When I try to manage risks, I start with a good scan of what could go wrong. Some of these we insure, some of these we cannot. Frank Knight broke risk into two categories, uncertainty and real risk. Real risk is calculable, it has a frequency and a severity. Uncertainty has neither.
Donald Rumsfield’s comments on knowledge can be related to risks. Rumsfield stated that there are known knowns or things we know we know. These risks have a known frequency and severity and are generally insurable and controllable.
There are known unknowns, which are questions which we have, but which we don’t have an answer. These are complicated risks that can’t fully be insured because the frequency is low, or the severity is incalculable. These risks can still be managed.
Finally, there are unknown-unknowns, where we are not aware of the questions or the answers. Risks that are unknown can’t be managed or insured. This category is the same as Knightian uncertainty.
The risks that make business crack up are generally unknown-unknowns and are often a surprise to management and investors. Risk management for the CFO becomes a process of handling the various real risks and trying to better understand Knightian uncertainty.
Bad and unusual events that we were not aware of are sometimes referred to as black swan events. Nassim Taleb defined black swan events as a surprise with a major impact. The thing about black swan events is that it may be a surprise to you, but it doesn’t mean mean that the event wasn’t known by others. That is true also for Knightian uncertainty. A larger knowledge base decreases uncertainty and unknown unknowns can be reduced by learning.
I therefore break uncertainty into two slices, hard and soft. Soft uncertainty are issues that could be learned with a reasonable investment in diligence and research. Hard uncertainty can’t be. The trick is to convert soft uncertainty into complicated risks, where management, insurance and reporting processes can be brought to limit losses. Hard uncertainty remains retained risk.
“Risk comes from not knowing what you’re doing.” – Warren Buffett
Converting uncertainty into something that can be managed requires an open mind and a sense of paranoia. CFO’s who think risk management is an annual lunch with the broker are going to find themselves surprised by events.
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