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. 


Wednesday, November 23, 2011

"All Ways are My Ways!"


This past Sunday, Paul Krugman had an op-ed piece distinguishing between technocrats and ideologically driven "impractical romantics."
 They are, to be sure, a peculiarly boring breed of romantic, speaking in turgid prose rather than poetry. And the things they demand on behalf of their romantic visions are often cruel, involving huge sacrifices from ordinary workers and families. But the fact remains that those visions are driven by dreams about the way things should be rather than by a cool assessment of the way things really are.
How timely then, that a new round of emails from the University of East Anglia have  flooded the internet.  Depending on who you role with, the way the emails are sorted and searched varies.  But, there is something there for everyone.

For me, there is climate change and insurance.

What may not be incredibly obvious is that the IPCC and the insurance (and banking) industry are chummy.  Both work through the UNEP.  The IPCC defines and characterized the climate risk and the UNEP-Financial Initiative commodifies it.  It's been going on for awhile and is now quite a big business.  As I was in the midst of teenage angst when the groups "joined forces" (a term on the the UNEP website, at least at one point) and sought to establish a financial market around climate change, I'm a bit late on the bandwagon.  Nonetheless, from what I can tell, the relationship presents significant problems.

First and foremost, evolution of scientific understanding is linked to and constrained by financial markets.  The opinion that the IPCC has of the state of the science effects the risks available to the insurance industry.  So, for example the IPCC cannot become of the opinion that climate change is not affecting disaster losses. If it does, the market tanks. No worries though, because there are plenty of impractical romantics high up on the IPCC list that are all too happy to "redefine what the peer-review literature is!"   I will take a guess that this relationship is in part why the wording about floods and hurricanes changed from the draft of the summary to the final summary.  In the draft, it was suggested that there was no link between damages and climate change.  In the final, it suggested that while no link is evident it need not suggest that one does not exist.

Beyond mere financial interests it appears that those who speak on behalf of the insurance industry and our our abilities to adapt to climate change risks have personal political agendas as well. For instance, a review editor of the part of the SREX report has a clear professional goal to rid the world of alternative views,

...it would be good to show the sceptics up in the naked daylight for the charlatans they are!
and...
...I want to do my bit in sweeping the sceptics out of insurance (as far as possible!)   

Sunday, November 20, 2011

What's 'In' and 'Out' in Climate Related Disasters?

Much like a fashionista's excitement for a debut of a designer's latest line, the world's climate intellectuals have waited with bated breath for the IPCC's latest review of disasters and climate change released this past Friday.

The blogs went wild, as everyone weighed in on the IPCC's qualitative judgment of science's array of argumentative points supporting and negating links (in both type and magnitude) between weather disasters, climate change and social effects.  There is much that can be said in the successes and failures of their judgment calls and the wording of their official summary that still looks like a draft (The final report is out in February.)  Such comments have been eloquently summed up with the workday's highlights here.  That the blogs buzzed in such a way with discussions of right and wrong indicates something else too... the important role the IPCC plays as purveyor of what is 'in' and 'out' in moral claims about climate change and its scientists.  

In the past, those that have discredited assessments/judgments made by the IPCC have faced great wrath from those that have sought to quell any disagreement with the entity's authoritative word in interpreting climate science.  The behavior is characteristic of any moral panic worth its salt.   In effect, the arguments the IPCC made were "in" and arguments against them or questioning them were not only out of fashion but amoral.  On Friday, the IPCC revealed a new interpretation of scientific truth.  This has changed not only what is in and out, moral and amoral, but who falls into these categories.  In an instant, the persecutors became the folk devils and now we all wear a scarlet letter.

Tuesday, November 15, 2011

Occupied by a Loss of Trust

World Map of Occupy Protests from http://www.guardian.co.uk/world/occupy-movement

I have noted some things about the Occupy protests...

The protests have been largely poo-pooed, regarded as an amorphous social phenomena and a logistical nightmare for municipalities to manage.  Worse, some have framed them as problems due to specific individuals or companies.  But it should act  far more as an indicator of a widespread distrust in the governing systems that rely heavily on the maintenance of that trust for power to govern.  Trust and risk are inversely related.  As trust decreases, perceived risk increases.  That the governing systems seem to be perceived as a risk to the public well-being should be a concern to those powers as it is an indication that the public has lost trust in their ability to govern effectively. 

Also, a common complaint about the protesters is that their demands seem unorganized.  It appears more of an uprising with general discontent then one of traditional demand for specific policy action.  But it is not fair to ridicule protesters for this.  Because the public does not know the intricacies of the system and cannot know the intricacies, they trust others to make decisions about the system for them.  This is the purpose of electing officials that consult with technical experts.  To accuse them of not formulating specific policy demands is a slap in the face to those that have put their faith, debt, and dollars into the ideals of democracy and by extension, modern capitalism.  

A brief editorial by Richard Lambert in the Financial Times reflected on this issue well
...The fact that the protesters have no clear agenda is irrelevant. They represent concerns that many people can relate to, and they are unlikely to go away.
So it may be that capitalism is approaching some kind of tipping point, away from the winner takes all culture of the past three decades. If left unchecked, public disquiet will sooner or later bring a political response, maybe in the form of much more aggressive regulations and progressive tax systems. These could be at least as damaging as the free market fundamentalism that they would seek to replace.
Much better for business itself to recognise that it has a real economic interest in the well-being of the societies in which it operates; that success or failure is not just determined by earnings per share or profits per partner; and that a successful market economy has to be built on a degree of trust and mutual respect. Capitalism has adapted to changing political and social pressures in the past, and now is time for it to do so again.

Wednesday, November 9, 2011

"But I'll take your bet, your gonna regret, 'cause I'm the best that's ever been."


I have some obscure "hobbies."  For example, I like to guess what sorts of feelings and responses advertisements try to fetch.  When I can't make any sort of conclusion, I suppose that I am not the target audience.  I get really excited when I meet someone that admits an affinity or dislike for a particular commercial because I think it tells me something about that person.  Indeed, commercials are one of my favorite topics.

In line with the above, I like to make note of job postings sent out by an academic department to their student listserves.  These are regulated and often have a one or a handful of gatekeepers.  So, I tend to assume that whatever goes out on the listserve is symbolic of the direction that the department hopes their students go.  It is symbolic of the ideals supported by the department.    

In 2005, I proudly graduated from the Climate and Society program.  The cost of doing so was debt accrued in 1 year that amounted to ~50% of the cost of attending a Texas state institution for 4.5 years.  Benefits were also substantial: I met some awesome people, saw some cool things, and garnered a healthy skepticism of climate science, the UN, economists, and anything "Ivy League."

It should be noted that the Climate and Society graduate program is the baby of the IRI at Columbia.  Being in the program, I got the feeling that the intent was to rapidly teach many individuals how to use the climate forecasts so they could go forth and do just that.  Slap a Columbia certification on 'em and you got yourself someone with legitimacy. 

Anyways, long story short, I'm on their listserve.

Several moons ago, I got an email from the Climate and Society graduate program listserve advertising a job that was forwarded by one of the program's graduates.   The job was for a "Manager, Insurance Program" with Ceres.  An excerpt,

Organization
 ... 
The insurance industry performs two distinct roles in the global economy—risk management and investment—making it both subject to the impacts of climate change and an essential driver of climate action.  As risk experts, insurers have special credibility in delivering messages—via the media and directly to the companies and individuals they insure—that affirm the reality and impact of climate change.  Insurers also are some of the largest investors in the world, controlling more than $23 trillion in global investments. US insurers hold more than a quarter of this total, making them a critical source of capital for the global economy to transition toward a low-carbon future.  Ceres is the only sustainability NGO with deep expertise on the insurance industry...
(Bold mine)

Description & Responsibilities

Ceres is looking to hire a manager focused on the insurance sector... The manager position offers a unique opportunity to move a key sector of the economy toward action on this century’s most pressing environmental issue... Specific duties include, but are not limited to the following:
·     ...engaging with a range of insurance industry actors, including large insurance and reinsurance companies, insurance regulators, catastrophe modelers, and climate scientists on climate change and insured losses.
  ...
·       Effectively communicating to a broad range of actors, including the broader financial community, equity analysts and bond rating agencies, about the risks that climate change poses for insurers.
  ...
·       Writing research reports and other multi-media communications to reach companies and stakeholder groups with timely information on Ceres’ industry programs and sustainability issues...
So it is interesting to me to see the ways the program seeks to have climate information used.  That C&S has suggested that its graduates go into insurance, backs the IRI's involvement in insurance, generally and edges the program and its sponsoring research group towards a position of policy advocacy... or maybe puts them squarely in such a place.

Columbia has close ties to the UN, which also backs the insurance to address climate change issue.  Maybe it is ultimately just towing the company line, as the UN is all about the carbon market and the insurance that can stabilize its existence.

I remember the first day of class.  It was also the first day of the program!  A well known, brilliant climate scientists asked us something like, "Do scientists have an ethical obligation to society?"  It wasn't until many years later, and more debt :-), did I realize the true depth of this loaded question.

Wednesday, November 2, 2011

Eat the Rich

Prior to starting a grad school I had a bona fide job. The one charged as head of the company was a a savvy politician but also of the grandfatherly type. A good man that I learned much from in a short period of time. Replying to my general personality of skepticism, he told me, "You are too young to be so cynical." Maybe, but it has boded well for my graduate studies.

The Financial Times has picked up the Oxfam-Swiss Re collaboration (mentioned in the past, here). The article reports (written by an academic at UNC-CH) that the collaborators are creating a "work-for-insurance" plan.
Insurance companies and non-profits would link up to use this market-based solution to help poor African farmers mitigate the effects of drought. It would also have the potential to create new insurance and risk-management markets.
The program seeks to be modeled after a government "food-for-work" program.
In 2008 Oxfam and Swiss Re adapted Harita, a livelihood development plan that packages crop insurance with access to credit, savings schemes and advice on crop yields. It has since evolved into a “rural resilience” package, now called R4. Oxfam and Swiss Re gave local insurers and partners the confidence to adapt the food-for-work schemes to make crop insurance available in a similar way for the first time.

The key to offering crop insurance to very poor people is to keep costs down, and index insurance – which pays out all policyholders when factors related to crop failure occur – is less expensive than verifying farm-by-farm claims. Oxfam, Swiss Re and partners designed such a scheme based on rainfall data. Oxfam uses satellite information, while farmers also have cylinders on sticks to measure rainfall themselves. If rain fails to reach certain levels, the policy pays out.
...
It also integrates insurance with risk reduction because the work farmers do for the insurance relates to outcomes, such as digging ditches or cleaning seeds.
...
Swiss Re’s pledge of continuing support suggests to stakeholders a sincere attempt to build a new market with long-term, market-based solutions.
...
Although it is early days, the scheme indicates a new way to make profits while also making a difference.
Thoughts...
1) Sounds a little like indentured servitude.

2) Work for food, offers food (I guess). What makes matters different from work-for-food, is that there is no food. Does payout guarantee food will be available for purchase? I don't imaging that it would because many of these areas depend upon subsistence ag and suffer from a lack of infrastructure. One can't eat their insurance payout.

3) Let's say Dr. Joe Climate Scientist predicts a drought year (coupled with climate change of course). If the rates for insurance increase, does the work required for insurance increase? How will such a situation interact with predictions of loan defaults as suggested here.


In 2009, the IRI published a report on their experimentation with index insurance around the world. The report is revealing of some experienced difficulties, what it takes to establish an insurance regime in areas without prior experience with insurance, and the process of creating and characterizing insurable risks.

I am curious to see how this plays out over the years. My cynicism leaves me quite skeptical. In general, there seems to be much about the decidedly insurable risks that are hidden behind an array of models and a primary motive for establishing international trading markets. For example, the IRI report mentions that,
Another advantage is that the insurance product facilitates price discovery for Ethiopian drought risk in international financial markets. Putting a price on drought risk allows for better understanding of investment tradeoffs for mitigation/ management of drought risk.
Also, thus far, implementing insurance in these rural developing areas is being done on a foundation of implied good faith in the industry, aid groups, and scientists. There seems to be no means of accountability. In the end, it may be that poor farmers are becoming vulnerable to much more then just drought.