Risk of Extreme Events and the Fallacy of Expected Value [chapter]

2005 Risk Modeling, Assessment, and Management  
Most, if actually not all, managerial decisions are characterized by (a) elements of risk, uncertainty, and .inadequate information and (b) multiple, noncommensurate, competing, and often conflicting objectives. To manage risk, professionals must assess it. This is usually done by a process of its identification, quantification, and evaluation. Thus, the assessment and management of risk is essentially a synthesis and amalgamation of the empirical and the normative, the quantitative and tbe
more » ... itative, and the objective and the subjective. This paper will address the process of risk assessment and management, focusing on the trade-offs that must be made among all costs, benefits, and risks. In the process of risk assessment, however, extreme and catastrophic events are often underestimated and commensurated with other less consequential events . Managers and decisionmakers are often most concerned with the risk associated with a specific case under consideration, and not with the likelihood of the average outcomes that may result from various risk situations. In this sense, the expected value of risk, which has until recently dominated most risk analysis in the field, is not only inadequate, but can lead to fallacious results and interpretations. A modification of this approach through the use of conditional expectation will be shown to better capture the risk of extreme and catastrophic events. This paper will focus on the importance of addressing extreme and catastrophic events explicitly and within the overall risk-based decisionmakmg process, where trade-offs among costs and risks can be generated and evaluated. 8 Y.Y. HA!MEJS all, engineering systems are designed, manufactured, marketed, distributed, apd maintained under conditions of risk and uncertainty. Technological risk, risk to human health and safety, and environmental risk -both man-made and natural -have also been of much concern to the public during the last two decades. Dam failures, nuclear power plant failures, ocean dumping of waste, groundwater contamination, hazards associated with nuclear and toxic waste disposal, and such natural calamities as earthquakes, landslides, tsunamis, windstorms, floods, volcano eruptions, and wildfires have claimed our attention recently along with the less visible but potentially adverse effects of acid rain and possible global warming . Whether the hazards are man-made, natural, or a combination of both, and whether the primary risks are to humans or the environment, fundamental and difficult choices must be made about which adaptive strategies will be the most effective and efficient. And, these choices cannot be made simply on the basis of the average level of adverse effects resulting from these natural and man-made hazards . Budgetary constraints and fears of adverse economic consequences add to the difficulty of making the right choices . With the increase of public interest in risk-based decisionmaking and the involvement of a growing number of professionals in the field, this relatively new professional niche of risk analysts has gained maturity as well as numb ers during the last decade. The professionals involved in risk-based decisionmaking are experiencing the same evolutionary process that systems analysts and systems engineers went through a decade or two ago and may be are still going through. That is , risk analysts are realizing and appreciating both the efficacy and also the limitations ofmathematical tools and systematic analysis . In fact, there are many who simply see risk analysis as a specialized extension of the body of knowledge and evaluation perspectives that have come to be associated with systems analysis. Professionals from diverse disciplines are responding much more forcefully and knowledgeably to risks of all kinds as well and, in many instances, are leading what has ultimately come t? be a political debate. This professional community is more willing to accept the premise that a truly effective risk analysis study must, in most cases, be crossdisciplinary, relying on social and behavioral scientists, engineers, regulators, and lawyers. And, this professional community has become more critical of the tools that it has developed because it recognizes their ultimate importance and usefulness in the resolution of critical societal problems. Clearly, for these risk methodologies and tools to be useful and effective, they must be representative, that is, they must capture not only the average risks but also the extreme and catastr.ophic · .mes . We are also able to acknowledge the fact that the ultimate ut,ility of decision analysis, including risk-based decisionmaking, is not necessarily to articulate the best policy option , but rather to avoid the extreme, the worst, and the most disastrous poli cies -those actions in which the cure is worse than the disease. Thus, risk assessment and management must be an integral part of the decisionmaking process, rather than a gratuitous add-on technical analysis. Viable risk management must be done within a multiobjective framework, where
doi:10.1002/0471723908.ch8 fatcat:ghx7jr3wlbb53gu2p33xhs2tfe