Showing posts with label Laplace. Show all posts
Showing posts with label Laplace. Show all posts

Dec 3, 2010

God’s Definition of Risk

To snap things in the right perspective, now and then it's good practice to consider how actuarial science really started:

Yes, like Laplace stated in his masterwork 'Théorie Analytique des Probabilités', it all began with 'games of chance'... and - today -  perhaps it still is.....

From 'gaming', probability theory developed to 'actuarial science' and finally to 'risk management'.

Risk Levels
Today we distinguish three main types of risk levels:

Risk Level 1
In fact what we are modeling mostly, are the risks we know, the 'known risks'... These risks are the familiar operational, financial and compliance risks

Risk Level 2
These are the strategic risks. Risks related to new markets, mergers and acquisitions, investments, but also business development, brand and reputation risks.

Risk Level 3
These are the unpredictable, the so called 'unknown, unknown risks'.

The Rumsfeld definitions of risk levels
A similar more humorous, but also interesting definition of risk levels, has been given by the United States Secretary of Defense  Donald Rumsfeld  during the Iraq War:
  1. Known Knowns
    There are known knowns; there are things we know that we know
  2. Known Unknowns
    There are known unknowns; that is to say, there are things that we now know we don’t know
  3. Unknown Unknowns
    But there are also unknown unknowns; there are things we do not know we don’t know."

If we're honest, we'll have to admit that even our 'known known' and 'known unknown' risks in our models in reality have a high 'unknown unknown' origin.

Or, as Barry du Toit at Riskworx shows in an excellent paper called 'Risk, theory, reflection: Limitations of the stochastic model of uncertainty in financial risk analysis' : our stochastic model of uncertainty is powerful but limited.

It's (p.e.) an illusion to use 'standard deviation' as a stand alone measure for risk. We must be aware to apply our models without a healthy portion of 'common sense'. Or, to put it in air-plane words:

The danger inherent in 'altimeter usage' is that its unquestioning use will stop pilots from using a range of more intuitive risk measures, such as looking out of the window!

God’s definition of risk
There is no ultimate "God’s definition of risk", we'll have to manage with our limited models as a help to our Risk Insight. Success!

Sources and related links:
- Limitations of the stochastic model of uncertainty in financial risk analysis
- Laplace: analytic theory of probabilities (English)
- Strategic Management of Three Critical Levels of Risk
- Managing Projects in the Presence of Unknown Unknowns