Thursday, May 23, 2013

Mud in the Crop Insurance Tires

Thanks to tinyprayers at flickr.
Last month, the Environmental Working Group, an advocacy group focused on minimizing government subsidies, released a report on crop insurance.  Bruce Babcock, an economist from Iowa State University, authored the report.  The report was big news, picked up in several places including NPR.

The EWG report focused attention on a type of policy that offers revenue protection, which it dubs the Cadillac Crop Insurance Policy.  The central argument is that payouts are greater then premiums demonstrating a public subsidy.  The report advocates that "farmers pay a larger share of the incremental cost" of the insurance coverage to reduce the subsidies.
EWG Report p.15
However, uncertainty about revenue is a speculative business risk.  These types of risk are uninsurable because they encourage willy-nilly risk taking in the marketplace to the potential sacrifice of public policy goals of wellbeing.

So, the coverage in question being offered by the Feds is not really insurance.  It may be called as much for whatever reason, but it's more akin to a financial mechanism like, perhaps, a put-option.  The EWG report alludes to this at the end of the report when it argues that the Cadillac coverage is a means to hedge bets in agricultural trades.
There is only one possible risk management benefit for farmers who buy RP. Farmers who forward sell their crop face the risk that they will not have enough yield to deliver on the contract. If the price of the contracted commodity rises, producers with a short crop will lose money because they must purchase more expensive grain to honor their contract. Farmers who forward contract the exact same proportion of their crop that they insure with RP will find that the additional payout under RP compensates them exactly for this hedging loss. Thus purchasing RP lowers the risk to farmers of forward selling their crop. 
Perhaps, it is the case that the program was intended as insurance but over the years, develoved into a political tool of some sort used to stabilize aspects of the economy.  This would be similar to Florida's Citizens.  I am not familiar enough with the history of US agricultural policy to say.  

My only point here is that attempting to solve a perceived problem with insurance, that is not in fact insurance, muddies the policy waters, masks the underlying debate (whatever that may be) and misleads expectations of policy outcomes.  It also facilitates movement into an endless battle over the right risk so as to charge the appropriate premium.  This skirts the debate about whether or not the public wants the agricultural market risk at all, why the financial mechanism is in place, who wins and who loses from removing or altering the program, and other possible solutions.

Friday, May 17, 2013

(one) Infinite Agent of Change

The use of catastrophe modeling permits participants in the ratemaking process to battle different perspectives of risk through scientific information, each with a with a guise of accuracy.  Competing perspectives view each other as foolish or manipulative while carrying the assumption that a true or real measure of risk is not only possible, but they have succeeded in its identification.

The reality is that different assumptions lead to different measures of risk; and with today's increasing complexity in modeling, risk estimates have no bounds.  A measure of true, correct, or right risk is not possible.

It seems that economic markets (where risk is a good that carries a handsome price) favor the limitless production of risk estimates.  However, public pocketbooks have constraints far narrower than the global risk transfer system.

In my previous post, I argued that Citizens is a mechanism to control the bounds of Florida's hurricane risk.  Where it creates these bounds implies different information and assumptions about future loss behavior.  In doing so, Citizens limits the amount of market contrived risk imposed upon the public as hurricane risk.  Without arguing that Citizens is the best policy tool for accomplishing this task, the alternative is a boundless, infinite conception of risk based on economic market goals.

A recent report from RMS,  describes an upcoming model platform that provides everyone the ability to be their own unique agent of change and demonstrates the "To infinity and Beyond" practice of estimating risk.  The report tells of standard practices in the industry of pricing, selling and trading risk and emphatically highlights that no two entities have the same quantification of risk.  The upcoming modeling platform, known as RMS(one) to be released in 2014, promises to permit for an even more diverse array of assumptions and views of risk.  Here is the executive summary.
Many RMS clients take steps outside of modeling applications to develop their own view of risk— running sensitivity tests, adjusting model loss, and blending model output. Until RMS(one), catastrophe models have not offered insurers and reinsurers the ability to develop their own view of risk, tailored to their guidelines and representative of all exposures. 
The ability to flexibly investigate modeling assumptions, improve the understanding of uncertainty and portfolio sensitivities, and combine losses from numerous sources leads to better business decisions, more efficient use of capital, and ultimately a more resilient risk management strategy. It is no longer enough to have a “one size fits all” approach to risk modeling—our clients need to be confident that their view of risk reflects the uniqueness of their portfolios. Finally, insurance regulators and supervisors increasingly require companies to demonstrate that they fully 
understand the modeling basis for their submissions.  
The RMS(one)™ environment supports (re)insurers in developing their own view of risk, by delivering “open modeling” through the RMS MetaModeler. Clients can incorporate their own research and experience into their modeling; manage model change; prepare market submissions; and meet their regulatory obligations in an efficient, transparent, and documented way.  
Open modeling increases model understanding, enabling our clients to customize RMS models by adjusting or overriding model components and data. Clients can host their own models in the RMS(one) environment—as well as non-RMS models and model results—and can blend model output.  
Through this suite of open modeling capabilities, RMS(one) enables clients to make defensible, transparent, auditable changes to their models and model output in one efficient experience. By gaining control over model assumptions, clients can develop a tailored, complete view of risk at all organizational levels. For the first time, they can confidently validate model applicability on a single platform and can test and modify model assumptions, data, and components, bringing resiliency to their risk management strategy.

Thursday, May 9, 2013

What does Citizens do?

Recently, I have noticed insurance literature referring to Citizens as the "so-called" residual market mechanism   This conjures memories of a Manic-Panic punk-red, Claire Daines lamenting her So- Called Life.  It is the same situation.

The angst ridden, fictional teenager, Angela Chase, felt she had little control over her daily coming and goings.  What was supposedly her life, to live guided by her own expectations, was heavily influenced by the decisions, wants, and needs of those around her.

Insurers believe they should have control of Florida's residual market mechanism (RMM) as a tool to stabilize the property insurance market.  Their decisions ought to dictate what risks are put into the RMM and at what cost.  A so-called situation arises when insurers feel that the RMM has fallen out of their control, overtaken by the decisions, wants, and needs of others.  Hence, the tragic angst regarding Citizens, the so-called RMM.

Despite teenager and insurer disgruntlement, many saw Angela Chase as a bright promising young adult, similar to those that appreciate Citizens as a saving grace.  In order to understand the dissatisfaction with Citizens, we must first understand what it is intended to do...

Fundamentally, Citizens controls probabilistic "tail risk" by providing coverage for the stuff that insurers don't want because they think it is too risky.  In other words, it "caps" the private market risk.  As a state run entity the tail risk becomes the public's responsibility.  The controversy comes from deciding where the tail begins and how thick is the tail.

Below is a generic probability distribution of losses.  The graph shows a high probability of small loss with gradually lower probability of large loss.  When Citizens sets its rates, it inadvertently designates the tail because the price an insurer can charge is a limiting factor of the amount of risk they can take.  Where decision makers draw the line between private market risk and RMM tail risk is arbitrary, negotiable, and controversial because it defines winners and losers in society.

Claims made about whether or not Citizens is truly an "insurer of last resort" speaks to this negotiation about the tail.  If an insurer believes that the unwanted tail risk begins at the blue arrow, then Citizens rates at the purple arrow will appear unfairly competitive.  Citizens does this to help control policy cost in the (very) short run.  However, the decision may be at the sacrifice of public long run benefit because the public gets stuck with more large loss risk.

But we also have to decide the thickness of the tail or rather, how quickly the probability of large loss diminishes... that is, if it diminishes at all.  The below graph shows a "fat tail," where the probability of big losses is greater than that in the above graph as well as non-diminishing.  With the fat tail, there is a relatively substantial probability that really big loss, (limited only by your wildest imagination) will occur.
Fat Tail
Choice of tail thickness has implications for how wise or good a rate decision appears to an onlooker.  If one believes to have information that indicates a thick tail, then the decision to make rates based on a thinner tail would appear to be willful ignorance.  On the contrary, those that believe the tail to be narrower view those peddling a thicker tail to be exaggerating the uncertainty.  In both cases, either party waves their modeled information around and looks to the other as being foolish at best, and manipulative at worse.  

Dissatisfaction arises because all conflicting opinions involved believe to be doing the public a so-called favor.

Thursday, May 2, 2013

Dirty Cash: Exploring Potential Solutions to Florida's Hurricane Insurance Woes

The issue of insurance "rates" nauseatingly consumes Florida’s public debate about hurricane risk.  On one hand, the private market wants higher insurance rates to mirror their beliefs about higher hurricane risk.  On the other hand, the Florida public wants lower insurance rates to mirror their beliefs about lower hurricane risk (or lower as compared to other risks).  In order to provide for the public welfare with a stable insurance market the two hands must meet somewhere near the middle. This will not happen without addressing the underlying issues with housing affordability (both costs of ownership and incomes) and building practices.

This ought to be great news for policy makers because it broadens the realm of possible solutions beyond the heavily politicized discussion of hurricane rates and risk.  For example, if the problem were better understood as one of distorted real estate markets and undesired building then perhaps addressing Florida’s tax evasion and money laundering might be helpful in relieving the hurricane affordability-insurability problem.

In the 1970’s and 1980’s Miami became a hub for cocaine trafficking.  Historians argue that this sudden influx of cash into the city’s economy brought forth unto this world the Miami of today, characterized by its modern financial and real estate economy.  At the hight of the cocaine trade, 20% of all real estate transactions in South Florida were paid in cash and caused an inflation of real estate prices.

Current statistics suggest that this tradition of money laundering is alive and well in the state.  According to the Department of Justice,  the Florida of today ranks fourth for “suspicious” banking activity.  The FBI reports that Florida is a national leader in mortgage fraud.   According to the  February issue of The Economist the world’s wealthy use Miami as a hub for “off-shore” banking activity- including tax evasion and money laundering.  The magazine reported that America keeps its “dirtiest” money on “Brickell”- as in Brickell Ave.  Perhaps not so coincidently, South Florida real estate purchases are predominantly  in cash- especially on the luxury end.

Florida’s queationsable financial scruples may significantly be impacting its social and economic systems causing difficulty for the successful implementation of an insurance regime.

In drug exporting countries, policy analyst Ignacio Navarro at the California State University- Monterrey Bay has demonstrated (for example here) that the illegal drug trade significantly contributes to increases in construction and housing prices.  He concludes,
… the strong cocaine export effect on urban construction and housing prices is mostly caused by money laundering that artificially inflates the demand for housing in these urban centers…  Illegal goods impact urban economies not mainly through employment like legal exports do, but through money laundering. This difference has profound implications for long-term economic development as they tend to create boom and bust cycles of real estate prices that can be catastrophic for local economies (and here).
Organized crime and corruption expert Louise Shelley at George Mason University has documented several instances where money laundering into real estate has had negative consequences for society, including some OECD countries:
  • exacerbation of economic bubbles in Japan and Dubai,
  • price increases of South Africa homes, 
  • “over construction of expensive housing and hotels” in Turkey and South America,
  • urban decay in Ohio (the US state), and
  • environmental degradation in Italy.

There is nothing here to suggest that Florida’s hurricane affordability-insurability problems will surely be solved by addressing the legality of how money enters the state.  Nor do I mean to argue that all of the money entering Florida does so illegally.   

I am arguing that Florida's hurricane insurance situation will not be resolved be endless debate about rates because the competing parties have different values at stake.  However, compromise may be found by addressing underlying distortions in the social and economic system.  Florida's tradition of money laundering may be one place to start.