Risk & Insurance Online

When trying to untangle the cases of past disasters, have you ever noticed that somewhere in the chain of events, someone made an irrational decision? Most risk managers will attest that people make bad, silly and crazy decisions from time to time.

By Beaumont Vance

In this profession, one gets to see the aftermath of bad ideas.

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When studying economic theory, one learns early on about the concept of the "rational man." The idea is that in any market economy, decisions are made based on rationality. There is no room in traditional economics for irrational exuberance, risk-averse bank runs or your crazy Uncle Bob who spends large sums of money collecting old cardboard. In order to understand how the market works, one is told, one has to simply accept that man is rational and would never buy something for more than it is worth, or sell it for less than the market value.

Many people take the rational man concept quite seriously. It has been an almost unquestioned concept for much of the past 100 years. But recently, some have actively questioned it. For example, about a decade ago, a group of physicists met with a group of economists at the Santa Fe Institute and questioned them on this point. The physicists, having experienced real human beings, could not understand how anyone could create an entire discipline based around the assumption that humans are rational.

The economists replied that they had to make this "rational man" assumption because, if they did not, their mathematical formulas would be too hard to solve. Imagine how great calculus class would have been if this type of thing worked in college. After the final exam, you could have simply explained to the professor, "I just assumed that the answer to every question was 64 because the equations were too hard to solve otherwise."

Of course, no math professor would accept this kind of explanation; in fact, many scientists don't accept the economist's theory of rationality either. In the 1970s, two professors, Daniel Kahneman and Amos Tversky, decided to test just how rational people are when making decisions involving risk. They conducted an enormous number of studies that show that, most of the time, people make decisions that are demonstrably irrational. In 2003, Kahneman was awarded the Nobel Memorial Prize in Economic Sciences for this work. (Amos Tversky had passed away by the time of the award.)

The work of Kahneman and Tversky did change the science of economics. It even spawned a new field called behavioral economics. Unfortunately, it has not been widely adopted within the discipline of risk management. It is important to the profession that this work take a more prominent role.

The dominant driver of risk is human behavior. Whether one is dealing with workers' compensation or directors' and officers' coverage, the primary driver of the risk is the decision-making of the people involved. Even with something as seemingly complex and abstract as market risk, when one drills down to the proximate causes of market movement, it comes down to individual people making decisions and taking actions that, in the aggregate, create the market phenomena such as the current subprime mortgage issues.

While people might be irrational, they are at least predictable in this irrationality. Kahneman and Tversky provided numerous studies that demonstrate exactly when and how people will become overly risk averse or choose to take too much risk. A 1979 study even shows when and how people will choose deductibles over quota-share coverage. It would be nice if the practical ideas of Kahneman and Tversky displaced the less useful concept of the "rational man."

BEAUMONT VANCE is the risk management columnist for Risk & Insurance®. He manages risk for a leading financial company.

May 1, 2008

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