Elicitation & Elucidation of Risk Preferences Working Party 2005 CAS Annual Meeting Session C 21 Parr Schoolman / David Ruhm

Elicitation & Elucidation of Risk Elicitation & Elucidation of Risk Preferences Working PartyPreferences Working Party

2005 CAS Annual Meeting2005 CAS Annual Meeting

Session C 21Session C 21

Parr Schoolman / David Parr Schoolman / David RuhmRuhm

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:AUDIENCE QUESTIONSAUDIENCE QUESTIONS

• Without looking up any information, estimate Without looking up any information, estimate Wal-Mart’s 1999 revenue:Wal-Mart’s 1999 revenue:

• Put an upper and lower bound around your Put an upper and lower bound around your estimate, so that you are 95% confident that your estimate, so that you are 95% confident that your range surrounds the actual quantity: Lower range surrounds the actual quantity: Lower Bound________ Upper bound________Bound________ Upper bound________


• Linda is 31 years old, single, outspoken and very bright. Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice concerned with issues of discrimination and social justice and she participated in antinuclear demonstrations.and she participated in antinuclear demonstrations.• Rank order the following 8 descriptions in terms of the Rank order the following 8 descriptions in terms of the

probability (likelihood) that they describe Linda:probability (likelihood) that they describe Linda:• a. Linda is a teacher in an elementary school.a. Linda is a teacher in an elementary school.• b. Linda works in a bookstore and takes yoga classes.b. Linda works in a bookstore and takes yoga classes.• c. Linda is active in the feminist movement.c. Linda is active in the feminist movement.• d. Linda is a psychiatric social worker.d. Linda is a psychiatric social worker.• e. Linda is a member of the League of Women Voters.e. Linda is a member of the League of Women Voters.• f. Linda is a bank teller.f. Linda is a bank teller.• g. Linda is an insurance salesperson.g. Linda is an insurance salesperson.• h. Linda is a bank teller who is active in the feminist h. Linda is a bank teller who is active in the feminist

movement.movement.


• You are out of town at a business meeting that runs late. As 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 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 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 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 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, not get to the airport until 8:52 PM. You run to the gate, arriving there at 8:57 PM. When you arrive, either:arriving there at 8:57 PM. When you arrive, either:

(A)(A) You find out that the plane left on schedule at 8:30 PM, or You find out that the plane left on schedule at 8:30 PM, or

(B)(B) You see the plane depart, having left the gate at 8:55 PM.You see the plane depart, having left the gate at 8:55 PM.

Which is more upsetting (circle one)? A B NeitherWhich is more upsetting (circle one)? A B Neither

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:INTRODUCTIONINTRODUCTION

• Risk Management & Risk Measurement Risk Management & Risk Measurement requirements are increasing:requirements are increasing:• Sarbanes-Oxley Sarbanes-Oxley • Rating Agency pressuresRating Agency pressures• CEO Attestations of Financial StatementsCEO Attestations of Financial Statements

• Result:Result:• Companies are being required to have Companies are being required to have

documented Risk Management Policies and documented Risk Management Policies and ProceduresProcedures

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:PURPOSEPURPOSE

These requirements provide an These requirements provide an opportunity for management to institute a opportunity for management to institute a consistent viewpoint regarding risk:consistent viewpoint regarding risk: Some tradeoffs are acceptable, some are notSome tradeoffs are acceptable, some are not Some tradeoffs are preferable to othersSome tradeoffs are preferable to others

Without a consistent policy on decisions:Without a consistent policy on decisions: Senior management input on tradeoffs is Senior management input on tradeoffs is

confined to highest level of decisionsconfined to highest level of decisions Unconnected, ad hoc business unit Unconnected, ad hoc business unit

decisionsdecisions

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:PURPOSEPURPOSE

ObjectiveObjective Rational framework for making Rational framework for making

decisionsdecisions Explicit evaluations of risk vs. returnExplicit evaluations of risk vs. return Management risk preferences codifiedManagement risk preferences codified Decision consistencyDecision consistency Enterprise implementationEnterprise implementation

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:KEY STEPSKEY STEPS

• Key Steps for determining a Firm’s Key Steps for determining a Firm’s “Risk Policy”:“Risk Policy”:• Define Risk UnambiguouslyDefine Risk Unambiguously• Assess Context Assess Context • Determine Risk MeasuresDetermine Risk Measures• Ascertain Risk Preferences (i.e., find Ascertain Risk Preferences (i.e., find

consensus)consensus)


• Define Risk UnambiguouslyDefine Risk Unambiguously• What do you mean by “Risk”?What do you mean by “Risk”?

• Risk of losing money or of “missing Risk of losing money or of “missing plan”?plan”?

• Reduction in accounting book Reduction in accounting book value (or income) or lost market value (or income) or lost market capitalization?capitalization?

• Ultimate value or mark to market Ultimate value or mark to market shortfall? shortfall?


• Define Risk Unambiguously Define Risk Unambiguously (continued)(continued)• What are the firms’ key risks?What are the firms’ key risks?

• FinancialFinancial• OperationalOperational• CompetitiveCompetitive• StrategicStrategic

• For what time horizon?For what time horizon?


• Define Risk Unambiguously Define Risk Unambiguously (continued)(continued)

A useful risk definition is:A useful risk definition is: Specific, rather than ambiguousSpecific, rather than ambiguous Accepted by involved partiesAccepted by involved parties As comprehensive as neededAs comprehensive as needed


• Examples of heuristics that could be Examples of heuristics that could be given specific operating definitions:given specific operating definitions: Build in enough profit margin to insulate capital against Build in enough profit margin to insulate capital against

unexpected events and unknowable factors. (profit unexpected events and unknowable factors. (profit measure)measure)

Don’t over-concentrate the underwritten risks. (percentile)Don’t over-concentrate the underwritten risks. (percentile) Do business in markets where the company has an Do business in markets where the company has an

identifiable, durable operating advantage. (margin)identifiable, durable operating advantage. (margin) Don’t write what you don’t know. (parameter variability)Don’t write what you don’t know. (parameter variability) Don’t deal with untrustworthy parties. (historical data)Don’t deal with untrustworthy parties. (historical data) Avoid mass tort exposure. (exposure type’s aggregate loss)Avoid mass tort exposure. (exposure type’s aggregate loss)


• Risk Definition Examples:Risk Definition Examples: Accident Year Total Return shortfall relative to cost of Accident Year Total Return shortfall relative to cost of

capitalcapital Rolling 4-quarter income shortfall relative to cost of Rolling 4-quarter income shortfall relative to cost of

capitalcapital Statutory Surplus decline over the next yearStatutory Surplus decline over the next year Ratings downgrade probability over the next 5 yearsRatings downgrade probability over the next 5 years


• ContextContext• Corporate CultureCorporate Culture• Financial CharacteristicsFinancial Characteristics• Perspectives of Key Decision MakersPerspectives of Key Decision Makers


• Context - Corporate CultureContext - Corporate Culture• Age of OrganizationAge of Organization• Tenure of Current ManagementTenure of Current Management• Company HistoryCompany History


• Context - Financial Context - Financial CharacteristicsCharacteristics• Financial StrengthFinancial Strength• Size of FirmSize of Firm• Ownership StructureOwnership Structure

• Stock vs. MutualStock vs. Mutual• Privately held vs. PublicPrivately held vs. Public


• Context - Key Decision MakersContext - Key Decision Makers• Sales background vs. financial Sales background vs. financial

backgroundbackground• Perceived relative importance of top linePerceived relative importance of top line

• Time in career could influence risk Time in career could influence risk appetiteappetite

• Life vs. P&CLife vs. P&C• Life: Cognizant of persistency, investment Life: Cognizant of persistency, investment

risksrisks• P&C: Cognizant of catastrophe, reserve risksP&C: Cognizant of catastrophe, reserve risks


• Risk MeasuresRisk Measures• ObjectiveObjective• TransparentTransparent• AppropriateAppropriate

• Timeliness vs. Accuracy Trade-offTimeliness vs. Accuracy Trade-off• IT and Budget resource constraintsIT and Budget resource constraints• UnderstandableUnderstandable


• Risk Measures - ObjectivityRisk Measures - Objectivity• Objective:Objective: Probability of 2005 Probability of 2005

reported net income being reported net income being negative.negative.

• Not too objective:Not too objective: Probability of Probability of very high net losses for accident very high net losses for accident year 2005.year 2005.


• Risk Measures - Risk Measures - TransparencyTransparency• Transparent:Transparent: Probability of a net Probability of a net

loss for the line or segment.loss for the line or segment.

• Not so transparent:Not so transparent: The beta of The beta of the line or segment’s net income the line or segment’s net income distribution.distribution.


• Risk Measures – AppropriatenessRisk Measures – Appropriateness• Appropriate:Appropriate: Short-term net income Short-term net income

distribution for property catastrophe distribution for property catastrophe lines.lines.

• Not that appropriate:Not that appropriate: Short-term net Short-term net income distribution for long-tail lines income distribution for long-tail lines and lines whose principal risk is surplus and lines whose principal risk is surplus drain.drain.


• Ascertaining Risk PreferencesAscertaining Risk Preferences• Survey methods have been Survey methods have been

developed for marketingdeveloped for marketing• Conjoint AnalysisConjoint Analysis• Quality Functional Deployment (QFD)Quality Functional Deployment (QFD)• Multi-Attribute Utility Theory (MAUT)Multi-Attribute Utility Theory (MAUT)• Many others as noted in paperMany others as noted in paper


• Ascertaining Risk Preferences Ascertaining Risk Preferences (continued)(continued)• Survey methods from marketing:Survey methods from marketing:

• Example: used to find out car buyers’ Example: used to find out car buyers’ preferencespreferences

• Younger buyers: styling, performance more importantYounger buyers: styling, performance more important• Family buyers: space, seating, mileage more Family buyers: space, seating, mileage more

importantimportant• These are tradeoffs of desirable featuresThese are tradeoffs of desirable features

• Could be used for management risk preferencesCould be used for management risk preferences• Determine acceptable tradeoffsDetermine acceptable tradeoffs• Isolate those risks that management considers more Isolate those risks that management considers more

important / quantify relative importanceimportant / quantify relative importance

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:BIASESBIASES

• Key BiasesKey Biases• Framing – Loss (Risk Seeking) vs. Gain (Risk Averse)Framing – Loss (Risk Seeking) vs. Gain (Risk Averse)

• An uncertain loss is preferred to a sure lossAn uncertain loss is preferred to a sure loss• A sure gain is preferred to an uncertain gainA sure gain is preferred to an uncertain gain

• Overconfidence in accuracy of estimatesOverconfidence in accuracy of estimates• More easily remembered More easily remembered seems more probable seems more probable

• Catastrophe RiskCatastrophe Risk• Terrorism RiskTerrorism Risk• AsbestosAsbestos

• Anchoring & AdjustmentsAnchoring & Adjustments• RepresentativenessRepresentativeness• Regret AvoidanceRegret Avoidance

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:BIASES - FRAMINGBIASES - FRAMING

Question 1:Question 1:In addition to your initial In addition to your initial wealth, you are given $1,000 wealth, you are given $1,000 and then have to choose and then have to choose from among the following from among the following choices:choices:

A)A) Receive $1,000 with prob. Receive $1,000 with prob. p=.5 or receive $0 with p=.5 or receive $0 with prob. 1-p=.5.prob. 1-p=.5.

B)B) Receive $500 with Receive $500 with probability p=1.probability p=1.

Results:Results:A: 25A: 25B: 72B: 72

Question 2:Question 2:In addition to your initial In addition to your initial wealth, you are given $2,000 wealth, you are given $2,000 and then have to choose and then have to choose from among the following from among the following choices:choices:

A)A) Lose $1,000 with prob. p=.5 Lose $1,000 with prob. p=.5 or lose $0 with prob. 1-p=.5.or lose $0 with prob. 1-p=.5.

B)B) Lose $500 with probability Lose $500 with probability p=1.p=1.

Results:Results:A: 60A: 60B: 35B: 35

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:BIASES - FRAMINGBIASES - FRAMING

Question 1:Question 1:You have just learned that the sole You have just learned that the sole

supplier of a crucial component is supplier of a crucial component is going to raise prices. Two going to raise prices. Two alternative plans have been alternative plans have been formulated to counter the effect formulated to counter the effect of the price increase. The of the price increase. The expected Impact is:expected Impact is:

Plan A)If this plan is adopted, the Plan A)If this plan is adopted, the company’s costs will increase by company’s costs will increase by $4,000,000.$4,000,000.

Plan B) If this plan is adopted, there Plan B) If this plan is adopted, there is a 1/3 probability that there will is a 1/3 probability that there will be no cost increases, and a 2/3 be no cost increases, and a 2/3 probability that the company’s probability that the company’s costs will increase by $6,000,000.costs will increase by $6,000,000.

Which do you prefer?Which do you prefer?Results:Results: A: 36 A: 36 B: 61B: 61

Question 2:Question 2:You have just learned that the sole You have just learned that the sole

supplier of a crucial component is supplier of a crucial component is going to raise prices. The price going to raise prices. The price increase will cost the company an increase will cost the company an additional $6,000,000 in supply costs. additional $6,000,000 in supply costs. Two alternative plans have been Two alternative plans have been formulated to counter the effect of formulated to counter the effect of the price increase with savings in the price increase with savings in other parts of the company. The other parts of the company. The anticipated consequences of these anticipated consequences of these two plans are:two plans are:

Plan A) If this plan is adopted, the Plan A) If this plan is adopted, the company will save $2,000,000 in company will save $2,000,000 in operating expenses.operating expenses.

Plan B) If this plan is adopted, there is a Plan B) If this plan is adopted, there is a 1/3 probability that the company will 1/3 probability that the company will save $6,000,000 in operating save $6,000,000 in operating expenses, and a 2/3 probability that expenses, and a 2/3 probability that no savings will be achieved.no savings will be achieved.

Which do you prefer?Which do you prefer?Results:Results: A: 84A: 84 B: 12B: 12

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:BIASES - OVERCONFIDENCEBIASES - OVERCONFIDENCE

• Without looking up any information, estimate Wal-Without looking up any information, estimate Wal-Mart’s 1999 revenue:Mart’s 1999 revenue:

• Put an upper and lower bound around your estimate, Put an upper and lower bound around your estimate, so that you are 95% confident that your range so that you are 95% confident that your range surrounds the actual quantity: Lower Bound________ surrounds the actual quantity: Lower Bound________ Upper bound________Upper bound________

• 23 out of 80 actuarial students’ intervals contained the 23 out of 80 actuarial students’ intervals contained the actual figure ($166.8 billion).actual figure ($166.8 billion).

• The actual probability that a randomly selected The actual probability that a randomly selected student’s range contained the actual figure was 29%, student’s range contained the actual figure was 29%, far less than 95%.far less than 95%.

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:BIASES - REPRESENTATIVENESSBIASES - REPRESENTATIVENESS

• Linda is 31 years old, single, outspoken and very bright. She Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice concerned with issues of discrimination and social justice and she participated in antinuclear demonstrations.and she participated in antinuclear demonstrations.• Rank order the following 8 descriptions in terms of the Rank order the following 8 descriptions in terms of the

probability (likelihood) that they describe Linda:probability (likelihood) that they describe Linda:• a. Linda is a teacher in an elementary school.a. Linda is a teacher in an elementary school.• b. Linda works in a bookstore and takes yoga classes.b. Linda works in a bookstore and takes yoga classes.• c. Linda is active in the feminist movement.c. Linda is active in the feminist movement.• d. Linda is a psychiatric social worker.d. Linda is a psychiatric social worker.• e. Linda is a member of the League of Women Voters.e. Linda is a member of the League of Women Voters.• f. Linda is a bank teller.f. Linda is a bank teller.• g. Linda is an insurance salesperson.g. Linda is an insurance salesperson.• h. Linda is a bank teller who is active in the feminist h. Linda is a bank teller who is active in the feminist

movement.movement.• 52 out of 80 actuaries ranked “h” more likely than “f”!52 out of 80 actuaries ranked “h” more likely than “f”!

Elicitation & Elucidation of Risk Preferences:Elicitation & Elucidation of Risk Preferences:BIASES – REGRET AVOIDANCEBIASES – REGRET AVOIDANCE

• You are out of town at a business meeting that runs late. As 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 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 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 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 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, 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:arriving there at 8:57 PM. When you arrive, either:

(A)(A) You find out that the plane left on schedule at 8:30 PM, or You find out that the plane left on schedule at 8:30 PM, or

(B)(B) You see the plane depart, having left the gate at 8:55 PM.You see the plane depart, having left the gate at 8:55 PM.

Which is more upsetting (circle one)? A B NeitherWhich is more upsetting (circle one)? A B Neither

Results: A: 3 B: 60 Neither: 16Results: A: 3 B: 60 Neither: 16

Documents

Elicitation & Elucidation of Risk Preferences Working Party 2005 CAS Annual Meeting Session C 21 Parr Schoolman / David Ruhm