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08.29.07

Tim O'Reilly

Tim O'Reilly

Securitizing Catastrophe

Paul Kedrosky sent in a link to a fabulous article in the NY Times Magazine this last weekend by Michael Lewis (author of Liar's Poker, Moneyball and many other books that delve into the fascinating overlap of numbers and society) about the development of the market for so-called "catastrophe bonds." The article is entitled In Nature's Casino, and focuses on the work of hedge fund manager John Seo in developing risk models for what are, by definition, one-of-a-kind events.

This is a story that hits a number of Radar themes: the value of building prediction models based on data that's already out there but largely ignored, the way that financial markets progress via "hacks" designed to solve hard problems, and the way that global problems are increasingly being tackled by private enterprise via "collective" action (of which insurance is one of the models, albeit one ignored by most thinkers about Web 2.0 and collective intelligence.) And as you know from the announcement of our Money:Tech conference and the recent Release 2.0 issue on the subject, the connections between Web 2.0 and financial markets is very much on our mind.

The bottom line:

An insurance company could function only if it was able to control its exposure to loss. Geico sells auto insurance to more than seven million Americans. No individual car accident can be foreseen, obviously, but the total number of accidents over a large population is amazingly predictable. The company knows from past experience what percentage of the drivers it insures will file claims and how much those claims will cost. The logic of catastrophe is very different: either no one is affected or vast numbers of people are. After an earthquake flattens Tokyo, a Japanese earthquake insurer is in deep trouble: millions of customers file claims. If there were a great number of rich cities scattered across the planet that might plausibly be destroyed by an earthquake, the insurer could spread its exposure to the losses by selling earthquake insurance to all of them. The losses it suffered in Tokyo would be offset by the gains it made from the cities not destroyed by an earthquake. But the financial risk from earthquakes — and hurricanes — is highly concentrated in a few places.

What's more, the scale of such occurrences could, in fact, bankrupt the insurance industry. This issue first became clear in 1992, when Hurricane Andrew validated the work of an insurance company researcher named Karen Clark. In 1985, Clark had published a paper entitled "A Formal Approach to Catastrophe Risk Assessment in Management":

To better judge the potential cost of catastrophe, Clark gathered very long-term historical data on hurricanes. "There was all this data that wasn't being used," she says. "You could take it, and take all the science that also wasn't being used, and you could package it in a model that could spit out numbers companies could use to make decisions. It just seemed like such an obvious thing to do." She combined the long-term hurricane record with new data on property exposure — building-replacement costs by ZIP code, engineering reports, local building codes, etc. — and wound up with a crude but powerful tool, both for judging the probability of a catastrophe striking any one area and for predicting the losses it might inflict. Then she wrote her paper about it.

The attention Clark's paper attracted was mostly polite. Two years later, she visited Lloyd's — pregnant with her first child, hauling a Stone Age laptop — and gave a speech to actual risk-takers. In nature's casino, they had set themselves up as the house, and yet they didn't know the odds. They assumed that even the worst catastrophe could generate no more than a few billion dollars in losses, but her model was generating insured losses of more than $30 billion for a single storm — and these losses were far more likely to occur than they had been in the previous few decades. She projected catastrophic storms from the distant past onto the present-day population and storms from the more recent past onto richer and more populated areas than they had actually hit. (If you reran today the hurricane that struck Miami in 1926, for instance, it would take out not the few hundred million dollars of property it destroyed at the time but $60 billion to $100 billion.) "But," she says, "from their point of view, all of this was just in this computer."

She spoke for 45 minutes but had no sense that she had been heard.

That is, until 1992, when Hurricane Andrew validated her models. By then, Clark had her own forecasting firm, Applied Insurance Research, and she was the only one who came close to forecasting the true cost of Andrew's devastation in Florida, which "exceeded all the insurance premiums ever collected in Dade County."

But once the industry realized that Clark was right, there was still no solution to the problem:

The companies' models disagreed here and there, but on one point they spoke with a single voice: four natural perils had outgrown the insurers' ability to insure them — U.S. hurricane, California earthquake, European winter storm and Japanese earthquake. The insurance industry was prepared to lose $30 billion in a single event, once every 10 years. The models showed that a sole hurricane in Florida wouldn't have to work too hard to create $100 billion in losses. There were concentrations of wealth in the world that defied the logic of insurance. And most of them were in America.

The more John Seo looked into the insurance industry, the more it seemed to be teetering at the edge of ruin. This had happened once before, in 1842, when the city of Hamburg burned to the ground and bankrupted the entire German insurance industry many times over. Out of the ashes was born a new industry, called reinsurance. The point of reinsurance was to take on the risk that the insurance industry couldn't dilute through diversification — say, the risk of an entire city burning to the ground or being wiped off the map by a storm. The old insurance companies would still sell policies to the individual residents of Hamburg. But they would turn around and hand some of the premiums they collected to Cologne Re (short for reinsurance) in exchange for taking on losses over a certain amount. Cologne Re would protect itself by diversifying at a higher level — by selling catastrophic fire insurance to lots of other towns.

But by their very nature, the big catastrophic risks of the early 21st century couldn't be diversified away. Wealth had become far too concentrated in a handful of extraordinarily treacherous places. The only way to handle them was to spread them widely, and the only way to do that was to get them out of the insurance industry and onto Wall Street. Today, the global stock markets are estimated at $59 trillion. A 1 percent drop in the markets — not an unusual event — causes $590 billion in losses. The losses caused by even the biggest natural disaster would be a drop in the bucket to the broader capital markets. "If you could take a Magnitude 8 earthquake and distribute its shock across the planet, no one would feel it," Seo says. "The same principle applies here." That's where catastrophe bonds came in: they were the ideal mechanism for dissipating the potential losses to State Farm, Allstate and the other insurers by extending them to the broader markets.

The big challenge, and the one that John Seo has tackled, is pricing. Before catastrophe bonds can work, they need to be priced appropriately, so that, despite the scale and uniqueness of catastrophe, providers of the bonds can raise enough money to actually spread the risk far enough to make "the financial consequences of catastrophe ... into something they have never been: boringly normal."

It's a fascinating tale of how financial traders developing new instruments are, at their best, hackers working on really hard problems. Well worth reading.

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Comments: 16

Andrew Davies   [08.29.07 10:34 AM]

The first thing I thought about when I read the article was climate change, and how it's changing the odds.



Swiss Re has been talking about implications for the insurance industry for years.

With that in mind this paragraph jumped out at me...

Next to what Wall Street investors tried to predict every day, natural disasters seemed almost stable. “In the financial markets, you have to care what other people think, even if what they think is screwed up,” Seo says. “Crowd dynamics build on each other. But these things — hurricanes, earthquakes — don’t exhibit crowd behavior. There’s a real underlying risk you have to understand. You have to be a value investor.”

Of course there are some very good climate models, but if you're making bets on the really long term then you still need to guess at human behavior. The models can only predict what will happen with a certain level of greenhouse gas emissions. Much harder (I think) is guessing how fast we'll react and change those emissions levels.



Maybe that means short term "catastrophe bonds" (month or year bonds) are more stable bets than long term. Don't know myself, but suspect some clever investor out there is thinking on it.

Ajeet Khurana   [08.29.07 02:52 PM]

My mind goes back to the time I was attending grad school in 1991-3. At that point of time the new found financial hack was applying the theory of heat transfer to financial markets, i.e., using models of transmission of heat to simulate transmission of news in financial markets. Our professors told us how chaos theory was the favorite a few years before that.

I am reminded of it based on the article mentioning "what Wall Street has become: quantitative."

Tim is right financial engineers are hackers working on tough problems. But the problems are tough only because they defy quantification.

And the risks are there for everyone to see. A financial giant, Barings Bank, was brought down by the risk mismanagement of one individual.

I recently invested in a structured index based product that will make me 50% of the variation of S&P index regardless of the direction. It was almost too good to be true.

I think that the day of the esoteric financial models is just coming of age.

Thomas Lord   [08.29.07 02:58 PM]

I think there is a category error, here. Catastrophe is, by definition, an unmanageable hardship. What insurers are noticing is what any Taoist could have told them based on a priori principles: there is no such thing as security unless there is also such a thing as threat.

I don't believe that preparedness for catastrophe can possibly reside in financial instruments. By definition, financial instruments summarize collective knowledge -- by definition, catastrophe is the unknown.

Rather, preparedness for catastrophe resides in securing a capacity for productive improvisation. Preparedness is readiness to respond to catastrophe by making up a plan after the fact. That means laying in tools and developing skills.

Concretely: let's take Miami (please ). Rather than insuring the current value of property even post catastrophe, insurers should offer instruments that guarantee the possibility of orderly evactuation, search and rescue services, and preferential position in the recovery effort.

In other words, when a catastrophe hits the value of the property falls and so, therefore, does the insurer's liability. The insurer goes from insuring a gazillion dollar hotel to insuring a washed out condemned skeleton, but owes no pay-out for that. Instead, the insurer both financially and logistically provided for the evacuation of the hotel and, during the reconstruction, the insurer can be on the hook to supply labor and materials to insured party at guaranteed low rates. That is, the insurance regarding a catastrophe is that the insured gets a buffer against the inevitable profiteering that occurs during recovery.

-t

Alex Tolley   [08.29.07 07:50 PM]

Securitizing catastrophes (Black Swan events) is mostly bogus. Sustainable insurance works only when quantification can work. Rare events don't work that way by definition.

It is no accident that Lloyds of London was the preferred insurer for these kinds of events - but they worked not by reinsurance or securitization, but by the "names" having deep enough pockets to pay for catastrophic losses. Now that losses can exceed those deep pockets, that game is over. But securitization will not work for the same reasons it failed with junk bonds, MBS's etc. Whenever you hear about some new financial wizardry to create a market, just be aware that a major blow up will likely happen sometime down the road due to mis-pricing of the true risks.

Simone Brunozzi   [08.30.07 12:49 AM]

Hi again, Tim.
Nice post, and this is my take on it:

I agree that in 2007 there is not so much room to diversify risks, for insurance companies.
I also agree that the climate change, and the uncontrolled construction of buildings and facilities around the world, can bring higher costs.

But, wait a moment: this just means that THE PROBLEM is HOW we build things, and how we manage our lives.
Insurance companies are just trying to keep with us, but they are facing increasing difficulties.

So, what about a better, smarter (and hopefully greener) way of building cities and infrastructures?
I'm sure that there is much room for improvement, and in that case, insurance companies would have lower costs in case of emergencies.

That's the only escape I see.
Let me know what you think.

Thomas Lord   [08.30.07 08:08 AM]

But, wait a moment: this just means that THE PROBLEM is HOW we build things, and how we manage our lives. Insurance companies are just trying to keep with us, but they are facing increasing difficulties.

Precisely. Which is why insurance for catastrophes should guarantee an advantage during recovery but not guarantee that the insured is "made whole".

My hope is that such instruments, or even just the idea of such instruments, can help change how people value properties and how they build and how they plan.

That's the only escape I see. Let me know what you think.

I, for one, agree but now comes the hard part: Individual property owners in these highly at-risk places have little or no opportunity to take individual action -- the market fights against them. The hard part is constructing regulatory and economic opportunities and incentives for a collective change in behavior -- not so easy.

There's some flip remark in the article about how if you spread the costs of recovering from an earthquake around the globe then it's just a blip and nobody feels the financial pain. That's just not true because it fails to account for the fact that the rest of the world is *already* feeling the pain of major disasters when productive centers are off-lined. Buying securitized catastrophe insurance isn't a hedge: it's an anti-hedge that doubles down on the risks of your other investments. The risk of the catastrophe is *already* spread out around the globe and now the proposal is to purify it into an instrument and sell more of it? Yeah, right.

-t

Alex Tolley   [08.30.07 08:20 AM]

Thomas Lord: "Buying securitized catastrophe insurance isn't a hedge: "

It isn't supposed to be. Insurance is just a way to make individual losses non-catastrophic and thus allow sensible risk taking through risk management.

If one could properly price this as a security, then that would be OK. The problem is that you can't really, not should it be. The purpose of securities is an investment, but rare, random catastrophes will result in mispricing so that there while the globe buys these securities, at some point the owners will take a bath. I assume that is what you meant by an "anti-hedge".

Simone Brunozzi   [08.30.07 11:58 PM]

Thomas: in fact, I hope that the government can intervene in the process of "securing" new buildings and infrastructures, for example regulating needs and limits that help prevent damages from natural disasters.

John Seo   [08.31.07 06:13 AM]

Tim, thank you for sharing your thoughts on Mr. Lewis's NYT article. I believe this is the first time that I have posted a comment to a blog, but I am such a fan of O'Reilly books that I had to say something....

Posters' comments are excellent, but I would to like to offer two comments:

(1) No pretentions. Rare events, catastrophes: it is true that, by nature, these things generally defy quantification, but catastrophe bonds cheat these categorizations (or, to borrow Tim's wonderful terminology, hack these categorizations) by exploiting certain aspects of event randomness and by using loss triggers that, as a whole, do a reasonable job of keeping human factors in check. I love to philosophize and find it useful, but, in the end, catastrophe bonds are best understood as a form of engineering, complete with its own, particular, exhilarating mix of building upward toward the sky while remaining concerned that, despite best efforts, cracks in the foundation laid down on the first day might need major repair effort somewhere down the line. The hundreds of professionals involved in the catastrophe bond market are building, trying to be honest with themselves at all times, and moving forward together in yet another human enterprise. No pretentions here beyond that.

(2) Loss mitigation. I was glad to see some mention in these posts about loss mitigation—constructing and locating homes, buildings, and infrastructure to make them less vulnerable to catastrophes. Loss mitigation is not the entire answer (past a certain point, it is just like telling everyone to dress in the same model of silver jumpsuit to reduce waste from fashion frivolities), but I think loss mitigation is an extremely important way to address catastrophe exposures, and I fear that, despite my wishes to the contrary, current private market mechanisms (including catastrophe bonds) will not move society far enough on this issue. My current take on the situation is that loss mitigation is a matter of getting folks to nudge the architectural design pendulum back toward function and away from form (dear architects: I assume that where you are concerned I am largely preaching to the choir on this point). We should try to make this happen in catastrophe prone areas. (I have no idea how.) The benefits to our society would be substantial.

Tim O'Reilly   [08.31.07 07:45 AM]

John, I am totally honored to see you responding here. I found the article fascinating, and loved learning about your work. I really do believe that one of the defining characteristics of great hackers is that they love hard problems. And this cuts across many disciplines. I have one friend who recently left a hedge fund for an innovative energy company because, he said, "the math was harder." And at our recent "Science Foo Camp," one of my favorite comments was from a researcher who was telling me about his work analyzing the ecosystems of bacteria that are part of the human body (turns out there are more bacteria, by count, in our body, than human cells -- an ecosystem like a rainforest!), and then he suddenly said, "But what I really like about this field is that it's just so hard!" You sound like a similar kind of guy -- attracted to solving really hard problems. So I'm really glad you're an O'Reilly fan!

As to your comments themselves, I'm glad to see that you worry that insuring against catastrophe can encourage people in bad building practices. But as you note, if we used that as a touchstone, we'd have to take aim at many other market mechanisms and government policies! But I'd encourage you to think if there are any financial mechanisms that could create the correct incentives.

Thanks a lot for responding!

Tim O'Reilly   [08.31.07 08:11 AM]

Hal Varian mentioned to me that he'd written a couple of short NYT pieces on Cat Bonds. The first of them has a very simple, clear explanation of how cat bonds work:

Catastrophe bonds could fill the gaps in reinsurance

The second one, Novel Ideas for a Risky World explores some of Robert Schiller's ideas for novel approaches to insurance, some of which do address the moral hazard of people indulging in more risky behavior because, after all, they are insured.

John Seo   [08.31.07 06:27 PM]

Tim, the honor is truly mine.

Interesting that you should mention the love of hard problems because it's true: I have practically been manipulated in my choices in finance by those who have pointed out that this or that particular problem or field of finance was too difficult to enjoy. Colleagues would try to talk me out of doing this or that. I would usually listen to the advice, but if they were simply saying that the problems were too difficult to solve, I perked up and asked more questions. They had my attention. It was the same for me in science.

I failed to mention in my first post that I think it interesting that you see hacking across many fields. I have been talking this way for years. In particular, I believe that mathematics, particularly at the cutting edge, bears a strong resemblance to programming. Read a rigorous mathematical proof, and it is easy to see that you are nothing but a compiler at that point! I believe that many programmers would benefit from more exposure to formal mathematics, but I am convinced that most, if not all, mathematicians would benefit from an exposure to programming.

Thank you for the references to Varian's articles. I was not aware of their existence; I will be sure to read them. I have read a couple of books of his, both recommended highly to me by my father.

dave mcclure   [09.01.07 10:56 AM]

late to the party, but here are my thoughts:

1) john may be individually brilliant at how he comes up with opportunities for cat bonds & pricing, but i think the real innovation he brings to the table is the more general benefit of helping make a market in an asset class that is currently not very liquid. by increasing the number of options to play & the # of players participating in this sector, overall market intelligence is increased & risk is reduced.

2) while cat bonds definitely serve a market need, they are by definition a creative solve for an infrequent set of occurrences. i wonder if a more general solution could help provide greater participation & liquidity... that is, capitalizing & valuing individual and/or aggregated human life, and then creating opportunities for individual entrepreneurs / market actors to hedge and/or short certain assets where they perceive risk occurring that would damage the value of those human securities.

3) ultimately, when catastrophes occur the impact is not just on hard assets, but also on individuals. unfortunately, unless the individuals are aware of specific & defined coverage opportunities, and have purchased insurance in that area, they are generally at risk. people who don't know they are at risk of earthquakes, floods, terrorist attack, nuclear or biological threat, or polluted food/water supply probably aren't going to purchase insurance to deal with those situations -- that is, presuming any is even available.

in summary, my belief is the larger solution to this problem set is to Securitize Individuals (and/or aggregate groups thereof) and their 'Happiness' (that is, derivative instruments based on their education, healthcare, etc), as well as the Natural Resources they depend on. if we were to fully realize the creation of these new asset classes, market actors could then opportunistically "play" the market to achieve profits, which in turn would optimize for the overall happiness / well-being of society.

while i'm not sure i've got it all figured out, i've written a few posts several years back on this subject below:

Securitizing Human Happiness
http://500hats.typepad.com/500blogs/2002/06/random_rant_on_.html

Securitization Examples for Social Entrepreneurship
http://500hats.typepad.com/500blogs/2005/01/securitization_.html

going forward, my belief is that venture capital & microfinance are two relatively new asset classes that can provide some of the basic foundations for these new proposed asset classes.

i'd love to share notes / chat with anyone else interested in these topics...

- dave mcclure
http://500hats.typepad.com/

Terrence McLean   [09.03.07 06:18 PM]

Like John, this is my first blog post. Given that this is the seemingly the first time that my business is in being covered by mainstream press, I thought I’d offer a few thoughts.

1. Reinsurance and the pricing of catastrophe risk is not new

2. Catastrophe-linked reinsurance securities are good for buyers of insurance (i.e. everyone) as they introduce liquidity to the marketplace

3. There are many governmental and non-governmental organizations working toward improving the quality of buildings

I used to be a bit surprised when people responded to the mention of reinsurance with, “reinsurance, what’s reinsurance?” Many people are surprised when they realize that there is an industry that dwarfs the size of the Geico, Progressive, Allstate, State Farm type names. My general response is, “Who do you think State Farm buys insurance from?” The reality is that there exists a global industry that “reinsures” the risks that primary insurance companies (like State Farm and Allstate) and has existed for quite a long time. These companies exist with very large pools of capital to absorb risks from all around the world. When there are no catastrophic events, these companies generally make very healthy returns. When there are big or numerous events, these companies generally don’t fare so well, and in turn, usually have to raise more capital after events. This natural spread of risk around the globe is relatively efficient (from a financial and capital management point of view).

Reinsurance companies have had to price risk for quite a long time. Sophistication in their techniques has improved dramatically over time with the use of the mathematical and engineering tools. What makes the pricing correct…the same thing that it does in any supply & demand mechanism…a willing buyer and a willing seller. There have been comments that quantifying these events is bogus and unmanageable. While it is clearly challenging, 2004 and 2005 have passed and an orderly reinsurance market insuring trillions of dollars of property around the world is doing just fine after losing tens of billions of dollars.

Catastrophe-linked securities are simply collateralized reinsurance. The work of guys like John Seo have brought liquidity to the marketplace and have made the marketplace more efficient. This increased liquidity in the reinsurance market is great for buyers of insurance. This is similar to the efficiency that securitization brings to the mortgage market (of course there are blips in the level of liquidity such as the current environment). How does anyone know the price is right? Well, if someone wants to take the risk at a certain price (usually because there are other bidders waiting in line at a similar or slightly worse price), then one could argue that the price is right. Often after major events, the price of risk changes dramatically in response to the changed perception of risk. While buyers of catastrophe-linked securities are sometimes surprised by their losses, the same happens in other markets (i.e. current subprime mess). These markets and the market for catastrophe-linked securities will surely continue.

My last point is that there are many organizations working on reducing the impact of catastrophes. The Institute for Building and Home Safety - ibhs.org is one non-governmental agency devoted to this cause. Also notable is what the state of Florida has done in improving building codes (and enforcing them).

Chris Zambito   [09.04.07 09:27 AM]

Thanks for the article...love the radar BTW...first blog post as well. I work in the local aspect of this subject matter in a discipline known as Hazard Mitigation. This is basically an all-purpose planner/analyst type position in local government that looks at local exposures to natural and man-made risks and then works with regulation, planning, insurance, and emergency management types for all things related to this field. While planning tends to lean more subjective in nature, I'm more prone to the quantitative side and typically use geospatial tools to look at risks spatially (and more recently, temporally).

This article reminds me of another one I saw in a GIS mag a few years back...found the link to Financing Risk Assessment

Some of the things that the articles seem to share in common is that it's not the risk itself that's the issue, but the ability to accurately/fairly predict the risk and then adjust market mechanisms accordingly.

The problems I have with this and I know it may not be an issue for those that are used to working at a more macro level are:

1) What aggregation level do you use for this? Town, City, Zip, State, Region all would have different risk results that would affect a model.

2) Even with better building codes and better planning practices, hazards still overlap. Elevate a house for flood, more vulnerable to wind. Move a tree away from house to reduce fire hazard, now have greater chance that tree will breach roof and not lean against house.

3) Time provides a false sense of risk. Again, I'm working with small areas and larger numbers may correct some of this, but when I tried to create some general modeling techniques to assess a "simple" known risk of FEMA repetitive loss properties in my area, I could not find any adequate indicators. Why? Mainly time. At a micro level, there are so many changes over time that are positively and negatively affecting risk exposure (houses rebuilt, more infrastructure, claims may/may not be reported, stronger storm systems, etc.).

I love the subject matter and that it's being tackled rationally. I'm always concerned on how the macro will get passed down to the micro. Even at a large County level here, what's good for the community as a whole, may not be good for the individual resident.

Philip Richardson   [09.07.07 09:32 AM]

I too regulate development, working for a local government. What puzzles me is - if the hazardous areas are identified, why develop in these areas? Take flooding for example; this is a naturally occurring phenomenon and is not inherently hazardous...unless someone or something is in its path. Shouldn't we actively discourage people from developing in such hazardous areas? Doesn't the provision of insurance - especially when federally subsidized (as with the NFIP) - tend to encourage the unwise development of these hazardous areas. And once a catastrophe has occurred, our tax dollars are used to mitigate the losses incurred by unwise development. With the federal money that has been pledged to rebuild New Orleans, every man, woman and child could have been given $250,000 to go somewhere else that isn't in a hazardous area and build themselves a new and better life.


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