Perception of Risk Posed by Extreme Events Risk Management Strategies in an Uncertain World Kim B. Staking

Risk Analysis Risk Assessment Risk Management Politics of Risk – “Preferences for risk decision alternatives are associated with differences in the perception of the relative risk of choice options rather than attitudes towards risk” (avoid options perceived as riskier)

Nature of Risk Scientific/technical/economic approach: Risk is Objectively quantified (quantifiable) by risk assessment Social science approach: Risk is seen as inherently subjective (“risk invented to help understand/cope with dangers and uncertainties of life) Can these approaches be reconciled?

Risk Perceptions Psychometric Paradigm Quantitative (normative) judgments on riskiness and desired regulation Perceived risk is quantifiable and predictable (orderly and complex) Factors: – Dread Risk – Unknown Risk – Number of People exposed (in some studies)

Social Amplification of Risk Amplification triggered by occurrence of adverse event (extreme event) Adverse impact may extend far beyond direct damage (litigation, loss of sales, increased regulation) Adverse impact may extend beyond responsible party

Human Processing of Risk Evolutionary (instinct) – Similarity and association – Hard-wired – Early warning system Rational – Algorithms and rules – Slow (not hard-wired) – need to learn rules Two rules work in parallel – often result in same decision – When systems disagree, evolutionary usually prevails – Rare events tend to over-weighted

Movement towards rationality Better information – Relate to problems at hand – Improve reliability of information – Increase trust in information Develop associations – Own experience – Experiences of others

Insurance Implications What impact does the price of risk have on perception or risk? How does the insurance industry communicate knowledge of risk? What happens to insurance markets When risk changes unexpectedly? – Change in judicial liability – Probability of Terror event

Emerging Market Examples Mortgage markets in Colombia and constitutional court – Direct impact – Capital Loss – Indirect impact – Higher cost of capital; loss of investment Collateral Arrangements in Latin America – Direct impact – higher risk  increased interest rate – Indirect impact – exclusion of some borrowers; slower decision making process

Suggestions for Empirical Testing Look at insurance markets when information is in flux. Attempt to replicate the analysis in other countries (look at behavior in emerging markets where exposure to extreme risk is more common.