Simulation models and analytics are helping risk managers and decision-makers understand the effect of uncertainties and the trade-off between risk and return
“The difference between risk and probability is that probability is everywhere, but risk is in the eye of the beholder,” says Sam Savage, the executive director of Probability.org.
Savage was speaking at the third day of inaugural Risk Awareness Week 2019 this morning, where he examined new models that are helping executives make decisions.
He explained that companies will have different risk attitudes from one another, so risk managers must find ways of using models to demonstrate the impact of decisions on probabilities.
The workshop showed how the free SIPmath enables simulation models to be communicated to senior decision makers, helping them to understand and appreciate the effect of uncertainty and the trade-off between risk and return.
What is critical here, says Savage, is the idea of limbic analytics, and models that can show executives how different probabilities can affect both their risks and their potential profits.
He started with the example of work that his company had done with Dutch Shell. One of the problems facing Shell was that while they could simulate individual oil exploration projects, they were unable to simulate a large portfolio of these.
By using the SIP technology, Savage was able to show visually how multiple projects could impact each other. This allows executives to look at the total risks, profits and probabilities even when it comes to multiple lines of business or differing areas of risk.
Using data in this way, means that decision makers can easily see what the impact of certain decisions are, Savage explained. It also means that they can evaluate how different projects running simultaneously might exacerbate a risk while running a different two might hedge one.
For example, if your two highest profitability ventures both involve providing oil to Europe, and the market collapses, then both projects will see a loss. But a lower profitability project that involves a pipeline elsewhere might helpfully hedge country specific risk.
As well as showing you how your different projects interact, the tool is visual, so you can easily demonstrate to managers what impact any individual decision will have on the risks, profits and probabilities involved. This means that managers can make informed decisions based on facts and within any given organisation’s risk appetite.
Savage explains: “Probabilities allow you to look at how different ventures interact and whether the risks overlap.
“The old way was to be a bully and put your favourite projects in, but with a model like this everyone else can see the risk of those decisions in a multi-dimensional way… It doesn’t give you the answer, there are trade-offs… but the social impacts of this on management are quite profound.”
He also talked about developments on the SIP model, such as SLURPS which are Stochastic library units with relationships preserved.
In a nutshell, these methodologies allow you to look at frontier hedges of probability without having to rely on emotional guesses about what the right business decisions are. Instead you can model scenarios and run different models depending on risk attitude and make an educated and informed decision.
Savage explained: “The biggest problem you have is not modelling these ideas, but getting management to understand the problem with the flaw of averages.
“Risk has to do not with average cases but with worse cases, with Sips you can have the 90% percentile of the sum.”
“Then you can start looking at different positions. The idea is keep the uncertainty alive, get the uncertainty in front of the stakeholder in an optimal way showing optimal trades offs. They can make the decision making by the seat of their pants, but only after they’ve been educated.”
To view Savage’s full workshop, click here: https://2019.riskawarenessweek.com/talks/the consolidated-risk-statement/