What Have The Past 30 Years Taught Us About Managing Risk? by [email protected]
How Managing Risk Has Changed
The problem with many catastrophic risks isn’t just that their impacts, when they hit, are so massive. It’s also that their odds of occurring in any given short time frame are very small, so that planning for them has to be handled as a long-term priority while the proverbial sun is shining. And neither companies nor individuals are particularly apt at taking serious, long-term action to prepare for low probability, high consequence events.
Enter the Wharton Risk Management and Decision Processes Center, which was created 30 years ago to help individuals, businesses, governments and global organizations to be better prepared for those longer range, more unpredictable dangers.
[email protected] spoke with Howard Kunreuther and Robert Meyer, co-directors of the Wharton Risk Management and Decision Processes Center, and executive director Erwann Michel-Kerjan about the center’s research and how managing risk has changed over the past few decades.
An edited transcript of the conversation appears below.
[email protected]: Howard, what led to the starting of the Risk Center 30 years ago?
Howard Kunreuther: Well, it’s interesting that our center has always focused on low probability, high consequence events, [because] it was a low probability, high consequence event that actually got the center started. I was in the office of the CEO of Rohm and Haas with my colleague Ned Bowman [of Wharton]. We were looking at the challenges that the company was facing in dealing with environmental risks, and when we arrived there, we were told that there had been a large chemical accident in Bhopal that the company was very concerned about. It involved Union Carbide, but every chemical company was involved. And that really was the start of the center, because we worked very closely with Rohm and Haas and Cigna to begin to look at issues like chemical accidents as a way of trying to figure out how we would deal with extreme events.
[email protected]: Thinking about the catastrophic risks that businesses faced 30 years ago, what were some of the most important risks in addition to manufacturing accidents like Bhopal that you were concerned about?
Kunreuther: It was really the chemical accidents that got us started, and I think technological accidents were clearly a very important part of how businesses had to think. They weren’t thinking as much about it as we would have liked them to. They were saying it wasn’t going to happen to me. But that was certainly on the agenda, and any time there was an accident like a Bhopal, they then paid attention to it. The other area we focused on — and that had been the focus of a lot of the research a number of us had been doing, including my late colleague, Paul Kleindorfer, who was co-director of the center when we formed it — was natural hazard risks and natural disasters. And those were risks that were not predictable, but if there was a severe hurricane or flood or earthquake, that might have an impact in terms of how the firms had to react.
“When you talk to companies or individuals and ask what risks they are most concerned about, typically, they are the things that just happened yesterday. People tend to focus on the disaster that just happened.” –Robert Meyer
[email protected]: What were some of the research projects that you took on to look into these risks?
Kunreuther: Well, because of our start with the chemical industry, we had a very large project with the Environmental Protection Agency on chemical accidents — how one dealt with them — and technological accidents, so we were certainly working on that. We were also working on the natural hazards area and why individuals were not protecting themselves and purchasing insurance. That was something that both Paul and I had been focusing on with others over a period of time.
The other area that emerged was the siting of the high-level radioactive waste facility at Yucca Mountain in Nevada. There was a whole project that was formed, and for 10 years, there was a group of us who were working together. It was very much an interdisciplinary group. Paul Slovic, president of Decision Research, was a part of that. Roger Kasperson, a geographer, a psychologist, and then there were anthropologists — we were all working with the state of Nevada to try to figure out how to site this facility, and so the center played a role in that. We had been looking at siting a liquefied natural gas facility before the center had been formed.
[email protected]: What would you say were some of the key findings of your earliest research projects?
Kunreuther: The key findings are findings we may want to talk about even today. Really, what was happening was that it wasn’t until a disaster occurred that there was really a lot of attention paid. There was a tendency to say, “This is not going to happen to me,” and firms were behaving that way. Certainly, consumers and homeowners were behaving that way. As a result, we as a center were trying to figure out the important things to think about beforehand, and what kinds of programs and policies could be put forward to try to deal with them so we didn’t have to be in a reactive mode after a disaster occurred.
[email protected]: If all of you were to look back over the past 30 years, how would you say the nature of risk has evolved and changed? Bob, would you like to start us off?
Robert Meyer: The risks have always been there. To build on what Howard was saying, one of the things we’ve observed as a center is that often, when you talk to companies or individuals and ask what risks they’re most concerned about, typically, they are the things that just happened yesterday. People tend to focus on the disaster that just happened, so one of the things we try to do as a center is get people and organizations to focus not only on the event that just happened, but also to refocus on unseen risks.
Just to give you an example, we work with the World Economic Forum, and every year, they come out with a survey of about 900 academics and ask them what are the risks that they are most concerned about. Typically, what you find is an awful lot of year-to-year variability in what is hitting the radar screen. For example, last year, the No. 1 thing that came up was state unrest, particularly in Europe. If you think about it, that makes sense, because one of the big news items in Europe last year was unrest in the Ukraine and so forth. But what’s interesting is a risk that was very important two or three years ago: cyberterrorism. In some sense, one of our challenges as a center is to get people and organizations to think about not just the thing that happened most recently, but to take a good long-term view of what are real risks. Often, the things you have to worry about are the things that you’re not currently thinking about.
[email protected]: Erwann, what do you think?
Erwann Michel-Kerjan: …The nature of risk management has changed a lot over the past 30 years, from something that was almost exclusively technical to something that remains technical, of course, but has become more and more strategic today. More risk committees are being formed as we speak in many industries across the world. The topic itself changed, which means that as researchers, we need to change the way we approach these issues as well, whether it’s natural disasters, cyber risk or interdependencies between these risks.
Maybe you looked at what was happening in Syria and thought, “Oh, it’s just a geopolitical issue.” Then three months later, it becomes an immigration issue, an economic issue in Europe. Then maybe in two months, it becomes a big issue in the U.S. The world is becoming more and more interdependent. It’s somewhat of a cliche, but I think we’re living it every day. An earthquake in China 30 years ago would have been an earthquake in China. Today, an earthquake in China has massive impact on global supply chains worldwide from Frankfurt to Detroit.
“An earthquake in China 30 years ago would have been an earthquake in China. Today, an earthquake in China has a massive impact on global supply chains worldwide from Frankfurt to Detroit.” –Erwann Michel-Kerjan
[email protected]: I wonder if I could turn to each of you and ask you to speak about a current research initiative that you are involved in, and why it is so important to business practitioners? Howard, could you start?
Kunreuther: Yes. Let me just add one comment to what Bob and Erwann have said.
One of the things that the center was focused on was the decision process. We always are thinking about essentially how people are behaving — whether it’s a consumer, a homeowner, a manager in a firm, or the government and the public sector — so that we can develop strategies for dealing with that. In that sense, the center is somewhat unique in that we are really trying to tie together the risk assessment part and also risk perception and risk management. It’s that theme coming together.
To talk about a current project, related to some of the points that were just made: We have been interviewing the CEOs of 100 of the S&P 500 firms in a large project funded by the Travelers Foundation, and that involves also the Wharton Center for Leadership and Change Management that [Wharton management professor] Mike Useem directs. What we’ve been asking these CEOs is what is the most important risk they are concerned about and have been concerned about — not just necessarily yesterday, but that they’ve been concerned might have adverse or catastrophic consequences to them. And you get a whole variety of different answers from them.
As Bob had indicated, often, it is a more recent disaster. Just to illustrate one example, the Fukushima earthquake was something that you hear of from these CEOs as being important. It highlights the points that Erwann was raising on interdependencies. These firms are very concerned. The automobile industry was really hurt by the supply chain problem with respect to that, so we’ve been interested in that.
The reason for doing this project is to try to develop some benchmarks with respect to how firms could behave differently in the future. We’re finishing it up now and we hope to publish our results over the course of the next year or so.
[email protected]: Bob?
Meyer: One of the things we’ve discovered in the course of our research is that often, one of the reasons that people have a difficult time making good decisions to prepare for rare events is that they have very poor mental models of how these events are going to unfold. A great example was Hurricane Sandy. One of the real surprising results is, even though this was an event that everyone in the world knew about, and there were front-page banner headlines telling people that this huge storm was coming in, and there was no shortage of warnings, there were an awful lot of deaths and damage primarily due to flooding.
Just as the storm was approaching, we asked people — this is before the storm actually hit – “What is the threat that you are most worried about?” And even though the main threat, the actual threat that they faced, was flooding, what people tended to say was they were mainly worried about wind. That’s a fundamental mistake, because the storm is coming in, it’s a flood threat, and they’re going out and boarding up their windows while at the same time leaving their car on the street. The next day, they wake up and, of course, their car is ruined. Or they don’t evacuate, and they don’t understand why they’ve been asked to evacuate.
So one of the things we were involved in doing is developing virtual web-based simulations that allow people to visually experience events like very severe storms and so forth which they otherwise wouldn’t be able to. In these environments, people are, for example, put into a virtual living room and they’re told that there’s a storm out in the distant horizon. They have the opportunity to gather information as they normally would, and they basically get to experience what it would actually be like to go through one of these events. We see that as a great vehicle for us — a teaching vehicle and also a research vehicle for studying very, very rare events. These are things that you want people to know about before they occur, not learn from unfortunate experiences after they occur.
Michel-Kerjan: And you want something that can be used anywhere in the world.
“One of the reasons that people have a difficult time making good decisions to prepare for rare events is that they have very poor mental models of how these events are going to unfold.” –Robert Meyer
Meyer: Yes, absolutely.
Michel-Kerjan: When you look at natural disasters around the world, flooding is by an order of magnitude the largest of all, in terms of number of people affected and economic cost. That’s throughout the world, and it’s true in the U.S. as well. So the center is doing a lot of work on flood-related risk, both on coastal flooding and inland flooding, trying to better understand the risk. And we’ve been doing lot of work on flood insurance as well. For instance, we have access through our collaboration with FEMA (the Federal Emergency Management Agency) and DHS (the U.S. Department of Homeland Security) to their entire portfolio of data. So we can actually crunch data — a few million data points — to try to better understand the national flood insurance program, then publish the results, and then work with the industry and also the federal government trying to improve that program.
Related to that project — there is a buzzword out there: “resilience.” You know, everybody talks about resilience, and we’re still having a hard time finding one person who is against resilience, which tells me that maybe we have an issue here. But joking aside, we decided as a group to take a serious look at flood resilience in a more quantitative manner. We have a few projects related to flood resilience. We have done some work in New York City. We’re doing some work with the Z Zurich Foundation, a Swiss nonprofit funded by insurers, in five or six different countries. And in all these projects, I think instead of having one person or two people working on a paper, which some of us tend to do, we recognize we need expertise from a large number of individuals. So most of our large projects tend to involve five, six, 10 people with different backgrounds, which obviously is much more interesting for us, because you can really tackle large-scale issues in a way that you couldn’t if you were just writing your own paper by yourself.
[email protected]: Now, let’s turn from the present to the next three to five years. Given everything that we have discussed about the interdependence factor, and not just in the U.S., but globally, what do you think will be the biggest risks that people and companies around the world should be thinking about for the next three to five years?
Kunreuther: Well, there’s no doubt that a risk we’ve all been thinking about but have a very hard time dealing with is climate change. That’s something the center has been paying attention to over the last few years, more so than in the past. It became really a very important theme in the 30th anniversary that we just had for the Risk Center. There was a long discussion at the end of our conference related to a question that had been posed. We did a little polling exercise over lunch, and one of the questions asked was, how serious does one think the climate change problem is?
When this was done with MBA students entering a couple years ago, there was a significant number, maybe 8%, who actually felt it was not a problem at all, which was very surprising. No one in the room felt that way. No one in the room felt that it was not serious. But there were a group of people who felt that it was serious, but not very serious.
How do you instill the fact that there are these problems that may not happen for 50 years in terms of very serious impacts, but that we have to worry about now? How do we deal with them? I think Bob’s simulation project is an example of how you get people to pay attention…. So, we had a discussion on how we could make everyone feel [climate change] is a very serious problem in this country so we could take some steps now to deal with it. Because if you have enough people believe that it isn’t very serious — and this was a group of people who really should have felt that it was very serious – that becomes a problem.
The challenge we face with our center is how do we stimulate long-term strategies and encourage people to take protection — organizations, countries to take protection — but at the same time, recognize that one has to address the short-run concerns that people have if we’re going to be successful. We may have to use new technologies and videos and pictures rather than words to be able to get that across.
Meyer: I think one of the issues is that climate change is an enormously difficult and fascinating topic. One of the things that’s involved in dealing with it is encouraging communities, individuals and organizations to develop much more of an adaptive mindset than has traditionally been the case. If you think long-term historically, human civilization emerged at a time of very extreme, rapid climate change. For example, as recently as 7,000 years ago — which is not really that long ago — if you lived in the Netherlands, you would walk to Great Britain. During that period, sea level was coming up very rapidly after the melting of the last glaciers. What would happen, of course, is that we lived in tents, and we wandered around anywhere. If the water came up, we would just move to a new place.
“How do you instill the fact that there are these problems that may not happen for 50 years in terms of very serious impacts, but that we have to worry about now?” –Howard Kunreuther
Of course, what’s happened since then is suddenly going from this mindset of “the world is constantly changing,” and we’re very much part of that change, to a more modern view of “the world is static,” and we put cities right at sea level and so forth, and we have an enormous civilization which is built on the premise that nothing ever changes: number one, that the climate is invariant, and number two, that we somehow or another are independent of the climate. That the actions that we take, the things that we build, the things we put into the air aren’t having an effect on climate. What’s happened is in recent years, there has suddenly come this big awakening that no, in fact, all of the world is constantly changing, and if we don’t have this adaptive mindset, we’re going to be facing enormous trouble. Unfortunately, the cost of getting from here to there suddenly is a significant one.
Because now, you’re going to have to take large cities like Miami and New York and say, “Well, what are you going to do when the sea level comes up by another six feet? What are you going to do with all these buildings?” And these are fundamental problems.
Michel-Kerjan: In addition to [climate change], which is kind of a big one, [other risks we need to focus on involve] cyber attacks, big data, risks related to new technologies, and overregulation. We haven’t talked about that, but it’s clearly something on the mind of many people around the world — although overregulation, obviously, depends on where you sit.
On the top [of the list] is terrorism…. Given what ISIS is doing in the Middle East, we know it’s not over. So the list is long. I think one big question we’ll have in the future, in addition to what has been mentioned already, is who’s paying for all of these catastrophes at the end? What type of optimal risk-sharing arrangement can you put together in a world where more and more governments are running very large public deficits, where more people ask for their government to help them during disaster times, but we don’t necessarily have the money? Reforming our own mindset, not only here in the U.S. but around the world. Who is supposed to pay for these disasters? How do we incentivize people, firms, governments and cities to start investing before a catastrophe happens? Again, we’re not just talking about natural disasters here.
We talked a lot about risks. There are great opportunities coming with that as well. By 2050, 80% of the world’s population will be in cities. So to think about cities as small pockets here and there, it’s totally irrelevant. There are great things with concentrating people and assets in the same place, but as Bob mentioned, when something hits that city, well, it’s a pandemic. An earthquake, a natural disaster, a terrorist attack — that will be a catastrophe almost by definition. And then, we need the other 20%, because the other 20% is basically agriculture. We need to feed other people as well. So there are amazing, amazing challenges and opportunities ahead of us.
Kunreuther: Let me add one point to what Erwann was just saying on who should pay, because I think it’s a really critical issue that we have been struggling with. And I want to raise the issue of inequality, which is now a real challenge. It’s not just the low-income people. As we all know, the middle class is a part of that discussion as well. We focus at the center on case studies and examples and concrete problems. Take the flooding problem, as an example, which is obviously related to the climate change issue, and what’s going to happen to a city like Miami, which is clearly at risk with sea-level rise and some of the things that are going to occur.
We really have a challenge here related to the affordability issue. We as a center have been focusing from almost the outset on the role that insurance can play as a way of getting people to take protection. But the way that insurance could play that role is the premiums have to reflect the risk, to let people know how serious the hazard is, but at the same time, to help them to maybe take some steps to reduce that risk — to elevate their house or to make their house flood proof in some fashion, because they’ll get a premium discount, for example. Now, the challenge we see in this relates to the who is going to pay when you have a lot of low-income and middle-income people who are living in high hazard areas who cannot afford that insurance when the premiums reflect risk. So the center has been focusing on that issue, and we’ll be doing a fair amount more in the coming years with the inequality issue in terms of answering the questions: Are we going to in some fashion subsidize low-income people? Should we do it through an insurance premium? Should we do it through other mechanisms such as vouchers or other ways that are now tied to insurance?
At the end of the day, the question of who should pay is going to come on the table, which is what we know Congress is facing when they are making decisions on what programs they are going to support.
Michel-Kerjan: We also know that the answer will depend on where you are. I mean, the U.S. may have a different view on the matter than Great Britain or Germany or India or China.
Meyer: Howard was talking about the importance of decision processes in all of this, and at the end of the day, a lot of decisions that people make — all the decisions that people make — about whether or not they want to buy insurance or undertake protection, are rooted very much in what they believe the risks are that they’re facing. So in some sense, in addition to the affordability issue, one thing that’s compounding it is the fact that an insurer may come in and say, “This is what we’ve calculated objectively your risk to be, and so based on that, here is the price of this coverage.” But then, of course, the people who are living in a home look at that and they say, “Well, that’s not at all my risk, OK, and in fact, I don’t have anything near the risk that you think I face, and therefore it’s grossly overpriced,” and so they don’t buy the coverage.
So in some sense, you could do risk-based rates, but basically if people feel that it’s mispriced and they don’t buy the coverage, then insurance doesn’t work. Then, essentially, you still have to ask the question: When the disaster comes and you have all these people that are uninsured, who pays for that at that point? And that’s a major problem.
Kunreuther: And that problem is compounded when you have a highly subsidized premium, because then people think that they’re safer than they actually are. So you have a combination of saying, “Here’s a premium that has a risk,” and they say, “That isn’t really my risk.” But then you also have the reverse problem, which is true in the flood case, where the premium is very low for many individuals and they say, “Well, I’m really a lot safer than I actually thought I was,” and they aren’t really that safe.
[email protected]: So given all the risks that you identified that the world will be facing over the next three to five years, what advice would you give to, say, chief risk officers or security officers about how to protect people and property against these risks?
“We have an enormous civilization which is built on the premise that nothing ever changes.” –Robert Meyer
Kunreuther: Well, I want to just follow on Bob’s comment on decision processes and the challenges, which I think is something that managers as well as homeowners and people face. The biggest [questions] that we have been trying to get across are: How do you get people to think long term? How do you get managers to think long term? But at the same time, we have to recognize that there are all sorts of reasons why they’re going to want to think short term. How do we develop the kinds of programs with incentives that will enable them to think long term, but at the same time reward them or reward their company, let’s say, if you’re talking about firms, or reward the homeowner if you’re talking about families, to take some steps today? We have thoughts on that, but it would be one area that we want to think about.
Meyer: My actual main position [at Wharton is] in the marketing department, and we’re trying to think about how do you persuade people to buy products and undertake certain sorts of actions. And I think that one of the real challenges that exists in the area of protective investments is the fact that there’s probably no harder sell. Because effectively, what you’re asking people to do is to invest a large amount in instruments such as insurance or protective measures that you hope they’re never going to use at all. So in some sense, it’s a very, very difficult thing, and you’re trying to convince them based on credence that somehow or another, in the long run — five years, 10 years, 50 years from now — this investment will prove beneficial in helping you avoid a loss that you might otherwise face. That’s just such a very difficult thing to do, to get people to think of those sorts of long-term benefits. So that’s one of the long-term challenges: How do you get people to shift their mindset from focusing on what’s the best use of my money today — which will almost never be to buy insurance, will almost never be to build a stronger house — and to say, no, no, no, no, you can’t think about today, you have to think about maximizing utility over a 50-year horizon.
Michel-Kerjan: Yes, all of that is right. You only rarely talk about insurance at the dinner table except to complain about it. Rarely do you say, “Oh my gosh, I got a great insurance contract.”
I think your question depends very much on whether you’re talking about individuals versus corporations, especially large corporations. I think the challenge with individuals is that, yes, there have been more floods, there have been more natural disasters around the world. But still, the likelihood of you being hit by a flood in the next 10 years, hopefully it’s not 100%, and it’s not 20 times during 10 years. So the salience of the event is important. When you move from these individuals to large, multinational corporations, what is the likelihood of that firm being hit by a serious crisis next month? Much higher.
So going back to Howard’s starting the center 30 years ago … maybe every 10, 20 years, [there was] a big event. It seems like now, every six months, you have another one. For example, what is happening in Syria and with the migrants. A year ago, it was all about Ebola.
People almost forget about Ebola. Then you have Volkswagen cheating the system, so the nature of its crisis will be different. But every time there is a disaster, I think that makes risk management even more salient at the level of the firm, which explains why so many companies have created a position called the chief risk officer, recognizing that we cannot just look at risk in silos. We have to aggregate risks. And more and more countries or cities, at least, are starting to think the same way, saying, “As a city, as the mayor of the city, I cannot just think about floods. Unemployment is a big risk. Health is a big risk.”
[email protected]: I have one last question. Research centers exist to do research, but also to make an impact. If you were to think about the work being done at the Risk Management and Decision Processes Center, what would you say its impact has been on the practice of management so far, and what kind of impact would you hope to have in the future?
Kunreuther: Well, I think I’d come back to some of the studies that we’ve done that actually are more optimistic than we would have thought when we started 30 years ago. I’ll just use the S&P 500 study that I mentioned earlier, which is looking at how firms have behaved. I think one of the major changes that has occurred is that firms are really seeing this issue as being important on the firm side. Maybe not the consumer yet; although as Bob was saying, maybe they’re still facing the challenge of how to deal with it. But firms are really focusing on this now.
I think what we’ve heard in almost all of our interviews with chief risk officers, CEOs or high-level people in these firms, is that now we’re in a new era of catastrophes. We’ve got to be thinking about these issues. It’s an important issue for the board. It’s an important issue for us to pay attention to. And most important, we’re learning from our past experience, which is one of the decision processes that we always focus on. There is a set of biases that exist when you have a serious disaster, then you pay attention. Firms are now paying attention to it in a way that they haven’t paid attention before.
I think the challenge for the center is to take advantage of the fact that people are now thinking about these issues, to begin to suggest some policies and programs that are a lot harder to actually adopt, not only for these firms, but for countries. I think the interdependency, the global issues, are important for our work not only on climate change, but on a lot of other risks. How do we actually take some steps so that we are able to change a system that’s not just for the corporations or for the individuals, it’s for legislation, it’s for governments and the public sector? We’ve put a fair amount of attention into trying to work in the U.S. with Congress, and with other countries’ governments, to try to deal with that. The World Economic Forum and the OECD are groups that we really have an integral working relationship with and are involved with, in order to make inroads on international and global problems. That’s what we really have to do, is to try to figure out how we take advantage of where we are today to make some very important changes as we go forward.