Wednesday, July 25, 2012

The price is right for who?



William Baldwin, at Forbes, poses a question to his readers:
How would you like to go into the insurance business, collecting premiums for insuring people against catastrophes?
He proposes that this could be a lucrative venture when the dominate perceived risk is high.  Baldwin leads the reader through a thought experiment using stock put-options.  He shows that model assumptions can play a leading role in creating perceived risk and therefore, risk estimates can vary.  Thus, deciding a good risk price is based on using "circumstantial evidence" and considering one's objectives.  In the excerpt from Baldwin's example below, the risk price could be sufficiently reasoned at $13.  But, given a high perceived risk, a tight market, and a personal goal of profit, $18 is a better price.  
The big question is whether that $18 price is a good one for the risk you are taking. Let’s start with the classic Black-Scholes option valuation formula. Plug in the 21% annualized volatility that stocks have exhibited since 1926 and an assumption that prices drift neither up nor down over time. The formula says those puts are worth only $13. 
[A finance expert] cautions that Black-Scholes underestimates the probability of big moves, like that freakish crash on Oct. 19, 1987. When you hear option traders talking about “tail risk” or “black swan” events, they are referring to this well-known deficiency of the formula. 
Tail risk makes put options worth more than Black-Scholes predicts. But something else makes them worth less: The formula’s assumption that stock prices trend sideways is too bearish.
...
Fat tails and upward drift—experts can debate which of these has the bigger effect and whether the true value of those SPDR puts is closer to $13 or $18. But the circumstantial evidence is that $18 is a rich price because of supply and demand. There are a lot of nail-biters who want protection. People willing to sell insurance are scarce.

Over at Artemis, this same phenomena is discussed in relation to catastrophe bonds. Writers there have given a series of posts analyzing a recent report from Willis.  The discussion is regarding the below chart.

Artemis suggests that despite a general leveling (and slight decrease) of risk estimates, the cost of that risk has continued to increase "steadily."  Artemis suggests that this may be due to increasing perceived risk of investors and reinsurers. Despite risk estimates then, a higher price better suits investor intertests.   

The risk premium has risen steadily over the last year and the average is now back near the highs seen in 2009, in the wake of hurricanes Katrina and Ike. This is interesting considering we haven’t seen a landfalling hurricane for a number of seasons now, and perhaps is more indicative of investors in the sector maturing and realising that they want a certain level of payment in return for this peak risk as well as traditional reinsurance pricing influences 
On the flip side to this discussion however is that a lower risk price could be equally as valid and used to suit other interests- such as public interests.  Because a choice must be made in what the risk is and its price, outcomes of these decisions reveal power dynamics in the ratemaking process.  Consistently choosing high measures of risk suggest that the decision making process is currently dominated by the risk perceptions of investors and financial interests which correspond to goals of profit and economic sustainability.


Tuesday, July 17, 2012

Negotiating Compromise Between Affordability and Actuarial Soundness


The Miami Herald reported on Citizen's Board of Governors recent meeting in Miami and described a "public outcry" against decision makers preference of actuarial soundness over affordability.  At the heart of the matter is debate about a politically acceptable characterization of  risk symbolically represented by the "rate."  

Affordability is a value of well being.  Actuarially sound is a value of skill.  Both are used as goals in the legislative mandate that created Citizens and neither are defined by the legislature.  They are used as battle cries in the political process of debating agreement about risk.  Free from a firm definition, interests propose different meanings. The affordability or actuarial soundness of a rate is determined by the ability of the rate to satisfy a given political agenda.

Reference to affordability often beckons consideration of the HUD defined affordable housing.  According to Miami Herald reporter's, this perspective was alluded to by a state representative from Miami,
“The decisions you [the Citizens' Board] make affect people that you may not think about,” said Rep. Carlos Lopez­ Cantera, R­Miami, referring to low-­income Miamians who have to choose between housing costs and food. 
From Lopez-Cantera's perspective, an affordable rate is one which allows housing goals to be met.  However, from an insurance perspective, an affordable rate is one which enables the continuity of business- the insurer is able to bear the cost of the risk.

Much of the same can be said for value of actuarial soundness.

The definition of actuarial soundness has eluded the insurance industry for some time yet it is very common in legislative mandates concerning insurance.  Most recently, the America Academy of Actuaries has attempted to address the issue by reviewing the literature in several actuarial areas.  They concluded that the term is
used as a general term, assumed to be understood to mean reasonable and consistent with generally accepted actuarial principles and practices.   
Nonetheless, the AAA acknowledges that debate arises as to what a generally accepted principle and practice looks like in application,
In the context of ratemaking for insurance companies, for example, disputes over whether a rate is an actuarially sound cost estimate tend to arise due to differences in opinion over the methods used to estimate future costs; the inclusion, exclusion, or limitation of certain costs; and how the rates are distributed to the individual classes of insureds.
Consider then that an actuarially sound rate is one which supports a given political agenda.  An actuarially unsound rate is one which does not support a given political agenda.  This interpretation gives reason to the debate about methods, because different methods produce different estimates of risk and therefore suggest different rates.  Such a perspective is consistent with the academic literature that discusses the use of the term "sound science" or "scientifically sound" and the contrasting rally cry, "junk science."

Hence, Florida Representative Fran Artiles alludes to proposed Citizen's rate increases as actuarially unsound because certain practices, such as litigation and administration, are inappropriate
I do not believe that a rate increase at this time is the right solution because your [Citizens] costs are not under control.
But for those that are seeking to reduce the size of Citizens', such as current Gov. Rick Scott, the proposed rates are sound.

So, affordability and actuarial soundness are values used as a means, or an ideological tool, to argue for a representation of risk that is favorable for obtaining other goals.

Friday, July 13, 2012

A Fine Line: Some lessons learned from the LIBOR estimate scandal



Recently, the economic and financial media has been awash with talk of a LIBOR scandal.  The London Interbank Offered Rate (LIBOR) is "the most important figure in finance" used to set payments on about $800 trillion worth of financial products (The Economist).  The scandal is that the figure is "rigged" and the process of establishing the LIBOR rate turns out to be a political one where experts work to influence the rate decision.  Emails between key decision makers and producers of the LIBOR estimate reportedly reveal political interests being interjected in the process of determining this most important risk estimate.


The Economist suggest that, in theory, LIBOR is
supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates.
But, there are two things that have become wrong with the process of setting the LIBOR rate and hindered a truthful estimation process.  
First, it is based on banks's estimates, rather than the actual prices at which banks have lent to or borrowed from one another. 
A second problem is that those involved in setting the rates have often had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. 
There are lessons to be learned from this oh, so familiar sounding situation.   


There is no right rate or estimate of risk.  Estimating risk based on something other than observation (eg. a historical average, or actual lending prices) is to give weight to other values, such as profits.  To do this is a decision.  If the decision is to weigh the risk along value preferences, then it is important to acknowledge that the process has become political with potential winners and losers working to influence rate policy.     


Another potential lesson is that there is a fine and non-stationary line between expert judgement and illegal manipulation.  This line ebbs and flows along with the mercy of public perception and trust.  Still not yet recovered from the 2008 loss of trust in the banking and finance industry, the public is quick to perceive bank executives less as insightful experts and more as ruthless money hungry manipulators.  What was once, perhaps, an acceptable practice of using a combination of expert judgment and technical facts now, in a growing number of instances, falls within the realm of illegal activity.  As it becomes increasingly perceived that the LIBOR rates were knowingly estimated for personal gain, banks are facing a potential onslaught of lawsuits akin to the "tobacco movement" of the 1990s.  Perhaps, financial statements will one day come with warnings and graphic images of the Occupy protests =)

Monday, July 2, 2012

Marine Mammal Risk... Governance


I am not in the habit of following the politics of workers' comp policy problems but I do have a soft spot for marine mammal science policy.  What does one have to do with the other?

In 2010, an Orca whale trainer, Dawn Brancheau, was killed at SeaWorld Orlando.  The trainer was an employee and SeaWorld an employer.  At first, SeaWorld was fined $75k by OSHA.  In the last month, Ken S. Welsch, a federal administrative law judge for the Occupational Safety and Health Review Commission (OSHA), ruled on SeaWorld's fighting of the penalty.  He reduced the fines to $12k, reduced the most serious violation from “willful” to “serious,” and demanded that physical barriers must be in place between trainers and Orcas (although I'm not clear if it is just Orcas or all marine mammals).

The case has been covered by insurance industry specific news sources with particular attention paid to the predictability of orca behavior and the precedence that the case sets for potential future mishaps.  But other societal interests have conflated the issue with concerns for human and animal well being.  What has emerged is a public policy issue or more specifically, a marine mammal risk governance issue.  The risk is composed of several political interests with their chosen avenues of marine mammal science used to support their preferred outcomes. Hence, governing the risk is a political process whereby society struggles with the moral, scientific, and economic implications of the intersect between society and marine mammals and defining the proper role and responsibility of marine mammal parks and research centers.  Many of these interests and their perceived risks are represented in the specific issue above...   


Human Well Being Risk
The risk to human safety begs the question (especially, if you are a concerned insurer), "How predictable is marine mammal behavior?"

Apparently, SeaWorld claimed that trained orcas exhibit behavior that can be predicted with more than 98% accuracy.  Welsch, however, rejected the risk estimate arguing that it was not based on science.

The judge instead appealed to an Orca's free-will to argue that there, fundamentally, cannot be any certainty
"Once a trainer is in the water with a killer whale that chooses to engage in undesirable behavior, the trainer is at the whale’s mercy,” the judge wrote in his ruling. “All of the emergency procedures, nets, underwater signals and hand slaps are useless if the whale chooses to ignore them."
A spokeswoman for SeaWorld argued that the science was being misunderstood
These allegations are completely baseless, unsupported by any evidence or precedent and reflect a fundamental lack of understanding of the safety requirements associated with marine mammal care.
There is, then, dispute of what is considered reliable science to support safety decision making between trainers and marine mammals.

There is also a question of the predictability of an individual animal.  Tilitkum, the individual Orca that caused the death of the Brancheau, had also been implicated in two other human deaths at a different marine parks.  The heightened risk perception of Tilitkum is communicated amongst trainers but it was disputed as to whether or not SeaWorld took appropriate precautions to protect its employees from this particular Orca.

Nonetheless, trainers often feel that the risk of harm is worth taking for the experience of caring for these animals.  To them, the risk is minor because constant interaction over time fosters a relationship between the trainer and the animal which enables the trainer to identify or foresee risky situations in situ.  
SeaWorld animal training curator Kelly Flaherty Clark, testified that in a 25-year review of whale behavior she couldn't find a case, other than Brancheau's death, when there weren't environmental or animal cues that would explain an animal's undesirable behavior.  
"Trainers are trained for different scenarios," Clark said. "You have to recognize everything in the environment. It may be behavior. It may be weather."
This perspective also holds that their is greater risk in managing interactions from a primarily business standpoint as well as a risk in losing the cherished ability to interact with the animals.


Animal Rights/Welfare Risk
Captivity vs. No Captivity Debate- The marine mammal captivity issue dates back at least to the 60's.  The No Captivity interest has held that the size of marine mammals and their natural habitat range dictates that captivity is in some way inhumane.  At times, this interest also appeals to the potential high intellect of many of these species.  Several protesters had gathered with signs of "Throw the Book at SeaWorld" and "Stop Imprisoning Orcas."  Comments left on online newspapers seem predominantly focused on this issue (eg. here) 

PETA took a public stance on the case arguing that the only way to reduce the risk it to abolish captivity. 
[T]he only thing that will prevent misery and death in the future is for SeaWorld to stop capturing and confining wild marine mammals and to let these orcas go," said PETA President Ingrid E. Newkirk. "The list of human beings—Keltie Byrne, Alex Martinez, Ken Peters, Steve Aibel, and Dawn Brancheau—who have been killed or maimed by captive killer whales, and the list of orca families torn apart by SeaWorld's greed, will only otherwise grow. 
PETA backs their position using the science produced by ex- SeaWorld Trainers Jeff Ventre and John Jett who now work with The Orca Project.  Their science draws a direct link between the animals' living conditions in captivity and their "desperate acts of aggression toward humans." 


In favor of Captivity, is the view that a wealth of enlightenment is garnered from maintaining the animals in parks.  It is argued that the opportunity to be exposed to marine mammals that are naturally far out at sea fosters appreciation and understanding of them.  Joy is had by families that visit the parks and those that work with the animals.  Research findings of animal behavior and physiology is also gained. 

Economic Risk

SeaWorld and parks like it are large employers and tourist destinations.  The "killer whale shows" of SeaWorld are its centerpiece.  The Orca Shamu serves as the parks mascot and has long been central to the corporation's logo (Although in more recent years the logo has been altered to dorsal fins.  I suppose they could be any dorsal fin.)  Therefore, changes in the perception of orcas or the orca show creates an economic risk for the business itself and potentially for the larger socioeconomic system dependent on the park.  In February 2011, SeaWorld Parks and Entertainment Inc sought to refinance its debt $1.2 billion of debt.  In reviewing the company for rating, Moody's suggested that recent attendance was down due to Brancheau's death. 

Changes in the risk perception of trainer-animal interactions can conceivably be extended to include human-marine mammal interaction such as that which occurs in "swim with the dolphins" type programs.  These programs are available at many parks and resorts throughout the world and are a major tourism draw and fetch substantial participation fees.  The safety of "swim with..." programs is an active area of research and one can find any number of studies that will support that such interactions are dangerous or profoundly healing.

Marine Mammal Health Risk
The risk perceived by having marine mammals in parks are often argued to be balanced by the good that marine park facilities are able to offer sick or injured marine mammals.  Wild marine mammals at risk of interaction with human society, often by collisions with marine vessels, benefit from the veterinary abilities of parks.  Marine mammals have very specific needs that are imposible to satisfy without the proper infrastructure.  Marine parks have the infrastructure necessary, food in quantity and quality, and manpower to "rehabilitate" a sick animal.  Hence, SeaWorld attorney Carla Gunnin told the administrative law judge hearing the case that the resort has a history of rescuing marine animals and is a leader in marine mammal research.

PETER ANDREW BOSCH / MIAMI HERALD STAFF
On the day the ruling of the SeaWorld case was printed by the Miami Herald, on the front page, the newspaper ran a simple image (right) with a caption describing the care given to injured manatees by the local Miami Seaquarium.  The Miami Seaquarium has long come under criticism for the pool size of its veteran Orca Tokita aka Lolita.