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.

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