Fundamentals of Risk Management

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Fundamentals of Risk Management
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The Ubiquity of Risks in Todays Socio-technical
Systems

• Automobile and plane crashes
• Toxic chemical spills and explosions
• Nuclear accidents
• Water and food security (contamination, shortage)
• Genetic manipulation
• Infectious diseases (AIDS, bird flu)
• Global climatic change
• Ozone depletion
• Extinction of species
• Oil dependence
• War and terrorism
• On and on and on

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The Rational Actor Standard

• Choice of actions
• Range of possible outcomes
• Assign probabilities to outcomes
• Order outcomes according to preferences
• Select optimal action
• Expected value calculations

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The Rational Actor acts

• Action is . purposeful behavior. Or we may
  say, action is will put into operation and
  transformed into an agency, is aiming at ends and
  goals, is the egos meaningful response to
  stimuli and to the conditions of its environment,
  is a persons conscious adjustment to the state
  of the universe that determines his life.
• Ludwig Von Mises, Human Action (1949) p. 11

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Human action vs. Human behavior

• Action has reasons, behavior has causes
• Action institution, will, duty,
  responsibility, obligation, right,
  constitution, contract, custom,
  traditions, and collective choices.
• Behavior social organization, behavioral
  measurement, human relations, reliability,
  validity, organizational design, attitude,
  human performance, power, performance
  evaluation, and leadership.

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Risk Evaluation vs. Management A Proposed
Distinction

• Risk Evaluation the cognitive process of
  determining or specifying a risk prior to making
  a behavioral commitment
• Risk Management the cognitive and behavioral
  process of designing and implementing controls on
  risky systems

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Evolution of Risk Management

• Early humans risks small scale, local
  management relatively straightforward
• Technology led to evolution of systems with
  larger scale, greater complexity
• Risk evaluation and management, today define the
  key analytical lens for attempting to anticipate
  the consequences of human action in social and
  environmental systems

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Definition of a System

• A section of the universe which an observer
  chooses to separate in thought from the rest of
  the universe for the purpose of considering and
  discussing the various changes which may occur
  within it under various conditions (J. W. Gibbs)
• Usual distinction made between (1) an observed
  object, (2) a perception of the object, and (3) a
  model of the object

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A Generalized Structural Graphic of a System
Environmental boundary
Outputi
Inputs
Process
Inputt
Outputj
Inputu
Feedback
Environment
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The Concept of a Structure

• A generic notion the structure of a building,
  a brain, an organization, a society, a research
  design, a decision process, a system
• A discernable (persistent) pattern or set of
  relations that connect a set of terms, nodes, or
  objects
• Formal bodies of scientific knowledge have a
  structure

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Systems concepts provide a means of integrating
basic tools of thinking

• Memory
• Association
• Pattern discernment and recognition
• Reason
• Experience
• Invention
• Experimentation
• Intuition

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Risk Management through Systems Control

• Choosing the inputs to a system so as to make the
  state or outputs change in (or close to) some
  desired way. (Arbib)
• A constraining effect on a variable
• A directing influence on the behavior of a
  system, or the setting of the parameters of a
  system.
• Any one-way communication, which by definition
  conditions a receiver's behavior in some
  respects, involves control (Principia Cybernetica
  Web)

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The Concept of a Constraint

• Limitations that preclude certain actions
• May preclude achievement of certain objectives
• Actions not precluded are feasible
• Elastic (removable) vs. inelastic (not removable)
  constraints
• Binding vs. nonbinding constraints

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Leibigs Law of the Minimum


                                                                  
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Large Scale Systems

• Costs
• Numbers of people
• Geographical or other extent of influence
• Volume of information required to describe what
  is happening within the system
• Number of interaction between components
• Size of the potential for disaster
• Extent of consequences of systems failure.

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The Structure of a Concept

• Underconceptualization a problem in managing
  risk in large scale, complex systems
• Concept a cognitively significant word or phrase
  used in a proposition to represent some aspect(s)
  of a system
• The division of a concept C is a concept, D(C)
  is a division of C if D(C) partitions C into
  components (Warfield 1990)

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Complexity may be conceived as

• ..the predicament presented to the human mind
  when it encounters conceptualizations that exceed
  its unaided power to assess or evaluate.
• John N. Warfield, Understanding Complexity
  Thought and Behavior

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Structural Underconceptualization

• When managing risk in complex systems, the
  formal, logical structure of the system is
  usually not specified. Why?
• Ignorance
• Decision-makers have diverse beliefs about the
  situation (often do not even share same
  linguistic domain)
• Organizational linguistics
• Differing values

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The Genesis of Value

• What are values?
• Are values controlled by hereditary instincts,
  genes, and personalities?
• Are individuals values determined by society?
• Are any values autonomously chosen?
• Can a unified theory of risk evaluation ever be
  obtained without answering these questions?

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A Key to Coherence in Managing Risk in Complex
Systems

• Recognition that there is an unavoidable trade
  off between simple assumptions and sophisticated
  models, and sophisticated assumptions and simple
  models
• The former is more the norm (e.g. neoclassical
  and price theoretic models of economic systems
  all assume homo economicus Marxs model assumed
  communist man)
• The latter is generally superior when dealing
  with large scale complex systems

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Disparate Risks and Catastrophes

• Disparate risks a serious imbalance among
  outcomes (no matter probabilities)
• A potential catastrophe exists when risks are
  so disparate that one outcome is incomparably
  greater than the alternatives
• Reschers principle All else equal, an action
  that might lead to a catastrophe makes that
  action ineligible (avoid any real catastrophe at
  any ordinary cost).

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Insurance Against Catastrophe

• Insurance as a device for reducing the prospect
  of substantial loss (a trade of hazards)
• The value of (price the rationale actor is
  willing to pay for) an insurance policy depends
  upon the alternative actions in the choice set.

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Risk Dilemmas

• Sometimes, all of the alternative feasible
  actions entail catastrophe
• In this case, the relative size of the
  catastrophe is the paramount factor
• The distinction between catastrophe and
  acceptable risk is a judgmental issue (example of
  Japanese attack on Pearl Harbor, page 90,
  Rescher)

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A Fundamental Principle of the Theory of Risk

• Risk acceptability is always comparative,
  relative to the options, and thus unacceptability
  is never absolute, only relative
• Implicit the risk-free option is, at times, not
  an element in the choice set

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Uncertainty

• Uncertainty indetermination through ignorance of
  otherwise, of some of the characterizing elements
  of a risk situation
• Reschers three modal taxonomy
• (a) Probability uncertainty (P-uncertainty)
• (b) Result uncertainty (R-uncertainty)
• (c) Outcome uncertainty (O-uncertainty)

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A brief history of uncertainty

• Plato lack of trust in sense experience as a
  basis for knowledge
• Rene Descartes systematic doubt, and the search
  for a priori certainty
• David Hume the problem of induction
• Wittgenstein language games
• Karl Popper Induction

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P-uncertainty

• Probabilities cannot be reliably determined
• Insufficient data to establish relative
  frequencies
• Insufficient theories, models, or data to
  establish likelihoods (e.g. nuclear casks)
• Subjective probabilities
• What probabilities does one use when evaluating
  the risk of nuclear war?

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R-uncertainty

• One faces outcomes with imponderable values
• Uncertainty about how to evaluate an outcome
• How did Truman value the loss of life when
  deciding to bomb Japan?

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O-Uncertainty

• Scientific knowledge is inadequate to describe
  the nature of the hazard
• Cannot fully specify range of outcomes
• What outcomes will follow from the US military
  invasion of Iraq?
• What is the national security risk attributable
  to US dependence upon Mid-Eastern oil?

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The Ecology of Uncertainty Sources, Indicators,
and Strategies for Informational Uncertainty

• Schunn, Kirschenbaum, and Trafton effort to
  develop one taxonomy each for sources, indicators
  and strategies
• Focus upon evaluation and management of
  uncertainty in three domains
• a) meteorological forecasting,
• b) fMRI data analysis
• c) submarine operations
• Interest in informational uncertainty

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Information

• Shannon, that which reduces uncertainty
• Bateson, a difference that makes a difference
• . equivalent of or the capacity of something to
  perform organizational work, the difference
  between two forms of organization or between two
  states of uncertainty before and after a message
  has been received Principia Cybernetica
• Elementary unit in information theory bit, a
  difference (e.g. between a 0 and a 1)

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Sources of Informational Uncertainty

• Physics uncertainty
• Computational uncertainty
• Visualization uncertainty
• Cognitive uncertainty

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Physics Uncertainty is uncertainty attributable
to

• Absence of a signal
• Noise/bias in the signal
• Noise/bias in the way the signal is transduced

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Computational Uncertainty is uncertainty
attributable to

• Unpredicted perhaps unpredictable? future
  changes in the system
• Statistical artifacts (e.g. the imposition of
  linearity, statistical assumptions, smoothing
  operations on data)
• Fast and cheap elaborate algorithms that require
  lots of time to run, even on high powered
  computers (more time than is available to the
  decision-maker)

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Visualization Uncertainty is uncertainty
attributable to

• Limits on the information that can be logically
  derived from a structural graphic
• Sometimes information is missing from the
  structural graphic
• Sometimes multiple dimensions are represented by
  composite indicators
• Sometimes there are multiple graphics that
  contain conflicting information

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Cognitive Uncertainty is uncertainty
attributable to

• perceptual error (e.g. in encoding, storing,
  retrieving, or processing visual information from
  the measurement devices)
• memory encoding error
• information overload
• retrieval error
• background knowledge error
• skill error

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Uncertainty Tradeoffs

• Tradeoffs evidently exist in which reductions in
  one source of uncertainty come at the cost of
  increases in other sources
• Physical and computational uncertainty
• Visualization and cognitive uncertainty
• Memory and perception within cognitive uncertainty

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Indicators of Uncertainty

• See no or unusually weak patterns
• See an impossible pattern
• See a pattern that mismatches a known state of
  the world
• See a pattern that is inconsistent across data
  sources

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Strategies for Dealing with Uncertainty

• Check likely errors
• Focus on reliable sources
• Adjust for known deviations from truth
• Average across sources
• Acquire more data
• Gather better data
• Bound uncertainty (satisfice)

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Implications of Deep Similarity Between Domains

• Taxonomies may be generalizable to other domains
• Dissatisfaction with conventional distinction
  between internal and external uncertainty
• Dissatisfaction with distinction between model
  errors and inherent stochastic variability
• Minor role of linguistic uncertainty

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Risk Management Strategies The Interrelation of
Rules

• Three cardinal rules of risk management
• Maximize expected values
• Avoid Catastrophes
• Dismiss Extremely Remote Possibilities
• The order of preference between them is (3),
  (2), (1)

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Risk Management Decisions

• May be oriented toward outcomes or toward
  processes
• Outcome orientation tends to be normative
• Process orientation tends to be descriptive
• Process orientation considers three stages
• 1) Pre-decision stage
• 2) Decision stage
• 3) Post-decision post-decision
• Each stage is itself composed of a series of
  partial decisions

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The Pre-decision Stage

• Motivated by a sense of discontent or conflict
  attributable to difference between an ideal and
  the real world (a problem)
• The decision-maker recognizes that the ideal
  alternative is infeasible (not in the choice set)

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The Decision Stage Sequences of Partial
Decisions

• Choice a matter of imposing constraints upon the
  decision situation in such a way as to rule out
  alternatives
• Alternative ways of binding the decision problem
  may be tried
• The choice is made when constraints are imposed
  and allowed to bind upon decision situations
  until only one alternative remains
• In Zelenys model, the operative rule is to thus
  select the alternative that comes closest to the
  ideal

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Question I

• Does the lack of an explanation of the genesis of
  value pose a serious threat to the orthodox
  theory of risk evaluation? If not, explain. If
  so, what in your view is the appropriate
  intellectual response?

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Question II

• Is there in your view a sense in which might one
  consider global security to be a matter of risk
  management? If so, in what way or ways do the
  basic concepts discussed today help to elucidate
  and examine it? If not, what alternative
  approach would you suggest other than risk
  management?

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Question III

• In your view, how realistic is the reasonable
  person standard at describing the psychological
  and social foundations of risk evaluation and
  management? Do you believe that risk managers
  really make autonomous decisions, or is all of
  the psychology involved in risk evaluation and
  management really social psychology?