Irrational Risk

Actuarial work is demanding..., so you're arriving late at your hotel that night. The hotel manager has only two rooms left. These two rooms are exactly the same, except for one aspect: The fire alarm.....

The manager tells you that in the event of a nighttime fire due to the usual causes, guests in Room 1, equipped with Alarm 1, have an actuarial calculated  2% chance of dying. Guests in Room 2, equipped with Alarm 2, have only a 1% chance of dying.

However - things in life are always complicated -  there's a slight problem.....

According to the manager...... The wiring of Alarm 2 is such that it sometimes causes electrical fires that increase the risk of dying in a nighttime fire by an additional 0.01%.

In other words, Alarm 1 is associated with a 2% risk of death and Alarm 2 is associated with a 1% + 0.01% (betrayal) risk of death.

What room do you choose as a professional actuary?

Outcome
According to a study by Gershoff and Koehler, most participants choose the room with Alarm 1. This,  even though this room 1 has double the increased risk of fire death, according the researchers. Reason: most participants found the tiny risk of "betrayal" (product malfunction) much more frightening than the much larger risk of actually dying.  When people get upset by a tiny risk, they often paradoxically choose the much larger risk.

Personally I think a more imaginable risk 'weighs' stronger than a non-specific abstract risk and in general people are unaware of conditional probability effects......

Conclusion

This simple example proofs that emotion has a strong influence on risk decisions.

Just like in our actuarial profession, risk decisions are often irrational.

It is our duty as actuaries to demystify and to rationalize risk. However, sometimes we're victim of the same emotional bias....




Read more about this interesting subject on:

- Vaccination and betrayal aversion (2011)
- Safety First? The Role of Emotion in Safety Product Betrayal Aversion (2011)

- The Risk-as-feelings hypothesis in a Theory-of-planned-behaviour
- Behavioral economics: the missing link in the financial crisis-  
- Decisions are Never Emotional

U.S. Debt Autopsy

Coming back from vacation, the world seems lost. You don't need to be an actuary to grasp that the recent decision to lift the U.S. debt ceiling is first class trickery and completely inadequate.

What the Chinese rating agency Dagong already concluded back  in November 2010, is only now (August 5, 2011) reluctantly and partly followed by S&P:

U.S. AAA status = Dead.

It's interesting to see which countries Dagong rates lower than  the three famous rating Agencies in the U.S.  (download complete Dragon report).

Meanwhile Dagong downgraded the U.S. again to an ordinary A-status on august 2, 2011.

The arguments for country degrades (as the U.S.) are as much clear as simple: if lifting debt ceilings is not at the same time combined with serious debt reduction measures (spending cuts), you go DOWN!

The outlook on the U.S. is still negative.

Outlook
Let's take look at what happened during 2011 and what 2012 will bring..

This chart instantaneously makes clear what's happening:

• Jan 2011 -  half May 2011
  Although  the whole world can figure out that the original debt ceiling of  $14.294 trillion will be reached within a few months, no measures or actions are taken by the U.S. Treasury to prevent a debt default,.
  
  
• May 16, 2011 - August 1,  2011
  Treasury Secretary Timothy Geithner informs Congress he will start tapping into federal pension funds on Monday to free up borrowing capacity as the nation hits the $14.294 trillion legal limit on its debt.
  
  By these and (possible) other optical actions the actual debt is kept artificially stable, slightly above the first ceiling. Of course the factual debt will (non reporting or visible) continue to keep growing.
  
  
• August 1&2, 2011
  The U.S. House of Representatives and the U.S. Senate pass the Budget Control Act on Aug 2, 2011.The debt ceiling is immediately raised by $400 billion, to $14.694 trillion.
  
  A second debt ceiling increase allows the current new ceiling to grow by an additional $500 billion, to $15.194 trillion, so that government can pay its bills until the end of February 2012.  However, Congress has the authority to reject this second increase.
  
  
• August 5, 2011 - March 2012
  
  TresuryDirect reports show the debt catch-up effects on August 5, 2011.
  
  Already $271 billion of the $400 billion debt ceiling lift turns out to be 'consumed'. Another $129 billion is left.
  
  As my two year old son can calculate: If no measures will be effective, around mid September 2011 a new ceiling crisis and media lift-show shall start.
  
  After agreeing in  September to the second ceiling of  $15.194 trillion the muppet debt show will start again in March 2012, when the second ceiling will break.

The party is over
I'm not a pessimistic person by nature, but the U.S. is running out of possible solutions. 

It looks like the financial space flight program is over. 

We'll have to build a society on new ethical financial principles.

If real measures stay out and claims on other countries or banks (as was the case with the sub prime debacle) are limited, the U.S. will unfortunately default in the end.

This U.S. default will take along most western countries.

It will result in a worldwide financial meltdown.

They only way out that seems left is:

Inflation

Let's hope for the best or a miracle. God bless America!



Related Links and Resources:
- Spreadsheet (Excel) with 2011 Debt Data
- S&P Report, August 5, 2011
- TreasuryDirect (U.S. Debt development)
- Debt Ceiling Increase of 2011
- Alert - Just So We Don't Get Confused As To The Source Of Our Little Problem

Humor: Actuarial Mind

In July 2011 holidays  - instead of blogs - are ahead...

Just chew this month on the next actuary no-brainer:

The smartest actuary in the world

The Pope, a well seasoned actuary and a student nurse are flying on an airplane. The captain comes back and says that he has some bad news and some really bad news. The bad news is that the plane is going to crash! As he puts on a parachute and jumps out he says that the really bad news is that there are only 2 more parachutes.

The actuary says: “I am the smartest man in the world. I've just calculated my life expectancy to be more than fifteen years. Excuse me...” With that he puts on a parachute and jumps out.

The Pope says: “Well, my child, I would love to live, but I believe that my time is up. Please take the other parachute and save yourself.”

The student nurse says: “Not to worry Holy Father. Right now the smartest man in the world is trying to find the rip-cord on my back pack!”