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December 30, 2010

Comments

Richard Gadsden

In the context of your point 1, there is also an agent/owner issue. The director of the company has much higher upside incentives than downside ones - the worst than can happen on the downside is that he loses his job and his reputation is damaged enough that he can't find a new one.

That's not exactly wiping him out, where a company that suffers as a result of this big downside can be badly damaged (e.g. BP) or even completely wiped out (Lehman Brothers).

Aligning the incentives better between the owner and the agent is a long-standing problem in modern capitalism, but I don't think you have a solution either.

Steve

The Minister also came on the radio saying that even pipes laid in 2008 had cracked, so perhaps it's all just down to the weather?

dcomerf

Weitzman's Dismal Theorem says that, as risk averse consumers, we should be almost infinitely averse to this tail risk. Backs up the principle-agent analysis above.

InfoholicUK

As you point out, the trouble with evaluating tail-risk is that because the events are by definition rare, it is difficult to evaluate with any accuracy either their likelihood or impact, because you have so few observation points. Your £150@2% analogy looks like a no-brainer, but what if it's actually 0.2% or 0.02%, or that loss could be £1500 or £15,000. Decision making is the easy part, its the generation of the statistics that is hard.

(Although I would have to say that, given I build Monte-Carlo risk engines for a living)

Metatone

I think that while there are elements of unknowability, they would be much improved if losses were not socialized. If BAA (and others) had to pay meaningful compensation to those whose travel plans were disrupted, I'd be much more sympathetic to the idea that they made a mistake with the probabilities.

As it stands, there is a massive power and risk imbalance. If I miss my flight by 30 mins because of unforeseen weather difficulties, I lose up to the cost of my ticket (depending on the exact ticket.) If they fail to run my flight for 5 hours... I get... possibly nothing and up to £5 to spend in the airport cafe.

Now I can take out insurance... but so can they... but they have no incentive to...

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