Professional Documents
Culture Documents
Master’s thesis submitted in partial fulfilment of the requirements for the degree of
Master of Science in Technology
Espoo, 2 August 2004
i
TEKNISKA HÖGSKOLAN SAMMANDRAG AV DIPLOMARBETE
ii
Preface
This work was carried out at the Systems Analysis Laboratory at Helsinki University of
Technology. I thank Professor Ahti Salo, my instructor and supervisor, for guidance and
invaluable feedback throughout the writing of this thesis. I am also grateful to Research
Professor Urho Pulkkinen at VTT Technical Research Centre of Finland, who put his
expertise on risk analysis at my disposal. I thank the whole personnel at the Systems
Analysis Laboratory for a great working atmosphere.
I thank Ph.D. Jukka Ranta and Professor Riitta Maijala at the National Veterinary and
Food Research Institute for sharing their time and giving me further insight in the
National Salmonella Control Programme.
Most of all, I wish to thank my fiancée Elina Karp, who helped me in many ways.
Discussions with her cleared up my thoughts during the writing and she kindly proofread
the thesis. I am grateful for her love and support as well as patience and understanding
although the final revisions of the manuscript took time from our wedding preparations.
Markus Porthin
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Table of Contents
Preface.............................................................................................................................................iii
1 Introduction ...........................................................................................................................1
1.1 Background .................................................................................................................. 1
1.2 Objectives of the Thesis............................................................................................. 2
1.3 The Case Method in Teaching Risk Management ................................................. 2
1.4 Structure of the Study................................................................................................. 4
2 Risk..........................................................................................................................................5
2.1 Definitions of Risk...................................................................................................... 5
2.2 Risk Measures .............................................................................................................. 6
2.2.1 Qualitative measures.......................................................................................... 6
2.2.2 Quantitative measures ....................................................................................... 7
2.3 Risk Analysis and Risk Management...................................................................... 10
2.4 Risk Management in Different Fields .................................................................... 13
2.4.1 Finance .............................................................................................................. 13
2.4.2 Process Industry............................................................................................... 13
2.4.3 Insurance ........................................................................................................... 14
2.4.4 Society and Foresight ...................................................................................... 14
2.4.5 Environment and Health ................................................................................ 14
3 Case Studies......................................................................................................................... 16
3.1 Salmonella Case......................................................................................................... 17
3.1.1 Background....................................................................................................... 17
3.1.2 Risk Assessment Model .................................................................................. 19
3.1.3 Risk Management Process .............................................................................. 20
3.1.4 Lessons from the Case .................................................................................... 22
3.2 Electricity Retailer Case............................................................................................ 23
3.2.1 Background....................................................................................................... 23
3.2.2 Value Tree Framework.................................................................................... 24
3.2.3 Risk Management Process .............................................................................. 26
3.2.4 Lessons from the Case .................................................................................... 27
3.3 Mining Case ............................................................................................................... 28
3.3.1 Background....................................................................................................... 28
3.3.2 Safety Assessment of Air Recirculation System .......................................... 29
3.3.3 Risk Management Process .............................................................................. 31
3.3.4 Lessons from the Case .................................................................................... 33
3.4 Pension Insurance Case ........................................................................................... 34
3.4.1 Background....................................................................................................... 34
3.4.2 Main Risks of a Pension Insurance Company ............................................. 35
3.4.3 Stochastic Programming Model for Asset Liability Management ............ 37
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3.4.4 Lessons from the Case .................................................................................... 37
4 Comparative Analysis of the Cases.................................................................................. 40
4.1 Risk Influence and Decision Makers...................................................................... 40
4.2 Type of Loss .............................................................................................................. 42
4.3 Modelling of Probabilities and Interrelationships ................................................ 42
4.4 Guidelines for Selection of Probability Assessment Method............................. 45
4.5 Types of Risk Management Decisions................................................................... 46
5 Conclusions......................................................................................................................... 49
6 References ........................................................................................................................... 51
7 Web References.................................................................................................................. 57
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1 Introduction
1.1 Background
Modern risk management started evolving after the Second World War on two
different fields: insurance buying as well as reliability and safety engineering. These
fields grew side by side for decades with very little interaction (Williams et al.,
1998). The lack of interaction can partly be explained by the organisational
structure of most businesses and governments and the different background of the
parties; the technically oriented specialists did not understand the financially
oriented ones, and vice versa. At first, the main duty of the financially oriented
corporate insurance buyers was placement and management of organisations’
insurance portfolios. Later other means of coping with financial uncertainties, such
as self-insurance and different loss prevention activities, have diminished the
relative importance of insurances. The first tasks of reliability and safety
engineering were to increase reliability and reduce maintenance costs of military
equipment (Andrews and Moss, 2002). In the 1970’s the nuclear power industry
became a significant field of application. Later on reliability engineering has been
widely used in process industries.
1
Today risk management on the reliability and financial fields are seen as two parts
of the same problem: reducing undesired uncertainty. Other fields of RM include
e.g. vaccination decisions, legislation on gene manipulated food and software
design. A current challenge is to study all risk factors in an organisation as a whole
and manage those using suitable methods from all available fields (Räikkönen,
2002; Räikkönen and Rouhiainen, 2003). This demands a holistic approach in
studying risks.
This thesis presents four pedagogical risk management case studies compiled by
the author for use at Systems Analysis Laboratory at Helsinki University of
Technology. The studies are narratives that tell how certain risks are managed in
the examples. The purpose of the cases is not to serve as a tutorial, but rather to
show how some risk management methods may be used in practice and to give
insight to the general principles of risk management. The studies are meant to
describe the whole risk management process from risk identification to the
evaluation of implemented solutions. The cases are chosen from different fields in
order to give a multifaceted overview of RM.
A comparative analysis of the case studies is also conducted. The objectives of the
analysis are to find similarities and dissimilarities from the cases and to deliberate
upon their causes as well as to identify causal relationships between different
properties of the cases. Using the insight from the cases, some general guidelines
and structural outlines concerning RM are also suggested.
Educational case studies are narratives that are rooted in real events and centre on
key issues of the topic at hand (Wassermann, 1994). The purpose of a case study is
to introduce realistic situations to the student. This method was first used at
Harvard Law School in 1870 and became subsequently a common teaching
method in law, business and medicine (Garvin, 2003). A widely used type of case
studies includes an introduction to the case context followed by a decision
situation or dilemma to be solved by the students. Other case studies are finished
2
stories that either describe a major failure and try to deliberate upon what should
have been done, or tell a success story presenting good or even best practice.
The main advantage of the case method compared to traditional teaching methods
is that it concretises the topic by putting it into a context. Thus, the student gets a
better picture of how the discussed methods are used in practice and learns how to
grapple with messy real-life problems (Herreid, 1994). This gives the student a
deeper understanding about the problem. The disadvantages of case studies are
also strongly linked to the presence of a context. Sceptics claim that case studies
are too bound to the context, making the lessons learned hard to generalise. In
addition, case studies do not necessarily communicate the big picture of the field
of study, but rather give a detailed description of a particular problem.
Furthermore, case-specific information is needed for a study to come to life, which
may not be of any general interest.
Books with case studies in risk management have been published e.g. by Greene
(1983) and the Risk and Insurance Management Society Staff (1988). In 1997, the
University of Calgary1 made a selection of these cases available on the World Wide
Web in html-format. These 14 case studies cover different fields from capital
budgeting and loss control to crisis management and earth movement. The cases
are short narratives of the risky situation of a company or organisation followed by
a set of questions for discussion. Most of the cases leave the end of the story
unfinished and pose questions that help the students to find a solution to the
problem. Philippe Jorion, the author of the book Value at Risk (Jorion, 2001), has
published on his WWW home page a case study about Orange County, which lost
$1.6 billion on the financial market, and describes how the losses might have been
avoided using Value at Risk2 (VaR). He describes the setting that resulted in the
huge loss and asks the reader to do various VaR-related calculations based on the
case information.
Studies of major failures can be found on the WWW, e.g. concerning losses on the
financial market3 and unsuccessful projects4. There exist also comprehensive
collections of case studies for management education5, which include a number of
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risk management cases, mostly from the financial field. The studies are supplied by
well-known business schools, such as Harvard Business School, The Richard Ivey
School of Business and INSEAD, and are available subject to a fee. The current
trend of increasing use of case studies in education can be seen in the related fields
of operations research / management science, too. There are recent examples of
case studies on e.g. police patrol car allocation (Rump, 2002), decision analysis and
dynamic programming (Rump, 2001) and optimisation of brewery location and
capacity expansion decisions (Koksalan and Salman, 2003).
The reminder of this thesis is structured as follows. Chapter 2 introduces some key
concepts in risk management. Different measures and definitions of risk are
introduced as well as the steps of the risk management process. A classification of
risk management decisions and key characteristics of different application fields
are also discussed. Chapter 3 presents four educational case studies, prepared to
give examples on the risk management practices on different fields. The studies
shed some light on the methods used in poultry production, electricity retailing,
mining and pension insurance companies. In Chapter 4, a comparative analysis of
the cases is conducted. Dissimilarities and their possible causes are identified and
some general guidelines are drawn. Finally, in Chapter 5, the thesis is summarised
and concluded. Future prospects of risk management are also discussed.
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2 Risk
Definition 2.1a Risk is an uncertain situation with possible negative outcomes. (See e.g.
(Rescher, 1983))
Definition 2.1b Risk is the potential variation in outcomes. The variation can be either
positive (upside risk) or negative (downside risk) (Williams et al., 1998)
Definition 2.1b is mainly used in finance, where both positive and negative
positions in securities are possible. In other fields, definition 2.1a is more
common. In this thesis definition 2.1a will be used.
Risks exist irrespective of whether one is aware of them or not. If a person puts
himself under risk due to a conscious action, he is taking a risk. A situation where
no clear action is involved is referred to as being under risk. Risks can also be
categorised based on by whom the risk is caused and whom it affects. Nicholas
Rescher (1983) identifies four cases (see Table 1). He calls people under risk for
“maleficiaries”, a negative analogue to beneficiaries. In the first case a person puts
himself under risk, e.g. by smoking cigarettes. By his action he increases risk for
lung cancer. However, if there are people in the vicinity of the smoker, so called
passive smokers, the risk is both self- and other-directed (case 2). More non-
standard cases include a person putting others under risk (case 3) and the
circumstantial case (case 4), where no clear agent is present.
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Table 1 Risk as classified based on agency (Rescher, 1983).
The definition of risk may be expanded to include the annoyance of foregoing the
occurrence of something good. This is called inverted risk or potential regret and
occurs wherever there are potentially lost opportunities (Rescher, 1983). E.g. a
person participating free of charge in a lottery risks not to win. This conception of
inverted risk broadens the set of situations that involve risk to all situations with
uncertain outcomes.
The risk definitions are of little use when comparing and measuring risks.
Therefore, several risk measures have been developed, most of them being a
function of a probability measure and a loss measure. A requirement for using
most risk measures is that the potential loss is quantifiable and projectable on a
one-dimensional scale. In order to make different types of losses comparable e.g.
value-tree methods can be used. Next a short summary of the most common risk
measures is presented.
The severity of a risk can be quantitatively assessed by mapping the risk on a risk
matrix according to (i) the value of the negativity of the outcome and (ii) its
probability (or frequency of occurrence), see Figure 1. The closer to the upper
right corner the risk is situated, the more critical it is. This is a good tool in risk
identification for a quick overview of risks and in order to determine which to
6
focus on in further analyses. From this graphical point of view, risk management
can be seen as striving to move risks towards the lower left corner by lowering the
probability of the undesired outcomes and/or lowering the severity of their
consequences. Instead of representing a risk by only one point on the risk matrix,
a curve can be drawn. The F-N, or Farmer, curves were introduced by Reg Farmer
in 1967 (Farmer, 1967). The most common improved version of these plots F(C)
against C, where F(C) is the frequency of events with consequences greater than or
equal to C (Ballard, 1993). The use of the curves is often convenient, because
many risky situations might result in variably severe consequences and usually the
less critical ones are more probable.
C
High
rit
ic
al
Se
rio
Probability
us
M
od
er
at
e
M
in
or
N
eg
Low
lig
ib
le
Low High
Consequence
One of the most basic risk measures is the expected loss. In this method, the
potential consequences, losses, of the undesired events and their probabilities are
quantified. The expected value of the loss is calculated based on this information.
Definition 2.2 Let L∈ℜ be a stochastic variable denoting loss. Expected loss is the expected
value of L:
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Expected loss = E ( L)
The expected lost utility is an extension of the expected loss, where potential losses
are not considered as such but rather their utility.
Definition 2.3 Let L∈ℜn be a stochastic variable denoting loss and U: ℜn → ℜ a utility
function. Expected lost utility is the expected value of U(L):
Due to the utility function (von Neumann and Morgenstern, 1944; Bunn, 1984),
the decision maker’s attitude towards risks is included. Thus the measure is
subjective containing the decision maker’s view. For those seeking an objective
risk measure, this is obviously a drawback. As one could expect, another problem
is to find a proper utility function. A slightly different point of view can be gained
by transforming the expected loss and expected lost utility as risk per time unit.
Often risk lies in the uncertainty of a numerical quantity’s future value. A common
example is the share prices on a stock market. When prices are modelled as
stochastic variables, the variance or standard deviation is a natural measure of
fluctuation.
Definition 2.4 Let Y∈ℜ be a stochastic variable, f(y) and E(Y) its density function and
expected value respectively. The variance σ2 and standard deviation σ of Y are:
∞
σ2 = ∫ ( y − E (Y )) f ( y )dy, σ = σ 2
2
−∞
These measures account for both negative and positive deviations from the
expected value and thus treat risk in the manner of the risk definition 2.1b. The
variance is usually estimated from data using the maximum likelihood estimator
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(see e.g. Milton and Arnold, 2002). On the stock market, the standard deviation of
a market rate is called volatility and is usually reported in percents of the market
rate value.
Value at Risk (VaR) was introduced in the early 1990’s as a tool for measuring
financial risks (Jorion, 2001). VaR measures how low the value of a portfolio could
fall over a given time at a given confidence level, see Figure 2 (Crouhy et al., 2001;
Jauri, 1997). For example, if the daily VaR of a portfolio is 100 000 € at the 99 %
confidence level, there is only 1 % chance that the portfolio will fall more than
100 000 € during the day. In other words, such an event will occur in average once
in 100 days. VaR can be calculated either relative to the initial value of the portfolio,
as in the example, or relative to its expected value (Jorion, 2001). The former is called
absolute VaR, the latter relative VaR. In the following definition the more common
relative VaR is used.
Definition 2.5 Relative Value at Risk measures the maximum loss in portfolio value over a
target horizon T with a given level of confidence 1-α:
where W0 is the initial value of a portfolio, E(W) and W1-α* its expected and lowest value at
confidence level 1-α after time T respectively. R1-α* and µ are the corresponding lowest and
expected returns.
(1 - α)
α
f(x)
VaR(α)
9
Denoting the relative portfolio value after time T as X = W – E(W) and its
probability density function f(x), the relative VaR at the 1-α confidence level can
be defined as
−VaR (α )
∫
−∞
f ( x)dx = α .
Several modifications and extensions to the VaR measure have been developed.
One of the most promising is the conditional Var (CVaR), which is defined as the
expected value of the portfolio, given that the loss exceeds the VaR (Rockafellar
and Uryasev , 2000; Rockafellar and Uryasev, 2002; Uryasev, 2000). In contrast to
VaR, CVaR is a coherent measure of risk and has shown to be very useful in
portfolio optimisation.
6 This is merely one of many divisions suggested in literature. For slightly differing examples see
e.g. (Haimes, 1998), (Pausenberger and Nassauer, 2000), (Rowe, 1977), (Lonka et al., 2002) or
(Weber and Liekweg, 2000).
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Risk identification
Risk analysis
Risk evaluation
(probability &
consequence)
Development and
evaluation of
RM methods
RM decisions
Evaluation of
implemented RM
solutions
The purpose of the first RM step is to identify all relevant risks of the situation
under study. There are several techniques available to aid the process. To identify
different risks and to visualise which are already known and properly managed a
risk window may be used (Suominen, 2000). Identifying methods used in the
process industries include e.g. hazard and operability study (HazOp) as well as
failure mode and effect analysis (FMEA) (see e.g. Andrews and Moss, 2002).
When a tentative list of potential risks is gathered, the risks are screened in order
to decide which ones may be neglected and which should be further analysed.
When risks are known, appropriate managing measures must be chosen. Often the
effect of different potential RM methods can be evaluated using the same models
as in the risk evaluation steps and, therefore, these activities are interlinked.
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Different risk management decisions may be categorised as follows (Suominen,
2000; Weber and Liekweg, 2000):
2. Accept. Sometimes it is advisable to accept risks as they are. This is the case
when a risk is a part of the core function of the organisation and the
opportunities overweigh the risks. It is also the most efficient strategy for
very insignificant risks. Large organisations may practice self-insurance; e.g.
in Finland, the state does not have theft insurance for its property, because
insurance policies would be more expensive than paying for the losses.
After the RM decisions are set into practise, they must be followed-up in order to
determine their appropriateness and cost-efficiency.
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2.4 Risk Management in Different Fields
2.4.1 Finance
Financial risks are easy to handle in the respect that the losses are usually well
defined with money as the obvious performance measure, which makes risks
commensurable and easy to valuate. The performance measure is in general
modelled as a one-dimensional real-valued stochastic variable X. The risk analysis
methods are based on finding a good estimate of its probability distribution in one
way or another and identifying which factors influence the distribution and how.
Widely used risk measures include distribution characteristics, such as the standard
deviation (or volatility) and low-end quantiles i.e. Value at Risk and other “worst
case” measures. Another group of risk measures is the sensitivity measures, also
called “the Greeks” (because they are denoted using the Greek alphabet)
(Melnikov, 2004). They are partial derivatives of the portfolio value in respect to
some market parameter (e.g. stock market index, prize of underlying asset,
volatility, interest rate, time). The probabilities are estimated using e.g. historical
data, time series or Monte Carlo simulations.
The systems in process industry are usually well defined, enabling the development
of sophisticated analysis tools. There are several methods for identifying critical
events or chains of events, e.g. failure mode and effect analysis (FMEA), Hazard
13
and Operability study (HazOp) and reaction matrix, to mention only a few
(Andrews and Moss, 2002). Methods for assessing the probability of an event and
the effect of potential actions include fault tree and event tree analysis. Also
several component importance measures (e.g. Birnbaum’s, Vesely-Fussell’s) can be
useful in trying to improve the reliability of a system (Andrews and Moss, 2002).
2.4.3 Insurance
Insurance is an old way of securing oneself against risk and is based on sharing the
total losses among a large number of policyholders. In this way everyone pays a
share of the losses and no one has to suffer unbearable loss. The philosophy
assumes that the losses can be compensated with money. Although this
assumption often is justified, it may be argued whether money can cover the
damage of death or physical injuries. The prising of insurances is based on the
average damage compensations, risk margins, administration costs and
contribution margins. The insurance brokers do risk studies to find out the risk
profile of the customers in order to be able to offer right insurances. Accident
probabilities are estimated using statistical information.
Risks threatening the society in the future are often characterised by high
incertitude and indefinability. Sometimes we just do not know what we do not
know. Because of the unpredictability of the problem, often no sophisticated
scientific analyses are possible. Thus, the studies must rely on different future
scenarios and expert opinions, which in general are nothing more than good
guesses or pure speculations. The risks can be tackled by conducting scenario
analyses and practising the precautionary principle.
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Table 2 Risk characteristics and common risk management methods in different fields.
Risk Well defined Probabilities of Loss shared among High incertitude Everyone exposed
characteristics performance specific events policyholders
measure (money) considered Causal relationships E.g. spreading
Loss compensated poorly known diseases,
Commensurability Severity of events with money environmental
and comparison of not necessarily impacts of human
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risks easy compared activities, changes
in the ecosystem
Systems well
defined
This chapter presents four RM case studies compiled by the author based on
articles and publications. The studies are developed to show examples of RM in
practice, the target group being graduate students. The emphasis is rather on
giving practical examples of the use of RM methods in different contexts than
trying to build a proper method tutorial.
The cases can be utilised both on introductory and more advanced courses.
Students, who are already familiar with the discussed methods, can attend an
advanced course in RM or read the cases independently without supervision to
obtain a better picture of how the methods are used in practice and which RM
steps need to be carried out. An independent study should take approximately 2 –
4 hours per case study. The cases can also be used in teaching RM methods in
class, either by introducing the methods through the cases together with the basics
of the methods, or serving as motivating application examples. One case study is
estimated to require 90 minutes of lecture time. The cases give also a general
picture of how risks are managed in different fields and which parties are involved
in the process.
Depending on the way of use, students with different backgrounds may profit
from the cases. Basic probability theory and an idea of the key RM concepts give
enough background knowledge, if the cases are complemented with information
about the methods used. However, when a higher level of understanding is
pursued, a broader knowledge background is needed. In the salmonella case, prior
experience on Bayesian analysis and Monte Carlo simulation is recommended. The
electricity case deals with financial risk measures and value tree analysis, and the
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mining one with fault tree analysis and importance measures. To profit the most
from the pension insurance case, knowledge about portfolio theory, optimisation
and time series are helpful.
After finishing a case study, the student should have a better picture of which risks
are present in the discussed field, how they are managed, which concrete actions
the RM process requires and which parties are involved. The student should have
improved his knowledge about the discussed methods. By studying all four cases,
the student gets an overall view of the application fields and methods of RM and
sees different realisations of the RM process. The student can identify which steps
the RM process requires and gains thus insight into how to approach an RM
problem. He learns which details are relevant and how to choose analysis methods.
With this insight, he will be better prepared if carrying out similar analyses in
practice.
The studies, as well as an introduction to the key concepts of RM, can be found in
pdf-format in the WWW at http://www.sal.hut.fi/Web-Activities/RM/.
3.1.1 Background
The responsible regulating authority for food production in Finland is the Ministry
of Agriculture and Forestry. In 1995, it set a National Salmonella Control
Programme to limit the number of human salmonella infections obtained from
food. Two of the main interventions of the programme concerning the broiler
production were (i) removal of detected salmonella positive breeding flocks from
the production chain and (ii) heat treatment of the meat from salmonella positive
broiler flocks (Maijala and Ranta, 2004). Without making any formal research,
17
these interventions were assumed to keep the salmonella prevalence on an
acceptable level.
3) Research interest
This study describes the actions made to examine the effect and appropriateness
of the intervention program. From a political point of view the research was
needed for justifying the programme, which was stricter than required by the
European Union. Another motivation is pure research interest. The intervention
program was evaluated by the Department of Risk Assessment at the National
Veterinary and Food Research Institute (EELA) on the demand of the Ministry.
The main components of the evaluation include a human health impact analysis,
cost-benefit analysis (Kangas et al., 2003) and a probability model of salmonella
transmission from broiler grandparents to consumers in Finland (Ranta and
Maijala, 2002; Maijala and Ranta, 2004). To keep the case study within reasonable
18
length, but still maintaining a detailed level, the focus is directed to the first part of
the probability model, the Primary Production Inference Model, handling the
other parts on a very general level. The main properties of the case context are
summarised in Table 3.
The risk assessment model of salmonella in the broiler production chain consists
of three parts: (i) the Primary Production Inference Model (PPIM), (ii) the
Secondary Production Simulation Model (SPSM) and (iii) the Consumption
Inference Model (CIM), see Figure 4 (Maijala and Ranta, 2004). The PPIM models
salmonella prevalence in the production chain from grandparent breeder flocks to
production broilers ready for slaughtering. The model is based on Bayesian
inference and enables assessment of the direct effects of removal of detected
salmonella-positive breeder flocks. The case study focuses on this part of the risk
model. The SPSM models salmonella prevalence in the secondary production
chain from slaughtering to ready food products and takes into account possible
heat treatment of salmonella-positive meat. This part is based on Monte Carlo
simulation. To find the eventual human salmonella cases a consumption model
using Bayesian inference was created.
Consumption Inference
Model (CIM)
Human cases
Figure 4 The basic structure of the risk assessment model of salmonella in the broiler
production chain. Modelled interventions are indicated with shaded boxes. (Maijala and
Ranta, 2004)
19
A simplified presentation of the PPIM is showed in Figure 5. It describes
salmonella prevalence in grandparent, parent and production broiler flocks and
takes into account both vertical and horizontal transmissions as well as persisting
infections within a flock. The parameters and prior distributions of the
probabilistic inference model were assessed using available data and expert
opinions. Probability distributions of salmonella prevalence in production broilers
were calculated under different scenarios. The quantitative results show that
removal of detected salmonella positive breeder flocks from the production chain
significantly reduces the salmonella prevalence of the production broilers. All in
all, the whole salmonella risk model indicates that a combination of both removing
of salmonella positive breeding flocks and heat treatment of contaminated meat
provides the best protection against human infections.
horizontal
persisting Grand- transmission (h)
infection (η) parent
vertical
transmission (v2)
environment
horizontal
personnel
persisting transmission (h)
Parent
infection (η) feeding stuffs
etc.
vertical
transmission (v3)
horizontal
Prod. transmission (h3)
broiler
Figure 5 A simplified presentation of the PPIM. The PPIM models salmonella prevalence
in grandparent, parent and production broiler flocks. Both vertical and horizontal
transmissions are taken into account as well as persisting infections within a flock.
The steps of the risk management process in the salmonella case are summarised
in Table 4. The whole case can be considered as an evaluation of implemented RM
solutions, the last step in the iterative RM process. The primary risk covered in the
study is the risk of human salmonella infections transmitted via broiler meat. The
infection probability was evaluated under several scenarios using the transmission
20
model presented in the previous chapter and the effects of two intervention
procedures were assessed. The health impacts of human infections and their
monetary expenses were evaluated in separate studies.
Risk identification Risk of human salmonella infections from broiler meat and
monetary loss for producers.
Evaluation of -
implemented RM
solutions
21
3.1.4 Lessons from the Case
The most important observations and conclusions from the salmonella case are:
• The risk assessment showed that both interventions (flock removal and
heat treatment of contaminated meat) were effective in reducing the
number of human salmonella cases and that the best result was received by
22
combining them. Thus, the process did not result in any major changes in
the programme.
3.2.1 Background
The electricity retailer case describes the selection of appropriate RM methods for
a mid-sized electricity retailer. An electricity retailer faces risks from numerous
sources, including e.g. different market, volume and credit risks. To manage them
in the daily operative actions, the RM specialists and traders need a set of analysis
methods giving enough information. The selection of appropriate RM methods
and setting rules for their usage is therefore a vital part of a company’s risk
strategy. The implementation involves acquiring of new software customised for
the company’s needs, installation into the computer system and training of the
staff. This makes the process costly and means that the decisions must be made
with an at least 5 – 10 years time horizon.
This study describes the development and implementation of a value tree based
framework (Keeny and Raiffa, 1976) for choosing RM methods. The framework is
developed by an RM IT-systems provider in collaboration with prospective end
users. In the model, the main criteria for selecting RM tools are their (i)
information utility, (ii) costs and (iii) usability. Traditional value tree analysis
requires the decision makers to give precise preference statements as well as
precise information about the options, which this was considered to be too an
ambitious task. Thus, a novel method for giving imprecise information was used,
Rank Inclusion in Criteria Hierarchies (RICH) (Salo and Punkka, 2004; Liesiö,
2002) developed at the Systems Analysis Laboratory at Helsinki University of
Technology. The main properties of the case context are summarised in Table 5.
23
Table 5 Main properties of the electricity retailer case study.
IT-provider
24
Accuracy
Measurement of Intuitiveness
extreme risks
Coherence
Attribution
capability to risk Robustness
factors
Information utility Accuracy
Measurement of
total normal risks Intuitiveness
Attribution Coherence
Method costs capability to pf.
components Robustness
Comparison - Implementation
attributes for RM - Introduction Measurement of Accuracy
methods - Usage sensitivity of risk
- Maintenance to changes in Intuitiveness
Flexibility
parameters and
Coherence
variables
Timeliness
Robustness
Usability Authority
Intuitiveness /
Simplicity /
Transparency
1. Position reporting
Because the value of information of these methods is not additive, the methods
were evaluated in conjunction as collections of methods. Using the evaluation
framework, potentially good combinations were identified and eventually
implementation strategies were suggested. It was concluded that position reporting
should be implemented first, because of its low costs and ability to give basic risk
information. It should be followed by scenario analysis due to its cost-efficiency.
25
In the third phase a decision between simulation VaR, variance-covariance VaR or
Maximum Loss should be made.
Risk evaluation – -
consequence
2) Costs
3) Usability
1) Position reporting
2) Scenario analysis
Evaluation of -
implemented RM
solutions
26
The different steps of the RM process of the case are summarised in Table 6. The
risk identification is not too a demanding task since the main risk drivers in the
electricity field are well known. As the task of the case was not to deal with daily
RM of the operative activities but, rather, to select tools for it, no actual risk
evaluation was done. On the contrary, the study focused on the development and
evaluation of RM methods. Because the main challenge was to compare different
solutions, a value tree framework was used. The process did not result in any real
decisions as such, but gave suggestions which methods to consider. As no RM
methods were implemented yet, an evaluation of their performance in action could
not be done. However, it is an important task to be performed in the future.
The most important observations and conclusions from the electricity case are:
• There are many financial risk analysis tools well suited for electricity
companies.
• While usage of the analysis tools is a part of the every day work of the risk
management specialists, choosing a suitable set of risk analysis methods
for the company is a strategic decision with a several years time horizon.
Changing the set of methods is both costly and time consuming, because
any analysis solution available on the market must be customised to fit the
needs and IT-system of the company and the personnel must be trained to
use the new software.
27
unrealistic aim, a method called RICH was used, enabling the use of
imprecise preference statements.
• When searching a suitable set of risk analysis tools, the candidates cannot
be evaluated in isolation one by one, because of the partial overlap of the
risk information given by the different methods. Thus, the value gained by
utilising a new method depends on the methods already in use. This
obstacle was overcome by considering the methods in sets.
3.3.1 Background
28
Table 7 Main properties of the mining case study.
• Methane entering the mine from the ground. High methane levels
constitutes a sever fire risk.
• Fan vibration
29
• Emergency stop buttons
Whenever one of the monitored properties satisfies its trip condition, the
recirculation fan should stop. This system can fail in two ways: (i) to fail to shut
down the recirculation fan when a trip condition is fulfilled or (ii) to switch off the
fan when no trip condition is fulfilled. The former is more critical and may have
severe health impacts. Although the latter is less critical, a spurious fan stoppage is
inconvenient, deteriorating the conditions in the mine due to high dust and heat
levels.
Fault trees were constructed and quantified for both failure modes. The system
was divided into eight sub-systems according to different trip conditions, which
resulted in a total of 16 fault trees. As an example of the trees, Figure 8 shows the
fault tree for unrevealed failure in one of the carbon monoxide detection systems.
30
2
Figure 8 The fault tree for unrevealed failure in one of the carbon monoxide detection
systems. (Andrews and Moss, 2002)
The different steps of the RM process of the case are summarised in Table 6. The
two failure modes of the system discussed in the previous chapter are easy to
identify. Risk drivers causing the failures were identified using failure mode and
effect analysis (FMEA) (Andrews and Moss, 2002). This part was not, however,
covered in the case study. The security system consists of a structured collection of
components that, in general, fail independently of each other. Some of the
components may shut down the system by themselves, while others cause a
malfunction only in conjunction with other component failures. Fault tree analysis
is a powerful tool in situations like this. A fault tree structures basic failures in a
tree-like manner, with logical gates describing their logical relationships. The
system failure probabilities, as well as the effects of suggested modifications, were
31
assessed by fault trees. The analysis lacks, however, a formal assessment of the
consequences of a system failure. It was only stated that failing to detect high
levels of methane or carbon monoxide were the most critical failures, and thus the
safety improvement study was focused on measures that would improve the
reliability on these fields. The reliability assessment concluded that the system
reliability was at a fairly good level. However, if improvements were needed, the
most effective action would be shortening of inspection intervals of the methane
and carbon monoxide monitoring systems.
Risk evaluation – A thorough fault tree analysis of the safety system. System
probability failure modelled as combinations of specific component
failures. Component failure rates assessed using general
component failure databases and maintenance records, repair
times estimated by engineers at colliery. System reliability was
concluded to be on a reasonable level.
32
Development and Three safety improvement strategies considered and evaluated
evaluation of RM using fault trees:
methods
1) Variations in system design
Evaluation of -
implemented RM
solutions
The most important observations and conclusions from the mining case are:
33
the component suppliers. In some cases, the only way to find information
is to interview experienced working personnel.
3.4.1 Background
The pension insurance case gives a presentation of the main risks a Finnish
pension insurance company is facing and how they are managed. It also presents a
new stochastic programming approach to asset allocation, with a vital role in the
management of investment risk. The model has been developed by researchers at
Mutual Pension Insurance Company Ilmarinen and Helsinki School of Economics
(Hilli et al., 2004). The main properties of the case context are summarised in
Table 9.
34
needed for future pensions. A part of the surplus from the investment activities is
paid back to the policyholders as bonuses.
Causes for starting the Improving models for strategic investment allocation
study decisions
The risks of the underwriting business are linked with the sufficiency of the
company’s pension contribution incomes and technical reserves to cover present
and future pensions. The technical reserves are minimum requirements for the
company’s assets and correspond to the present value of future pension
expenditures. In the long term, the main risk factor is the uncertainty associated
with life expectancy, affecting the length of old-age pensions. The uncertainty
associated with pension starts and sizes are the main short term risk factors (see
Figure 9). The companies are obliged to monitor and control the risks of uncertain
future pension expenditures.
In Finland, the pension insurance business is quite strictly regulated. The pension
contributions are common regardless of company as set by the Ministry of Social
Affairs and Health. Shortfall in the underwriting business within one company will
ultimately affect the policyholders in form of smaller or no bonuses, while
systematic shortfall in all pension insurance companies results in raised pension
contributions.
35
Risks of a
mutual pension
insurance company
Underwriting Investment
business risk activities risk
Number of Counterparty
pension starts risk
Size of Liquidity
pensions risk
Exchange rate
risk
The main risks of the investment activities are market, counterparty, liquidity and
exchange rate risks (see Figure 9). Market risk is managed by diversifying between
different asset types, countries, sectors and companies. Pension insurance
companies may allocate the assets in cash, bonds, stocks, real estate and loans to
policyholders. The allocation mix affects the risk as well as the expected return of
the investment portfolio. Counterparty risk is managed by analysing the
creditworthiness of bond issuers and by limiting investments in one issuer’s bonds.
Guarantees are also used to secure the investments. Liquidity risk can be managed
easily since pension expenditure can be accurately forecast. Exchange rate risk is
controlled using derivatives (Figlewski and Levich, 2002; Hull, 2002; Luenberger,
1997).
The value of the assets of a pension insurance company must always exceed the
technical reserves. The Ministry of Social Affairs and Health has set several target
values and borders for the solvency capital, i.e. the excess of investments over the
technical reserves. The target values taking into account the amount of money
invested in different asset types are meant to secure the value of the investments
from falling below the technical reserves. The challenge in the allocation of assets
36
is to pursue maximum revenue under prevailing market conditions in order to be
able to pay bonuses to policyholders. In the same time, the solvency capital must
be secured in the target zones set by the Ministry.
The pension insurance case does not describe a distinguished fulfilment of a risk
management process as such, but rather depicts the current risk situation in
pension insurance companies and introduces the idea of a new asset allocation
model. Therefore, it is not meaningful to conclude this case as in the other cases
using the RM process framework. Instead, the case is summarised by listing the
key points regarding risk management in a pension insurance company in general
and regarding the presented stochastic programming model.
37
• The main risks of the underwriting business are related with the average
length of pensions as well as pension starts and sizes. The insurance
portfolios of the major companies are so large that reinsurance is not
justifiable financially. As a result of regulations and governmental
guarantees, the underwriting risks of a pension insurance company are
ultimately carried by policyholders and the Finnish taxpayers.
• The main investment risks are market, counterparty, liquidity and exchange
rate risks, the most significant one being the market risk. It is managed by
diversifying between different types of assets (cash, bonds, shares, real
estate and loans to policyholders) and within each asset type by country,
sector and company. The asset allocation mix affects both the return
expectations and the risk level of the portfolio.
• With the purpose of securing the employers’ future pensions, the Ministry
of Social Affairs and Health restrict financial risk taking of pension
insurance companies by setting target zones for their solvency capital. The
most important of the limits, the solvency border, includes a buffer that, in
theory, corresponds to the one year 97.5% Value at Risk of the investment
portfolio. By placing money in less risky asset types (e.g. bonds), a
company can lower the solvency limits.
38
and long-term equilibria. The approach is especially well suited when the
available data displays characteristics that are believed to change in the
future.
• With the support of the model, the company can plan its strategic
investment actions such that it efficiently utilises the profitability potentials
of the investments without exceeding the risk limits.
39
4 Comparative Analysis of the Cases
The four case studies presented in chapter 3 give examples of different kinds of
risks in different fields and organisations and present methods for managing them.
Both similarities and dissimilarities can be found in the case studies, deriving from
their different characteristics. In the following, the cases are compared, aiming to
capture causal relationships between different case properties and to find general
RM guidelines.
In the salmonella case, the Ministry of Agriculture and Forestry tries to protect
people from salmonella infections originating from broilers. It obliges the actors in
the broiler production chain to follow certain procedures found to reduce
effectively the probability of contaminated meat. The consumers do not only
benefit from the risk management, but also pay a part of the costs. Thus,
redundant risk management is not in the public interest. However, in this case, the
ordinary consumer does not probably worry too much about the rise in consumer
prizes: The National Salmonella Control Programme is estimated to cost 0.02 €/kg
of broiler meat produced (Kangas et al. 2003).
40
Table 10 The instance making RM decisions depends on the ubiquity and influence of the
risk.
Risk Both self- and (Wholly) (Wholly) self- Both self- and
influence other-directed self- directed other-directed
directed
In the pension insurance case, the Ministry of Social Affairs and Health wants to
make sure that the companies are able to fulfil their obligations towards present
and future pensioners and that every employee is served on equal terms. The
Ministry has set up regulations on how to calculate the amount of assets needed
for future pension payments (the technical reserves) and how large buffer the
companies should have (solvency border) to secure themselves against fluctuations
in the value of their investments. These regulations form, however, only a set of
minimal requirements for the company; every properly run pension insurance
company have their own risk management functions which aim to run the
company as profitably as possible while maintaining a reasonable risk level.
In the mining case, Great Britain’s Health and Safety Executive requires security
control systems in mines with air recirculation systems. Although the possible
health impacts affect only people within the mining company, the miners do not
decide about the safety actions themselves and therefore, it is natural that the
miners’ safety is guarded by an external body.
41
In contrast to the other cases, the electricity company carries its risks mainly alone.
In situations like this, no strict governmental regulations are needed. The firm can
manage the risks itself in the most suitable way. If something goes wrong, it can
only blame itself and no innocent people are hurt.
The type of possible loss sets its own flavour to the analysis and management of
risks. From a technical point of view, it is easier to handle with monetary loss than
damage concerning e.g. human health or the nature. In the case of monetary loss,
as we see in the energy and pension insurance cases, the loss is well defined and
the expenses of undesired events and preventive measures are easily
commensurable. When everything is measured in monetary terms, it makes sense
to use probability distributions and covariances as well as sensitivity measures like
Value at Risk and partial derivatives to describe the situation.
When dealing with health issues, as in the salmonella and mining cases, it is not
always obvious how to measure loss and how to compare different expenses and
health hazards. In such cases, values and opinions play a greater role and plain
numbers and probability distributions should be used more carefully. Although it
is for several reasons seldom outspoken, the question “What is the monetary value
of human life?” often underlies precautionary security decisions. Political and
industrial leaders are careful not to address the question in public, because of the
emotionally charged debates it would evoke. Still, it is often possible to estimate
the number of lives saved by a preventive security investment. Thus, the decision
maker implicitly values the expected saved lives. In the cost-benefit analysis of the
salmonella case, the monetary value of a death caused by salmonella is derived
from data calculated for alcohol-induced deaths (Kangas et al., 2003), whereas the
mining case does not address the valuing issue.
42
The primary prevalence inference model in the salmonella case uses Bayesian nets
for modelling the relationships between variables. The probability distributions are
estimated by combining expert judgements and available data in a Bayesian
manner. This is a natural selection since the unknown quantities (e.g. true
prevalence) are represented by stochastic variables, but cannot be directly
observed. Using information about related observable indicators, conclusions
about the underlying variables can be made. On the other hand, in the secondary
production model of the same case, Monte Carlo simulation is used. It is a simpler
model for “forward simulation” which does not allow inference, i.e. probabilistic
learning “backwards” (Maijala and Ranta, 2004).
Table 11 The RM methods to be used are chosen on the basis of the characteristics and
focus of the problem as well as the available knowledge.
43
Expert opinion Prior Inputs to Some Economic
distributions the value maintenance equilibria and
tree (scores estimates trends
and
weights)
The mining case shows how fault trees can capture the relationships in a network
of independently failing components. Most of the input probabilities in the model
are derived from the data in a frequentist manner, whereas others are estimated in
quite an ad hock way by maintenance personnel. For modelling variation in market
rates and portfolio values, quite established methods exist. As the uncertain
quantities form sequential series, forecasting utilises often time series models such
as ARMA (Autoregressive Moving Average) and GARCH (Generalised
Autoregressive Conditional Heteroscedastic). In the pension insurance case, the
econometric factors that serve as inputs to the asset valuation model are forecast
using a Vector Equilibrium Correction (VEqC) model, a generalisation of Vector
Autoregressive (VAR) models. The model contains manually fixed parameters (e.g.
drift factors), enabling the use of expert knowledge in order to better forecast
patterns not derivable from historical data.
The risk management problem is slightly different in the electricity case: an array
of risk analysis methods exists for monitoring electricity related risk. Every method
44
gives a slightly different view of the situation; usability and cost of use vary also.
Since the characteristics of the methods are well known the challenge is to find a
set of methods that best fits the needs of the company. This calls for the use of
multiple criteria decision analysis (MCDA) methods, and the decision problem is
indeed tackled with value tree analysis.
In the case studies presented in this thesis, different methods for assessing
probabilities have been used. In general, the selection of the assessment method
depends on the proportions of available representative data and expert knowledge.
A rough division is presented in Figure 10. If very little data is available, but
experts have knowledge and experience about the phenomena, the most suitable
approach is to use some expert elicitation method (Ayyub, 2001; Cooke, 1991;
Hora and Iman, 1989; Keeny and von Winterfeldt, 1991; Porthin et al., 2002). If
more data is available, but not quite enough to solely rely on, methods that
combine opinions and data are used. The most recognised and theoretically
justified of these is the Bayesian methodology, where prior distributions, often set
using expert knowledge, are updated using available data. The beauty of the
Bayesian approach is that after making the needed model assumptions, all results
can be derived using available observations and well-established probability rules
only. The disadvantage is the requirement of significant computational resources.
If sufficient data regarded as representative is available, expert opinions become
redundant and probabilities are most efficiently estimated in a frequentist manner.
45
This does not mean that the Bayesian approach would be incorrect in any way.
However, the frequentist approach is computationally less demanding and results
in the more or less same outcome. Stirling (2001) suggests a similar guideline for
method selection in his outline of different levels of incertitude, but does not
recognise the use of expert elicitation methods.
Expert opinions
Data
46
controlling the severity of a risk by reducing its probability or impact. This means
is seen in all case studies. In the salmonella case, the probability of human
salmonella infections is reduced by various interventions. The risk impacts of the
investment activities of a pension insurance company and an electricity retailer are
reduced by setting risk limits. The impacts of abnormal situations in the mine are
reduced by installing a safety monitoring system and the probability of its
malfunction is assessed and reduced, if needed, by shortening the maintenance
intervals.
Reduction:
Investment risk limits
47
Although not explicitly reported, risk acceptance is definitely practiced in all cases,
as it is the only rational response to insignificant risks. Risk bearing and acceptance
is the core function of insurance companies making money by taking others’ risks
on their behalf. This is also the case in the pension insurance study for the
uncertainties concerning pension payments. A part of the company’s risks are
although transferred to employers, employees and Finnish tax payers through
pension guaranties given by the state (in case of bankruptcy) and adjustments of
insurance premiums and bonus payments.
48
5 Conclusions
This thesis presented four RM case studies compiled by the author. The aim was
to develop studies that describe the steps of the RM process and give examples of
methods used on different fields. The target group was university level students
with basic knowledge in operations research and risk analysis wanting to learn how
risks are managed in practice. A comparison of the cases resulted in several
observations and conclusions of dependencies of risk characteristics. Some general
guidelines for choosing probability estimation methods in different risk evaluation
situations were drawn, too.
The cases support the intuitive assumption that the level of regulatory RM
depends on whether the risk affects also others than the ones causing it and on the
ubiquity of the risk. The regulatory bodies regard the protection of people under
risk without being able to affect the situation themselves as their duty.
The RM approaches differ from field to field. The differences depend not only on
the modelling properties of the phenomena and the type of loss but also on the
traditions in each field. When the potential loss is purely financial, the monetary
loss is considered as a stochastic variable whose probability distribution is sought.
The risk is described using distribution characteristics such as volatility and VaR,
as well as various sensitivity measures. From a mathematical point of view, the
situation is quite similar to the salmonella case, but instead of money, the interest
was focused on the number of human salmonella infections. However, despite the
similarity, the risk was presented only by showing the estimated distribution
function and giving the median and the confidence interval. It would be interesting
to apply the financial risk measures in this kind of situations. Measures like
“Health at Risk” and those of sensitivity to changes in underlying factors could
give yet another point of view of the risk.
49
A general rule for choosing a probability estimation approach according to the
amount of available data and expert knowledge was proposed. If enough
representative data is available, a frequentist approach is the most efficient one.
On the contrary, when expert opinions are needed for further insight, Bayesian
approaches are appropriate. Finally, if hardly any data is available, expert elicitation
methods are suitable. A similar distinction between frequentist and Bayesian
methods was presented by Stirling (2001), but he did not acknowledge the use of
expert elicitations. In many cases, there just is not enough available information to
perform an informed probability and risk assessment. In such cases, application of
a formal risk assessment method will most probably result in biased results.
Instead, scenario analyses and precautionary principles should be applied.
The main purpose of risk analysis is to serve as a basis for risk informed decisions
and actions. One of the objectives when developing the cases was to depict the
whole RM process from risk identification to decisions and evaluation of actions.
This goal was best achieved in the salmonella case. It showed that a risk
assessment does not always result in significant changes, but may as well confirm
the appropriateness of current practices.
Different types of management actions are suited in different risk situations. Risk
reducing activities, either by lowering the probability of losses or limiting the
potential damages, were observed in all cases. Risk compensating, or hedging, and
setting risk limits are important tools in finance. The main idea in insurance
business is not to reduce the risk, but to transfer it to a party willing to accept part
of the risk. A successful company uses all five strategies (avoidance, acceptance,
compensation, transfer and reduction) to manage its risks.
The current trend in risk management is to aim at a holistic approach taking into
account also the correlations and interdependencies of an organisation’s risks
instead of independent risk management of different sectors. This is a challenge
for RM professionals, demanding high modelling skills as well as the ability to
comprehend and manage large complex systems.
50
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