Risk Aversion, Managing Risk in Extreme Environments, and Rare Events

risk aversion

18Sep08

This term is being bandied about a lot at the moment. It has a formal definition in the literature. But in extreme environments — and we are in one now, economically speaking — behaviours that speak of the big risk-taker may be misleading. I came across the following in Finance Director Europe by risk management specialist Duncan Martin who authored the book Managing Risk in Extreme Environments: Front-line Business Lessons for Corporates and Financial Institutions:-

Critically, risk aversion does not necessarily make you safer. Many people or communities express a low-risk enthusiasm but baulk at the expense of reducing their risk to match their appetite. They simply hope that the rare event doesn’t happen. However, in the end, even rare events occur. The results of mismatching risk appetite and resources were devastatingly demonstrated recently as Hurricane Katrina smashed into New Orleans.

Conversely, a large risk appetite is not the same thing as recklessness. A counter-intuitive aspect of risk management in extreme environments is that although the individuals concerned are very comfortable with risk, they come across in conversation as somewhat risk averse. While they accept risk in the sense that ‘everyone dies sometime’, they work hard to eliminate or mitigate tangible risks as far as they can.

Anyone who fails to manage risk in an extreme environment tends not to last too long. One former UK Special Forces officer relates the following episode:

‘We were in the back of the Land Rover, expecting contact [battle] any minute. Everyone was quiet, going through the plan in their heads, controlling their fear – except for one bloke at the back, who was mouthing off. He hadn’t been in a fight before and I guess this was his way of compensating. I decided that the first thing I would do when we got out of the Land Rover was hit him in the head with my rifle butt. He was too dangerous; I couldn’t accept the risk that he posed to the operation.’

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