Wednesday, November 30, 2011

Perceptions of Modeling Risk

Graph from a Merrill Lynch/Benfield presentation about catastrophe bonds from 2006.

Models are often referred to as 'black boxes.'  Their coding is as secret and highly guarded as Coca-Cola's recipe. Few have any idea what actually goes into creating any given model and they are often legally sworn to secrecy.  According to the graph above, this exposes investors in a catastrophe bond to moral hazard risk.  Further, if a bond is triggered only by measurements of the physical peril, then investor's moral hazard risk is reduced, but the actual versus estimated risk is greater for the issuer.  That is to say, one could be on the hook for a great deal more losses then will be reimbursed by the investment scheme.

Look at the way parametric index and pure parametric is situated.  The parametric index exposes the investor to greater moral hazard than pure parametric.  The difference between the two is that the index requires some calculation, formulation, math... well, modeling essentially. The latter does not.   

Also in the report was the following table: 
For each trigger, the means of mitigating risk is suggested to be evaluation of modeled losses to historical events.     

So, what can be gleaned from this....  
1) There is moral hazard risk associated with modeling, such that, those with control over the models control the risk that others are exposed to. 

2)  The farther removed one gets from actual loss triggering actual payout the greater the risk for entity responsible for the loss.  For instance, say your roof gets torn off in a Cat 3 but payout is not triggered unless your exact location is measured to have experienced winds at Cat 4... that would be a significant bummer.  Likewise, imagine your insurer gets flooded with damage claims but their reinsurance contract doesn't payout because winds were not high enough.  There arises some solvency concerns...

3) There appears to be a need to evaluate the models against the historical record :-P

4) On the bright side, if the models or prior agreed upon parameter dictates that you are to get paid, it will be quicker if no one has to come and look at your  house/crop/etc and you will not need to shmooze your insurance adjuster. 

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