The Implications of Risk Myopia and Misperception

Human risk perception and behaviour have been
scrutinized by economists, psychologists and
neuroscientists in recent years. As a more recent
interdisciplinary subject, behavioural economics is still
developing and its policy implications are only beginning
to be understood. However, basic elements are coming
more clearly into focus. Risk perception is one such
element. When faced with risks, humans often respond
in ways that are deeply rooted in their physiological and
neurological make-up. Fear, doubt, fight or flight are all
emotions and responses that limit our capacity for
rational decision-making. Fear of loss is an example of
one type of risk behaviour. In many different experiments,
research has found that people exhibit loss aversion by
avoiding short-term expenditures, even though they
could actually result in significant long-term gains. More
specifically, people often miss an opportunity to mitigate
risks by not acting with a long-term perspective and by
not taking interdependencies into account

An example from disaster mitigation:
Disaster preparedness and response planning is a good
example of how people fail to take sufficient action even
though they know they are exposed to a serious risk.
Property owners, lenders, investors and government
agencies often ignore worst-case scenarios and do not
invest adequately in infrastructure or enforce regulations
designed to reduce the risk of catastrophes and
accidents.

How can one explain this behaviour? Part of the
response is that people rarely look at probability
estimates in choosing between alternatives and tend to
ignore risks with perceived likelihoods falling below some
threshold of concern. For instance, despite the first
terrorist attack against the World Trade Center in 1993
which cost insurers several hundred million dollars,
terrorism risk continued to be included as an unnamed
peril in most US commercial insurance policies. When
the 9/11 attacks occurred, insurers and reinsurers from
all over the world had to pay US$ 35 billion of insured
losses.
There is another reason why many people do not act
until after a crisis has occurred. Individuals and
corporations have short time horizons when planning for
the future so they may not fully weigh the long-term
benefits of investing today in loss reduction measures
that could benefit them in the future. The upfront costs
of mitigation loom disproportionately large relative to the
delayed expected benefits over time. Applied to
businesses, short-term horizons can translate into a
NIMTOF perspective (Not in My Term of Office). In other
words, if a major crisis occurs everyone hopes it is not
on their watch.

Overcoming myopia: thinking ahead
One way to overcome the behavioural biases caused by
myopia and misperception of risk is to change the
decision time frame in which risk information is
presented. For example, recent research shows the
importance of reframing the probability dimension so
that people pay attention to the consequences of an
event. Rather than specifying that the chance of a
disaster occurring next year is greater than 1 in 100,
experts could indicate that the chances of a disaster
occurring in the next 25 years exceeds 1 in 5. These two
probabilities are identical except that the time horizon
has been stretched to obtain the latter figure. Empirical
studies have shown that people are much more likely to
overcome their risk misperception and to consider
undertaking protective measures when they focus on a
probability of greater than 1 in 5 over 25 years rather
than 1 in 100 next year because the longer time horizon is
above their threshold level of concern.
So how might this concept be applied to encourage
long-term thinking? One proposal in the context of
catastrophe risk financing is to move from the usual one year
contracts towards the development of longer term
contracts. Similar strategies may also be appropriate to
encourage longer term thinking in other areas. For
example, the standard annual bonus system
implemented by many organizations could be modified
so that a more significant portion of managers’
remuneration packages are contingent on multi-year
performance rather than on just the past 12 months.
This might induce managers to consider more
systematically the potential consequences of their
immediate actions in the long run and to pay more
attention to worst-case scenarios rather than hoping that
they will not occur by the end of the current year.
Furthermore, given the interconnectedness of the world
today, actions taken in one part of the world can have
ripple effects thousands of miles away and months and
years after these decisions have been made. Innovative
strategies will be crucial to help businesses and
individuals focus on the long term and to move beyond
“it cannot happen to us” to “what if it occurs” – a
mentality better suited to the current climate of
interdependent global risks.