Journal of Risk and Uncertainty, 7:89-94 (1993)

9 1993 Kluwer Academic Publishers

Ambiguity and Risk Taking in Organizations

ZUR SHAPIRA
Department of Management, New York University, 44 West 4th St., #7-59, New York, N Y I O012.

Key words: ambiguity, risk taking, decision behavior, organizations

Abstract

Kunreuther, Meszaros, and Hogarth (1993) argue that insurers are risk averse and ambiguity averse, and that
they use cognitive reference points and constraints in making pricing decisions. They further claim that insurer
ambiguity may be a factor that has a role in market failure at the industry level. Arguably, ambiguity may be an
important aspect of decision behavior. In this article, research on managerial risk taking is reviewed with a
focus on the relationship between ambiguity and risk taking. In particular, the effects of the organizational and
institutional context are highlighted. It is argued that the political aspects of insurer decision behavior should
be considered as well. Implications for further study and understanding of decision making are discussed.

Kunreuther, Meszaros, and Hogarth (1993) describe market failure in the insurance
industry and propose that classical economic analysis may not suffice to explain the
phenomenon. Rather, they suggest that intrafirm decision processes may prove benefi-
cial to that end. In particular, they raise three propositions arguing that insurance man-
agers are risk averse, are ambiguity averse, and utilize constraints and cognitive refer-
ence points in their pricing decisions.
Inasmuch as the classical model is concerned, the first proposition may not be a
problem. Usually, decisions in insurance companies are made by managers, whom the
classical literature conceive of as being generally risk averse (Arrow, 1965). The two
other propositions depart significantly from the classical model but bear relevance to
current analyses of managerial risk taking. Some aspects of this research are highlighted
in this article, and their potential relevance to insurer decision making is discussed.

1. Ambiguity and risk taking

In one of the classical studies in decision making, Ellsberg (1961) showed that people
were averse to risky choices where probabilities were not specified. He labeled this
phenomenon "ambiguity avoidance." Kunreuther et al. (1993) demonstrated ambiguity
aversion with data collected in surveys of actuaries and underwriters from primary insur-
ance companies as well as reinsurance firms. These authors defined ambiguity aversion
as the tendency to select one uncertain alternative over another even though both have
90 ZUR SHAPIRA

the same expected loss. The point is that the probability estimates in the second alterna-
tive were described as ambiguous. Operationally, ambiguity was defined as the case
where two experts give different estimates.
The data of these authors suggest that central tendency measures such as expected
loss may not capture insurers' conceptions of and attitudes toward uncertainty and risk.
This argument is reminiscent of March and Shapira's (1987) finding that managers
conceive of risk more as an amount than as a probability. Indeed, as one of Shapira's
(1994) subjects stated, "I take large risks regarding the probability but not the amounts."
The managers in Shapira's study were quite familiar with statistical descriptions of risk.
Nevertheless, when talking about risk, they tended to separate the elements rather than
combine them into expected values. This tendency was echoed in the words of a senior
vice-president who said, "A gamble of one million dollars in terms of success in a project
is risk; however, a gamble of half a dollar is not a risk." He added that this would be his
view even if the latter probability of loss was close to 1.00. Actually he argued, probability
didn't matter much.
Managers appear, therefore, to decouple probabilities and monetary values in the way
they define risk. Furthermore, they tend to place more importance on the monetary
amounts than on the probabilities. This may reflect the fact that money is better specified
than probability. If one is about to lose $1 million, the event is very dear. If, on the other
hand, the same person faces a .5 probability of losing $2 million, the picture appears
more ambiguous. While money is linear (though utility is generally not), the curvature of
perceived probability is more vague. In their discussion of decision weights, Kahneman
and Tversky (1979) suggested that these are not well defined near the edges. In examin-
ing nonverbal estimates of probabilities, Shapira (1975) found that subjects were not
sensitive to changes in probabilities between .3 and .7, but were very sensitive to changes
at the extremes.
Probability estimates appear in the first place to be less stable than monetary value
estimates. This may lead managers to focus on the latter, which appear to be more
credible than estimates of probability (March and Shapira, 1987). If another dimension
of unreliability is added to probability estimates, namely, a distribution over the esti-
mates themselves, then one gets the ambiguity aversion effect that Kunreuther et al.
(1993) found. The decoupling of probabilities and monetary values in managerial con-
ceptions of risk is not at odds with Tversky and Kahneman's (1991) notion of loss aver-
sion. They showed that the issue of loss itself may be separated from pure attitudes
toward risk. In other words, their analysis suggests that, unlike the classical notion,
people may be averse to losing and at the same time may not be averse to taking risks.

2. Cognitive reference points and risk taking

If we assume that insurers, like managers, separate rather than combine estimates of
probabilities and losses, then what anchor or reference point do insurers start from when
they evaluate alternatives in setting premia?
AMBIGUITY AND RISK TAKING IN ORGANIZATIONS 91

The natural point would be some central tendency measure, such as expected value;
yet, as was argued above, this may not characterize many decision makers. One alterna-
tive was suggested in a managerial risk-taking study (Shapira, 1994), where a certain
pattern emerged. It describes managers as starting from the worst-case scenario and
continuing from there. That is, in considering a risky project, if the manager feels that the
worst-case scenario is "acceptable" and will not jeopardize the survival of the firm, then
he or she is willing to continue the evaluation. He or she then considers the alternative
further by looking at the other side of the alternative outcomes, namely, the opportuni-
ties. In other words, if managers feel that their company can sustain the maximum
possible loss, they look for the potential gain that would counter that loss. The process
appears to be one of balancing the worst-case scenario's potential loss with a potential
gain that would make the project attractive. This process is an active one and differs from
a strategy of simply relying on summary statistics (see also March and Shapira, 1987).
March and Shapira (1992) proposed that two cognitive reference points govern risk
attitudes: a survival point and an aspiration level. Risk taking according to their model is
determined, in part, by the focal point. That is, differential risk tendencies ensue if the
decision maker is focusing on survival, is focusing on the aspiration level, or is shifting
his/her attention between the two. It is suggested, therefore, that decision makers may
operate by sequentially attending to different reference points. The process may con-
tinue until either the decision maker focuses on one point or a dominant alternative
emerges and gets chosen. A somewhat similar pattern was found by Shapira and Venezia
(1992) in their analysis of gambling behavior in state lotteries (which is a mirror problem
of insurance). They found that gamblers' behavior is influenced by the size of the first
prize, whereby both the cost of the lottery ticket and the probability of winning are often
neglected. Apparently, lottery administrators are familiar with this pattern of behavior,
as is evident in the way they advertise lotteries: "All you need is a dollar and a
dream."
The above discussion suggests that the findings in the insurance decision literature,
such as Roy's (1952) "safety first" constraint, go along with those in the area of risk
taking. Further research is needed to find when managers and insurers would start from
expected value and then go through adjusting (Hogarth and Kunreuther, in 1989) rather
than start from either the aspiration level or the survival point. Other potential reference
points should also be considered (Kahneman, 1992).

3. Organizational and institutional correlates of risk taking

Most important insurance decisions are made by professionals who are employed in
organizations such as insurance companies. Life in such organizations have certain char-
acteristics that affect risk taking. These characteristics stem from the fact that different
players take part in organizational decision making, many of whom have different incen-
tives as well as different information. These differences in information and incentives can
affect the decision process and may lead to biases. The existence of ambiguity can am-
plify the effects of these characteristics even further.
92 ZUR SHAPIRA

3.1. Incentives and risk taking

Managerial risk taking is strongly affected by incentive schemes. Despite top-

management familiarity with the calculus of risk taking and with the fact that the proba-
bility of failure may be high when risks are taken, success if often "shared," while failure
is often penalized (Shapira, 1994). Uncertainty about the consequences of risk taking
can be described by the anticipated type I and type II errors. As Shapira (1993) noted,
the importance managers attach to the visibility of type I errors (since they often lead to
penalties) leads managers to minimize the probability of these errors, thereby most likely
increasing the probability of type II (missed opportunities) errors.

3.2. Ambiguity and ffsk taking

Ambiguity can often amplify the possible negative consequences described above. Con-
sider the case of dynamic decision making by government bonds traders. The volatility of
prices of government bonds is among the highest in capital markets. Indeed, it is the
volatility that creates the opportunity for profit making. Nevertheless, in a study con-
ducted at one of the largest capital funding firms, managers in charge of the trading
desks complained about top-management behavior. The latter regularly voice their un-
happiness with volatility while at the same time push for more profits (Shapira, 1992).
Oftentimes, they would question the judgment of the traders and trading desks' manag-
ers. Operating in this huge market is vulnerable to judgmental errors, since there is much
ambiguity in terms of agreement on precise probability estimates. This ambiguity affects
the traders' behavior.
The traders in this business are following a multitude of data into which ambiguity and
uncertainty are interwoven. The traders are evaluated according to their objective per-
formance. Nevertheless, they often feel that uncertainty and ambiguity in their jobs are
working against them. As one of the traders noted, the statement that best describes the
traders' feelings about their performance and future employment is, "You're only as
good as your last trade." Incentives are tied to performance, which is affected by ambi-
guity. Incentives and ambiguities therefore combine together in shaping traders' risk
attitudes.

4. Organizational decision making as a political process

There are a multitude of agents participating in insurance decision making. Each may
have different incentives, and the situation may also be described as one of asymmetric
information. Hence, one possible way to analyze the process is to focus on the principal-
agent relations. However, such an analysis may be too simple. In the decision arena the
public also gets into the picture through the legal process which involves lawyers and the
courts. Regulators and legislators also take part in the process. It is here that ambiguity
affects the process even further, since in many cases, such as those involving punitive
AMBIGUITY AND RISK TAKING IN ORGANIZATIONS 93

damages, there is ambiguity about the standards that should be applied. Standards may
be clear in determining compensatory damages but may be ambiguous when punitive
damages are considered (Barrett, 1991).
Such ambiguity may have a strong effect on insurance decision making. Indeed, it may
be argued that in addition to the uncertainty pertaining to whether certain damages may
occur, the issue of uncertainty and ambiguity about possible future litigation emerges as
an important consideration. While this topic may have not been examined in past re-
search, it is reminiscent of Lanir and Shapira's (1984) study of decisions regarding the
construction of underground shelters in Israel. In making these decisions, data on prob-
abilities and expected losses under different scenarios were made available to the deci-
sion makers. However, it appears that the behavior of these decision makers in deciding
on this complex issue could best be described as decisions by politicians who were mostly
concerned about possible future "litigation." They were mostly concerned with whether
they could be held responsible for possible future "failures." Needless to say, such be-
havior does not necessarily lead to the best decisions.
In that political decision process, another layer of ambiguity emerged. Kunreuther et
al. (1993) defined ambiguity as resulting from the case where two experts give different
estimates. They proposed that these estimates be weighted equally. However, an impli-
cation of Lanir and Shapira's (1984) analysis is that the legitimacy of the source providing
the estimate may complicate things even further. Whether legitimacy is or should be
taken as a weighting function of the estimates is a question that needs to be examined.

5. Conclusion

According to Kunreuther et al. (1993), ambiguity may be an important determinant of

insurer decision making. These decision makers are apparently risk averse and ambigu-
ity averse and they use constraints and reference points in making pricing decisions. As
Kunreuther et al. (1993) suggested, ambiguity may be a factor that has a role in explain-
ing market failure in the insurance industry. They proposed some remedies in the form
of improving risk assessment on the one hand and creating institutional arrangements
for risk sharing on the other.
In this article, an attempt was made to draw similarities between insurer decision
behavior and managerial risk taking. There are quite a few parallels between the two.
Some empirical studies suggest that ambiguity may be associated with certain patterns of
decision behavior that depart from classical models of risky choice.
A final comment is devoted to the status of ambiguity in a more general way. It may
appear from the above analysis that ambiguity plays an inherently negative role in af-
fecting decision making. While in most cases ambiguity may complicate decision pro-
cesses, the arguments brought in this article suggest that attempting to deal with ambi-
guity may further our understanding of judgmental and decisional processes.
Furthermore, in considering insurer decision making as embedded in the larger organi-
zational/institutional context, one need not neglect the fact that there may be some
94 ZUR SHAPIRA

players in the game who may benefit from ambiguity. In a society that more and more
deserves the title of"litigating society," Naguib Mahfouz's (1988) comment that "Clarity
is good but so is ambiguity" may take on additional meaning.

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