How do you calculate risk in an era when nightmares are becoming headlines? That terrifying question, of course, faces anyone who flies in an airplane or opens an envelope these days. But it is a particular quandary for those who practice the relatively new profession called risk management.
Actuaries who set insurance rates, bank lenders who assign credit limits, Wall Street managers who keep their traders in line all try, in various ways, to look at the past and figure out what could go wrong in the future. Now that disasters are striking, these risk managers are revising their formulas and trying to figure out how to manage risks they never took seriously before.
"The things that happened a month ago were pretty darn improbable, the sort of things you worry about in your sleep," said Wilson Ervin, the head of strategic risk management for Credit Suisse First Boston. "We are living in a different world today. You have to re-examine every assumption you have made."
The insurance industry reacted the fastest. Companies that included terrorism insurance as a free bonus in property policies now are reluctant to sell it without taxpayer backing. Other insurance rates are shooting up. Traders are pulling in their horns, too, reducing their positions and their leverage. And lenders, beyond shying away from the industries that have been hardest hit, such as airlines and insurance, generally are becoming more cautious about making loans.
Suddenly old economy virtues like a healthy balance sheet become essential. "There is far less capital available than there was," said Leah Modigliani, a portfolio strategist at Morgan Stanley.
"The companies that are already strong and well positioned will tend to dominate."
The insurance industry is already coping with something worse than it has ever faced before. Analysts estimate that the total payout for the Sept. 11 attacks will range from US$30 billion to US$60 billion.
Harder to calculate is the cost of undermining assumptions about the world that largely determine how insurance rates are set.
"You know how often a big hurricane is likely to hit, and a hurricane today is very much like a hurricane 25 years ago," said Warren E. Buffett, the chief executive of Berkshire Hathaway, which owns several big insurance companies. "But terrorism today is not at all like terrorism 25 years ago."
Insurance companies are replacing open-ended policies that covered nearly any risk with much narrower ones that cover only certain, specified hazards.
Risk managers on Wall Street were merely rattled by the impact of Sept. 11 on their portfolios. That largely was because banks and brokerage firms already had endured a series of financial disasters, from the default of Latin American debt starting in 1982 to the 1987 stock market crash to the collapse of the Long Term Capital Management investment fund in 1998.
"Before Sept. 10, our worst downside case was a global recession," said Modigliani. "Now we still have a global recession case, but it's also a war scenario."
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