The conceptual framework for a man's search for meaning

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The turkey under the butcher’s knife

June 6th, 2011 by dimpledbrain

Have you ever wondered how do insurance companies make money? How exactly?? We have heard of some actuarial scientists yes who do all the dirty calculations and who are generally intelligent. However one cuts it, insurance companies must make profit from arbitraging the perceived risks between the issuers (i.e. the insurance companies with all the geeky actuarial scientists) and the buyers (i.e. the rest of us who buy insurance premiums). It then follows that whatever the insurance companies earn, they earn from our collective overestimation of perceived risks.

Risk really means the possibility of something bad happening. The best framework to understand risk is via what is known as probabilistic risk assessment (PRA). The 2 factors in a PRA framework are:

  • the magnitude (severity) of the possible adverse consequence
  • the likelihood (probability) of occurrence of each consequence

For the sake of discussion, we can easily visualize the above in a two by two matrix with a scale of low to high. Low-impact-low-probability (e.g. ability to sleep with your eyes wide open) or high-impact-high-probability (study hard and get good marks) events are real no brainer; just avoid the former and do the latter.

The dilemma begins with the inversely correlated combinations, especially high impact low probability events. The tri-disasters that recently swept Japan are extremely devastating (high impact) but don’t just happen every other day (low probability).

Why this is so interesting is that we often overemphasize low-impact-high-probability events but underemphasize low-probability-high-impact events. No way, the principles of economics describe us as rational. I think the term rational and predictable have been loosely used. Predictably irrational that is!

  • the probability of dying in a commercial plane crash is 1 in1 to 10 millions vs 1 in 6,000 in a car wreck. But on average fear of flying is stronger than fear of driving?
  • lottery winning e.g. 58 numbers jackpot has a 1 in 40 odd millions strike rate yet people (including myself) are mesmerized by it. Unless it’s for the sake of buying a dream I say.
  • Overbuying insurance premiums, anyone?

Don’t be the turkey
In his book The Black Swan: The Impact of the Highly Improbable, Nassim Taleb states that a Black Swan Event (read low probability high impact) depends on the observer. For example, what may be a Black Swan surprise for a turkey is not a Black Swan surprise to its butcher; hence the objective should be to “avoid being the turkey”.

I conclude with two more thought experiments:

  1. Why do people fight tooth and nail for their next career promotion (moderate impact moderate probability) at the expense of their family (high impact low probability), leading to divorce and strangely back to their own unhappiness? Or anything that isn’t rational?
  2. From a probabilistic risk assessment perspective, the probability of a medium probability moderately rich case and a low probability very rich case is the same. So why do people get obsessed with getting very rich a lifetime?

Wouldn’t life be ideal if we can see the world through the PRA (refer to paragraph 2 above) lens?…Avoid being the turkey.

p/s:  In a totally unrelated discussion, think about this too. Insurance companies which are thought to be socially responsible can get quite unscrupulous in their dealings – by not compensating rightful claims. On the other hand, governments impose ‘sin taxes’ on gambling companies which don’t dispute any bets that you win.

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  • Low severity high frequency events like shoplifting can leave a deep impact in the long run. It is how much we perceive the risk to be dangerous. Flying as a fare paying passenger can be perceived to be more risky than driving 200km/h on a highway … that’s because you know you have control in the latter.