The Cost of Uncertainty
“What we anticipate seldom occurs; what we least expect generally happens.”- British prime minister and novelist Benjamin Disraeli.
Risk managers understand that there is a price (or cost) to uncertainty. For example: money spent on a loss which did not occur was still spent. But you don’t have to be a “risk manager” to understand this, we know this from our own daily experience. Almost any variety of insurance expense incurred that went “unused” such as life insurance (because you didn’t die yet) or auto insurance (for a loss which did not occur during the policy period) was still spent. It is gone, ostensibly to pay for someone else’s loss (plus a portion for the insurer’s operating profit). This doesn’t nullify the need for the coverage, it just means it wasn’t “your turn” at the insurer’s trough.
Similarly, anticipated (projected) future losses may be worse than projected. They can be better (meaning “lower”) than expected but this seldom occurs in the wild. This usually occurs when a loss that happens today is not paid out by an insurer for years, which usually occurs with liability exposures. For example, take a situation where someone is injured severely in a car accident you caused and litigation ensues. The litigation process alone can take years to resolve. In the meantime, the prudent insurer has to put aside the money that it expects to pay for the loss, or hold it “in reserve” until the claim is resolved and the loss is ultimately paid.
As you can imagine, the process of reserving losses is just as much art as science. Most of my actuary friends (very, very smart numbers people) agree as these are the folks who are brought in to review these future losses regularly and to make sure the entity has the money to pay for the loss at that future date.
One of the factors used in their quantitative loss analyses is called an “uncertainty factor“. Think of it as (to paragraphrase ex-Defense Secretary Donald Rumsfeld), the “unknown unknown“. Most people know this term from their daily lives as the “fudge factor”, used when a variety of outcomes could ensue from a single event. Because all types of activity entails a certain level of risk, (including getting out of bed this morning to go to work), we can deduce that all activity contains an element of uncertainty.
I strive to keep political discourse here to a dull roar, except where it directly intersects the discussion and application of risk management techniques. For the past two days, the pundits are wondering why our financial markets have dropped about 10% since the results of the election. It’s uncertainty in action, folks. No one knows how President-Elect Obama will govern and perhaps a sense of buyer’s remorse is in play.
Added to this, is the stark realization that the $850B bailout isn’t necessarily going to help in the near term and that the federal government (that’s us guys!) may soon be in the business of bailing out individual state governments, instead of forcing them to live within their means. Of course, these events will only continue to destabilize and debase our currency because all we have left to do is print more money to “pay” for these bailouts, since no foreign government seems to be interested in buying our debt today.
We also don’t know the rules of the bailout lottery, as in why do some companies get bailed out (AIG, Bear Stearns) and some don’t (Lehmann Brothers)? We had a perfectly good remedy for companies that could no longer operate, it was called bankruptcy. It was messy, it took time, but it worked and we as a society understood it. Now we’re in unknown waters as no one can explain to us how the rules of the bailout lottery work. This apprehension breeds more uncertainty.
And as uncertainty grows, our economy, financial markets and society weaken.