Estimating Individual Risks

Here theory meets solid practical experience.

The direct estimation method integrates the definition of the risk and the agreed timeframe and confidence level with the judgments of independent risk assessors and relevant line managers.

The business line managers explore with the independent risk assessors some known or hypothetical extreme loss scenarios in order to quantify their full economic impact and their likelihood of occurrence. Their combined experience is also used to choose or confirm an appropriate shape for the risk distribution. This allows the risk's quantification to be extrapolated beyond the individual scenarios considered to the other confidence levels. In my experience it is possible to associate default risk distribution shapes (say out of half a dozen alternatives) to the different types of risk at the outset.

For instance, a line manager may only be comfortable estimating moderate extreme loss incidents, say that might happen once in every ten years. This estimate can be combined with a default risk distribution shape to calculate the impact at any other confidence level. It also allows calculation of an expected economic loss (the mean of the distribution) or most frequent outcome (the mode).

This estimation method is clearly both an interactive and iterative process. The expertise of the business managers and the independent facilitation and procedural consistency of the risk experts are both essential. The first estiamted risk distribution may not stand close consideration, leading to a revised scenario quantification or a different underlying distribution shape being chosen.

Underlying loss data is critical to support this confirmation processs, but not often available, at least at first. Moreover economic loss is much broader than accounting loss; and "extreme loss" incidents may have occurred in other similar organisations. The use of documented external risk incidents is important both to evoke risk consciousness but also to validate the "extreme loss" impacts estimated. For example, the Hammersmith and Fulham 1991 swaps disaster, with cautious banks still losing up to GBP75m, is a timely reminder to those in new business areas confident that they have eliminated all legal risks.

The independent risk experts are essential for consistency and integrity. They also add value to the process by sharing risk and risk management knowledge gained both externally and elsewhere in the organisation. This is not just a measurement exercise, but an investment in risk management culture.

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Last updated:16/5/07

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