view in such a situation.
Frequency vs. Severity thinking should also be applied to buying insurance. Non-risk managers put severity at the back of their minds, and their insurance brokers are more than happy to accept them. People take comfort in the fact that this type of event or that type of event “hasn’t happened here in 20 (or 30, 40, 50, enter your own number) years.” That kind of claim is flawed logic. Serious events don’t happen to any person or business with that kind of frequency. Our own unique experience base is too small to be credible. Only insurance companies, and depending on severity, only the largest insurers, have the critical mass to create models that use “frequency of severity” as a viable program. For the individual company, thinking that way is nothing more than an excuse to ignore the problem (or a defense mechanism if the loss has already occurred).
Understand the Black Swan problem, the psychology and incentives behind it, and how to handle it, and you’ll be in the top 20% of companies. Have a risk management culture and obtain risk management resources, either internally or through consulting.
(1) See The Black Swan by Nassim Taleb. You can also read Taleb’s follow-up book called Fooled by Randomness.
(2) Organizations such as elite military units, nuclear power plants, and hospitals are called “High Reliability Organizations” because of the immense importance of risk management to them. The principles and procedures of HRO can be classified as 1. Worry about failure; 2. Reluctance to simplify; 3. Sensitivity to operations; 4. Deference to experience; and 5. Commitment to resilience. See Handling the Unexpected by Weick and Sutcliffe.
