Bringing people (back) into risk analysis

Abstract

This paper explores the different ways in which people (i.e. human factors) have been incorporated in extant studies of risk. A preliminary scan of the literature shows that people are not just passive maleficiaries of risk but are also active participants in its inception. People are actors whose biases and behaviors give rise to risk and make an impact on both the degree of its likelihood and the severity of its consequences. Because people themselves undertake risk analysis (either as experts and/or stakeholders), the risk analysis process itself is subject to biases and human error. Therefore, it is argued that human factors must be explicitly brought into risk conceptualization, analysis, and theory development in order to enrich and extend the frontiers of the field. Scholarly contributions by members of the Society for Risk Analysis Australia and New Zealand (SRA-ANZ) investigating the challenges and complexities of incorporating people in risk analysis are introduced in this issue.     

The importance of risk and insurance teaching within the ARIA mission

The American Risk and Insurance Association (ARIA) is a scholarly association devoted to the study of and promotion of risk and insurance economics and has a history of innovative scholarship in fields that are vital to economic development and resiliency throughout the world. Association members have an equally important mission and history of passing along important knowledge to students and the risk professions. The Risk and Insurance Teaching Society (RITS) was established as part of the pedagogical and academic program roles of ARIA. This paper outlines the importance of pedagogy within business higher education and more specifically within the academic discipline of risk and insurance and the increasing role that RITS plays in pedagogical innovation and idea sharing among risk and insurance academics.     

How do consumers evaluate risk in financial products?

Decision-making processes consumers use in investing lump sums are reviewed, focusing on how investment risk is perceived and assessed. Primary research was undertaken with investment customers to explore the role played in evaluation of investment risk by risk perceptions and risk propensity. Both the literature review and the research findings indicate the central role risk perceptions play in financial decisions. Sitkin and Weingart's risk model is used as a research framework. Risk propensity and risk perception were found to be negatively correlated, however, deposit accounts were selected for investment irrespective of how risky a respondent considered them to be. Risk perceptions and expected return were positively correlated for all asset types apart from property. Further investigation revealed that experts exhibited positive correlation in risk return judgments but novices showed no correlation. There was no correlation between risk and return for either novices or experts for property. Return expectations were positively correlated with investment allocation. Provision of past performance information appears to create an expectation for future returns around the same level as past returns. Research findings suggest that outcome history is a predictor variable, with a Positive outcome history leading to higher risk Propensity. The level of risk customers are assuming shows a significantly increasing trend.     

Exploring the market risk profiles of US and European stock insurers

Market risks account for an integral part of insurers' risk profiles. We explore market risk sensitivities of insurers in the United States and Europe. Based on panel regression models and daily market data from 2012 to 2018, we find that sensitivities are particularly driven by insurers' product portfolio. The influence of interest rate movements on stock returns is 60% larger for US than for European life insurers. For the former, interest rate risk is a dominant market risk with an effect that is five times larger than through corporate credit risk. For European life insurers, the sensitivity to interest rate changes is only 44% larger than toward credit default swap of government bonds, underlining the relevance of sovereign credit risk.     

How attractive is central Eastern Europe for risk capital investors?

This paper addresses the attractiveness of Central Eastern European countries for risk capital investors by the construction of a tailored composite measure. Based on a survey among institutional investors, we define six key drivers that determine an emerging country's attractiveness for this type of investment. Using 42 socio-economic data series as proxies for these six key drivers, we benchmark the Central Eastern European countries with EU-15, Norway, and Switzerland and identify six tier groups of country attractiveness. We highlight socio-economic strengths and weaknesses of Central Eastern Europe and provide guidelines for policy improvements to attract more risk capital funding to spur innovation, entrepreneurship, employment, competitiveness and growth in the emerging region.     

GIRA: a general model for incident risk analysis

Most existing risk analysis methods focus on analysing risks that a system might face throughout its life. However, there is no explicit method for risk analysis during incidents. Approaches such as bow-ties and attack trees provide reliable information about triggers and escalation of incidents, but do not cover risk evaluation. Risk matrices include the entire risk analysis process; however, their risk evaluation approach is oversimplified. This paper presents a General Model for Incident Risk Analysis, which formalises the incident risk analysis process through an influence diagram. Our aim is to provide a decision support model that generates reliable risk information and enhances incident risk evaluation.     

Transitions in environmental risk in a transitional economy: management capability and community trust in Russia

Following the collapse of the Soviet Union 10 years ago, the Russian Federation has undergone a radical social, political and economic transformation. This paper's focus is particularly on the consequences of this transformation for the natural environment. This is done by utilizing Beck's (Risk Society: Towards a New Modernity, London: Sage, 1992) concept of Risk Society to explore the interrelationships between managers, firms and communities in terms of transitions in capabilities, knowledge, trust, and even the very notion of community vis‐à‐vis pollution control and environmental protection. A qualitative study of managers in Russian manufacturing enterprises, environmental regulators and local communities, was undertaken in two provincial Oblasts in the Russian Federation, identifying a number of factors characteristic of Beck's (1992) treatise including ‘risk culture’, ‘organized irresponsibility’, ‘individualization’ and ‘subpolitics’. In so doing a deeper understanding is developed of the impact of economic transition on the environment, indicating a different risk society trajectory to that predicted for the West. The implications for continued, in‐depth research in focusing on economies in transition are also discussed.     

Sovereign risk spillovers: A network approach

Understanding the global financial network for sovereign debt, particularly with a focus on interaction and spillover effects of sovereign risk, has become important for policy makers as they look to protect the stability of their economies. Using high dimensional Vector Autoregression techniques and network simulation on Sovereign Credit Default Swaps (CDS)’ data of 57 countries, we identify that the global sovereign CDS network is fully integrated as there is virtually no country without any connection to at least one specific node in the system. However, each country has a unique attribute in the network, as a risk exporter or importer and/or risk transmitter. Among developed countries, the US (unsurprisingly) holds the dominant position as a risk exporter while Germany is identified as a connecting country that transmits shocks. The most connected countries in the sovereign CDS network belong to the new European Union members. We examine possible drivers of the network relationships observed, in order to better understand the risk transmission process, and find that connections in the sovereign risk network are stronger within regional groups and countries with the same level of economic development. Central and Eastern Europe and Middle East and Africa have more interactive networks than Northern Western Europe, Asia Pacific and Latin America. We also identify that financial volatility and economic policy uncertainty increase the interactions in market-based default risk assessment.     

Transatlantic systemic risk

In this paper we study systemic risk for the US and Europe. We show that banks’ exposures to common risk factors are crucial for systemic risk. We come to this conclusion by first showing that relations between US and European banks are smaller than within each region. We then show that European banks react more strongly to the onset of the financial crisis than US banks. Regarding the consequences of systemic risk, we show that dependence between the banking sector and a wide range of real sectors is limited. Our results imply that regulators and supervisors should address international bank dependencies arising from common risk factors, while recessions in real sectors due to bank defaults should be a secondary concern.     

An integrated approach to supply chain risk analysis

Despite the increasing attention that supply chain risk management is receiving by both researchers and practitioners, companies still lack a risk culture. Moreover, risk management approaches are either too general or require pieces of information not regularly recorded by organisations. This work develops a risk identification and analysis methodology that integrates widely adopted supply chain and risk management tools. In particular, process analysis is performed by means of the standard framework provided by the Supply Chain Operations Reference Model, the risk identification and analysis tasks are accomplished by applying the Risk Breakdown Structure and the Risk Breakdown Matrix, and the effects of risk occurrence on activities are assessed by indicators that are already measured by companies in order to monitor their performances. In such a way, the framework contributes to increase companies’ awareness and communication about risk, which are essential components of the management of modern supply chains. A base case has been developed by applying the proposed approach to a hypothetical manufacturing supply chain. An in-depth validation will be carried out to improve the methodology and further demonstrate its benefits and limitations. Future research will extend the framework to include the understanding of the multiple effects of risky events on different processes.     

Systemic risk analysis using forward-looking Distance-to-Default series

Based on Contingent Claims Analysis, this paper develops a method to monitor systemic risk in the European banking system. Aggregated Distance-to-Default series are generated using option prices information from systemically important banks and the STOXX Europe 600 Banks Index. These indicators provide methodological advantages in monitoring vulnerabilities in the banking system over time: (1) they capture interdependence and joint risk of distress in systemically important banks; (2) their forward-looking feature endow them with early signaling properties compared to traditional approaches in the literature and other market-based indicators; (3) they produce simultaneously smooth and informative long-term signals and quick and clear reaction to market distress and (4) they incorporate additional information through option prices about tail risk and correlation breaks, in line with recent findings in the literature.     

Political Risk as a Determinant of Southern European FDI in Neighboring Developing Countries

This study analyzes foreign direct investment flows from southern European countries to one of two nearby developing regions: north African countries and new European Union member states in central and eastern Europe. As expected, good economic perspectives, human capital, and development of infrastructures attract greater investment flows. However, greater levels of political risk, measured through scales of political discretion, corruption, and economic freedom, do also attract higher inflows. Despite the fact that one might expect global flows to fall as a consequence of political risk, those from the countries in the sample increase, because they come from firms that are searching for a market niche where they can take advantage of their political capabilities.     

Testing the risk as feeling and risk as analysis perspective for insurance: the antecedents of purchasing unit-linked life insurance products

Risk and uncertainty are critical to human decision-making. Yet our understanding of the underlying traits that present the foundation of decision-making remains limited. The work develops a causal model of the antecedents of consumers’ purchase behavior in the context of unit-linked life insurance products. Our experimental approach (n?=?929) builds on the risk as analysis and risk as feeling perspective, which entails huge theoretical and practical contributions. Risk avoidance and uncertainty avoidance are identified to strongly influence the product perceptions. We complement our findings by investigating the conditions that favor the influence of both traits by investigating moderating effects.     

The social risk–rent thesis: A reply to Harney

The paper responds to Stefano Harney's critique, ‘Accounting, Risk and Revolution’ and in doing so offers a further extension of Toms, 2006, Toms, 2010 perspective on labour rents and capitalist risk. Harney's challenge, to ask what is left out of critical accounting's account of risk, is an important one. Therefore the social rent–risk (SRR) hypothesis extends the analysis of critical accounting from systematic risk to include firm specific risk and primitive accumulation risk. It is argued that the SRR approach provides a generalised method of accounting for social relations of production and the necessary conditions of social transformation.     

Idiosyncratic risk and the cross-section of stock returns: Merton (1987) meets Miller (1977)

Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] predicts that idiosyncratic risk should be priced when investors hold sub-optimally diversified portfolios, and cross-sectional stock returns should be positively related to their idiosyncratic risk. However, the literature generally finds a negative relationship between returns and idiosyncratic risk, which is more consistent with Miller's [1977. Risk, uncertainty, and divergence of opinion. Journal of Finance 32, 1151–1168] analysis of asset pricing under short-sale constraints. We examine the cross-sectional effects of idiosyncratic risk while explicitly recognizing the confounding effects that dispersion of beliefs and short-sale constraints produce in the Merton framework. We find strong support for Merton's [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] model among stocks that have low levels of investor recognition and for which short selling is limited. For these stocks, the relation between idiosyncratic risk and expected returns is positive, as predicted by Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510].     

Extreme risk spillovers from commodity indexes to sovereign CDS spreads of commodity dependent countries: A VAR quantile analysis

Given the financialization of commodities and the increase in the CDS markets' size and structure, we examine the co-movement and dependence structure between four commodity indexes and sovereign credit risk via an extreme volatility risk spillover methodology. We use the daily change in sovereign CDS data between October 1, 2010 to March 31, 2020 for ten commodity-dependent countries and four commodity indexes (agricultural, precious and industrial metals, and energy). The results of White et al.'s (2015) VAR for Value at Risk (VaR) and the pseudo quantile impulse response function (QIRF) show that the volatility of the primary commodity export category (e.g., agriculture, mineral, and energy) substantially influences the volatility of sovereign spreads (except for two agriculture-dependent exporters). Still, it does not always have the strongest risk spillover effect when other commodity indixes are included in the analysis. When drilling down on the data and examining the single commodity index (i.e., gold, corn, etc.), our results indicate that the primary commodity exports significantly influence the volatility of its sovereign CDS spreads. Based on the results of the QIRF, most shocks are absorbed within 30 days. Most risk spillover from the volatility of sovereign CDS spreads to the volatility of commodity indexes is found to be insignificant.     

Towards a concept of genetic risk tolerance: a risk analysis perspective

The starting point of the MindTheRisk project has been to raise socio-political questions about whether lay public’s understanding is satisfied about the genetic information they receive, and to what extent regulators do take this aspect on board when they decide to allow or restrict genetic testing or to develop communications about genetic testing. This article draws on the concepts that have emerged among the risk research community to tackle “risk tolerance’’. It explores the application of those concepts to the sharing and regulating of genetic risk information. We start with a conceptualisation of risk acceptability/tolerability in the genetic context, before turning to concrete hurdles that need to be overcome and questions that need to be answered. Finally, we suggest some direction for policy. The paper is based on an in-depth review supplemented by pilot interviews conducted with the European Medicines Agency, National regulatory agencies, academic and members of a patient organisation, all directly involved in policy.     

Fuel Risk Management at American Electric Power

The senior management team and board of directors at American Electric Power (AEP) have emphasized the importance of an Enterprise Risk Management approach for dealing with the wide array of risk exposures that the firm faces. Senior management has put in place a risk governance structure that facilitates the identification of major risk exposures, assesses their impact on the firm's overall risk profile, and interacts the risk management process with the strategic planning process. Central to this structure is the firm's Risk Executive Committee, which includes the senior leadership of the firm and the Enterprise Risk Oversight staff. Members of the AEP Enterprise Risk Oversight group have just returned from a meeting of the Risk Executive Committee. The discussion at the meeting focused on an event that recently came to the firm's attention—an unexpected disruption in the firm's coal supply over the coming year due to necessary repairs in railroad facilities near the coal source. By the end of the week, the Enterprise Risk Oversight group needs to communicate with the relevant teams within the organization as part of its effort to identify the potential repercussions of the event for the enterprise. In addition, the Risk Executive Committee would like the groups to identify other possible adverse events that could occur and steps that should be taken now in preparation.     

Short-term determinants of the idiosyncratic sovereign risk premium: A regime-dependent analysis for European credit default swaps

This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility.     

Interest rate linkages within the EMS and bank credit supply

The exchange rates between the currencies of European Monetary System (EMS) members are essentially fixed between narrow bands mandated by the Exchange Rate Mechanism (ERM). the intent of such a fixed rate regime is to enhance policy co-ordination within the EMS. However, it has instead led to German policy dominance within the system according to several recent studies. We examine the optimal dynamic credit policy of a bank in an EMS country that is subject to such German ‘dominance’. Our stochastic control model reveals conditions under which German monetary policies can influence domestic bank lending behaviour. It also suggests that banks may be able to hedge such risk exposure by increasing in size. the model offers ‘credit supply' based explanations for recent regulatory reforms in Europe towards unified banking and the attempts of several EMS members to de-link their policies from that of the German Bundesbank.