Risk in all its forms
Speech given on 25 October 2016 by Denis Kessler, representing the French Academy of Moral and Political Sciences.
Body
Risk is a variable that plays a fundamental role in all human decisions, both individual and collective. The principal characteristic of this variable is that it is "bipolar” in nature. It is interesting that this is reflected in its Chinese logogram, which accurately combines the two ideograms of danger and luck.
Risk’s negative pole evokes catastrophe, loss, ruin, despair, suffering and death. Risk is not something we can control, rather it is something we endure. Being closely related to harm and adversity, it is something we fear. We denigrate risk, seeking to shield ourselves against it, and when it does manifest itself, we bemoan it. Risk is a flaw, an imperfection, an error, an unwelcome intrusion. It generates fear, anxiety and incomprehension1. People believe risk to be largely "exogenous", outside their realm of responsibility; they “had little, or nothing to do with it”. Presenting itself in the form of accidents, losses and catastrophes, risk creates victims2. We have long considered risk to be divine will, or the work of the Devil, and we speak of it in terms of destiny, or as a curse and with a sense of fatality.
Viewed through this negative lens, the less risk there is in the world, the better our lives will be. To boost the population's well-being, we would need to reduce all types of risk to which we are exposed. From this perspective, we should do everything in our power to protect the physical and financial integrity of every citizen.
But risk also has a positive side that evokes endeavours, challenges, successes, exploits, achievements, conquests and heroism. In this case, risk-taking is not only intentional, but also admired, even glorified. Risk-takers are courageous, therefore virtuous. They are willing to lose in order to win. They go after victory at the risk of defeat. As the saying goes, "Nothing ventured, nothing gained". The hero is willing to risk his life or worldly possessions to advance further, at the risk of losing everything. In the words of Pierre Corneille, “To win without risk is to triumph without glory". Ad augusta per angusta. A risk-taker can or will become a hero, frequently admired by the risk averse among us.
This bipolarity also incorporates its psychological meaning: risk can cause suffering and depression, or excitement and pleasure.
A probabilistic world
Let's start by defining the modern concept of risk. It first materialised when we abandoned our determinist view of the world — a world in which our destiny was already written, Providence was omnipresent, and fatality governed — and replaced it with a probabilistic view.
This revolutionary shift dates back to the 18th century, with the Lisbon earthquake on 1 November 1755 playing a major role, as expressed by Voltaire with his own particular genius3. It was during this period that mathematicians established the key concepts of probability and statistics. Early work by Cardano (1501-1576), Fermat (1605-1665) and Pascal (1623-1662), was continued by Bernoulli (1654-1705), Lagrange (1736-1813), Laplace (1749-1827) and Gauss (1777-1855), and more recently by Borel (1871-1956), Itō (1915-2008), Arrow (1921) and Nash (1928-2015).
For every phenomenon, there are a number of possible "outcomes", both positive and negative. The occurrence of these outcomes corresponds to a law of probability explained in the terms of each scientific field. Historical experience has enabled us to identify, understand and corroborate the laws of probability. Divine intervention has thus been replaced with seismology, curses with genetics, and witchcraft with biology.
Each outcome is associated with a level of utility, which differs from one person to the next. A loss of €1,000 does not have the same value for one risk-taker as it does for another. In the face of risk, each of us seeks to maximise utility by weighing the utilities of the various outcomes against the probability that they will occur. From this angle, mathematical expectation replaces Providence!4 And science trumps divine will and obscurantism.
Risk and uncertainty
Risk is above all a knowledge problem. There are two spheres: 1) risk, i.e. the universe of probability, and 2) uncertainty, which does not appear to be governed by any law5. When uncertainty prevails, the future is unknown and cannot be seen. It is difficult to think the unthinkable, or to imagine unknown unknowns. But thanks to our ever-improving understanding, the sphere of risks has been steadily increasing, and that of uncertainty decreasing.
In a probabilistic universe, risk takes the form of a random variable which belongs in a distribution of probabilities. It’s the random nature of this law of probability that is for the most part unpredictable. While we know that John Graunt discovered the law of mortality in 16626, we do not know when any of us will die. It is not because we understand Portugal's seismicity that we can know with certainty that the ground will shake in Lisbon during mass on All Saints Day.
“Risk is not an event, a hazard, an accident, or an instance of good or bad fortune, rather it is a way of bringing all these things into existence through objectivity and value. There are no natural risks, nor indeed any risks without calculation, analysis and evaluation. Risk is a form of knowledge”7. There is a science of risk.
The risk universe is expanding
Risks are omnipresent, multifaceted, shifting, accidental or serial, independent or correlated, visible or latent. Let’s start with naturally-occurring risks. People have always feared natural catastrophes. The Bible makes reference to them all: volcanic eruptions, floods, earthquakes, storms, and so forth8. In fact, we call them Acts of God. These catastrophes have not disappeared and have become even more devastating than in previous times given the increase in population, population density and wealth.
Next there are man-made risks. Each scientific and technological development, and each new economic activity brings with it new risks, such as aviation accidents, nuclear explosions and cyber risks.
Lastly, there are "risks of the devil’s doing": violence, crime, war, terrorism... in short anything that can be described as voluntary destruction or violence towards mankind.
Major catastrophes, whether they are Acts of God, man-made or an act of the devil, have punctuated history and left a lasting imprint on human consciousness: Pompeii (79), the Black Death (1347), the great Fire of London (1666), the earthquakes in San Francisco (1906) and in Tokyo (1923), the Titanic (1912), the Spanish flu (1918), and the World Trade Center (2001).
The risk universe is expanding. Risks are becoming increasingly complex, interconnected and globalised. They therefore need to be managed, because the demand for security is paradoxically on the rise in the modern world.
Aversion to risk is the most commonly shared trait worldwide
In a probabilistic universe, we constantly need to be making decisions, which is a risky business in itself. Each of us adopts our own particular attitude to risk. Some people prefer stable but poorly paid jobs, others prefer risky but better remunerated work. Some people invest in bonds, while others opt for shares. Either we practice dangerous sports or we watch them in our slippers in front of the TV. We might challenge a verdict at the risk of receiving a harsher sentence on appeal, or we may be more fainthearted and accept the initial one.
To put it simply, a person is risk-averse if he or she would choose to walk away with €500 rather than risk losing it altogether for a 50% chance of winning €1,000. The person who makes the opposite choice is considered a risk-taker9.
Risk aversion is a “preference” which cannot be explained rationally: “De gustibus non est disputandum”10. And everyone fits into one of two categories: “riskophiles” in the minority, or “riskophobes” in the majority. Aversion to risk is clearly the most commonly shared trait worldwide.
Economists have tried to measure this variable more precisely and have discovered that people seem more risk-averse when faced with the risk of losing rather than the risk of winning.
Not all people have a clear vision of the risks that they face and do not know the underlying probability distributions. Information is often imperfect and subjective probabilities differ from their objective reality, especially for low-frequency risks.
The degree of risk aversion dictates our economic, financial and social behaviour, both individually and collectively, and thus our political choices.
In any case, risk-related losses that we inflict upon others must be repaired; this is the fundamental principle of civil liability. Nevertheless, the person causing the damage must have the means to cover repair costs. For this reason, civil liability has become a form of compulsory insurance, a prerequisite for social order.
The multiplicity of risk-management institutions
Over time, we have seen risk markets emerge in which certain people will pay to protect themselves from risk, while others will be paid to bear those risks: the foreign exchange market against currency fluctuations, the futures market against price fluctuations, the stock market against the risk of default of any given company, etc.
Many organisations, such as industry bodies, charities, mutual insurers, nonprofits, unions and public health insurance systems mutualise risk.
Mutualising financial risks within dedicated organisations (banks, insurance companies) creates a new risk, that of their insolvency. Hence the multiplication of prudential rules such as Basel III and Solvency II. And since the 2007 crisis, we now speak of systemic risk in relation to the collapse of the financial system.
Institutions such as the family, nonprofits, companies and the State are the first resort for managing risk among their members. Contracts often serve to share risks among the parties to the contract. Contracts are themselves risky, since the parties often have imperfect or asymmetrical11 information, because they are pursuing their individual strategic objectives. Contracts can also change the risk environment, a phenomenon known as moral hazard12. Accordingly, Jacques Rueff claimed that unemployment insurance had the paradoxical effect of increasing unemployment13.
The State, a major risk manager
Lawmakers are increasingly active in protecting their citizens in all areas of life. They pool the risks of old age, illness and work-related accidents at the national level, and compound legislation to prevent risks, heighten security and compensate victims.
Risk management is becoming the State’s main mission. We are becoming a very risk-conscious society.
Above and beyond traditional risk, society now also deals with the risk of exclusion, discrimination, precariousness and poverty. At the global level, States are now working together to combat the risks arising from climate change14.
Prevention is noble, precaution can be dangerous
In the risk-conscious society, the prevention principle is laudable15, but we should be more circumspect when it comes to the precautionary principle. If the precautionary principle means that we should stop developing technologies as soon as there is an uncertainty as to their consequences, then the principle itself is dangerous, since it could hamper scientific progress and the pace of innovation.
The future of the risk-conscious society raises three issues. The first is about responsibility: by making every loss eligible for compensation, we increase the number and types of victims and take away all individual responsibility. The second is about freedom: when everyone is protected by universal coverage, the proliferation of standards to control everyone’s behaviour hinders freedom. The third is about creativity: overly concerned by the negative side of risk and insistent upon eradicating risks, the risk-conscious society devalues risk-taking of the positive kind. Yet societies must take risks if they are to make forward progress.
Risk is intrinsic to entrepreneurship. In order for companies to develop and for new technologies to emerge, people need to take risks, to risk their name, their reputation, their assets. And they need to accept that they might fail. They take risks with the expectation that it will ultimately pay off, resulting in pecuniary benefits, or honour and recognition. Competition is risky, in that it is both creative and destructive. Being an entrepreneur is about accepting being ousted from the market, overtaken by competitors, or replaced by new technologies.
Appreciating risk-taking means not criticising failure, and above all accepting that success must be duly recognised and rewarded. Innovators, creators and entrepreneurs are people who deserve more respect.
The same applies to anyone involved in creative pursuits (art, music, architecture, cinema) who takes risks, upsets established order and transgresses codes and thus advances the arts and broadens our world view. Creating is a risky undertaking, just like entrepreneurship.
On the eve of a new risk culture
Letting ourselves believe that we can eliminate all risk – the absurd zero-risk thesis – is self-deception. Even if our understanding of risks continues to improve, we can’t stamp them out, because new risks are constantly emerging and mutating over time.
On the contrary, we should develop a new risk culture, dispel the fears created by scientific and technological progress and prevent the rise of a new form of obscurantism.
Society must accept these vagaries, not fear uncertainty or take refuge in irrational beliefs. “Without risk, there is no progress!” Let’s embrace a risk-conscious society, provided that it respects the principles of responsibility, liberty and creativity. Let’s embrace a risk-taking society, provided that risk-taking is valued, recognised and remunerated. These are the necessary conditions for reaching a new equilibrium between the positive and negative sides of risk and thus a better balance freedom and safety.
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1 DELUMUEAU, Jean, La peur en Occident, Fayard, 1978
2 KESSLER, Denis, « L’ère de la vulnérabilité », Risques, 2006
3 VOLTAIRE, Poème sur le désastre de Lisbonne, 1756
4 BERNOULLI, Jacques, Ars Conjectandi, Partie IV, traduction de Meusnier, 1713
5 KNIGHT, Frank H., Risk, Uncertainty, and Profit, Signalman Publishing, 2009
6 DUPAQUIER, Jacques, L’invention de la table de mortalité. De Graunt à Wargentin (1662-1766), PUF Paris, 1996, 177 p.
7 EWALD, François, KESSLER, Denis, « Les noces du risque et de la politique », Le Débat, 2002, n°109
8 SWISS RE, Sigma Report, 2016: natural catastrophes account for approximately ¾ of damage to persons or property
9 KAHNEMAN, Daniel, TVERSKY, Amos, Prospect theory: an analysis of decision under risk, Econometrica, volume 47, 2, 1979
10 This scholastic sentence was re-used by the Nobel prize for economy Gary Becker in an article he co-wrote with Georges Stigler on human preferences: “De gustibus non est disputandum”, American Economic Review, 1977
11 Which gives rise to the phenomenon of adverse selection
12 AKERLOF, George A., “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, The Quarterly Journal of Economics, 1970
13 Jacques Rueff, member of the French Moral and Political Sciences Academy and the Académie Française
14 First example of worldwide management of a global risk
15 We can reduce both the risk of road accidents and, when accidents do occur, reduce their severity (by wearing seatbelts, equipping cars with security features, etc.). We cannot reduce the frequency of earthquakes or cyclones, but we can reduce the damage to human beings and property with anti-seismic and anti-cyclonic buildings. It is also possible to plan for emergency aid and assistance when the risk event has occurred to limit the consequences on people and property.
16 In 2016, a school in the French city of Caen had to get rid of a hutch housing two hens in the name of the “precautionary principle”
