Florida bets annual state budget on 23 Red.
Well not exactly but pretty damn close: replace 23 red with frequency and intensity of storms hitting population centers in Florida and it is spot on. Only with 23 Red, at least the probability is easy to price.
Of course, ‘gambling’ is illegal in the Sunshine State
and if any resident wanted to offer or take odds on the likelyhood of a hurricane hitting their home town, of course they would be breaking the law. The irony of the state taking a giant punt with their taxpayer’s dollars is of course almost certainly lost on the state government…
One of the most significant business and economic opportunities that will arise out of the changing techno-economic paradigm over the coming ten to twenty years is the rethinking and transformation of the business of insurance. The rise and rise of the risk quark will inevitably reshape the landscape of risk transfer and mitigation. But it won’t be easy. Indeed their will be many backward steps along the way as the trinity of inertia, vested interests, and outdated regulatory frameworks conspire to perpetuate the current model despite it’s increasingly obvious failings.
How else to explain the recent de facto nationalization of property insurance in the State of Florida? (from The Economist:)
…insurance companies are shedding customers as fast as they can…
…The slack is being picked up by a fast-growing state-run company, Citizens Property Insurance. Citizens is acting as the insurer of last resort, underwritten by the Florida Hurrican Catastrophe Fund, a pool financed by the state. In January the state decided it could resolve the crisis by expanding Citizens and making it more competitive with private companies. It is now by far the state’s largest home-insurance provider, with 1.3m clients.
…And by allowing Citizens to grow so big, in the eyes of many agents, the state is exposing itself to tremendous financial risk in the event of a large-scale disaster. Unlike private companies, which can seek reinsurance on the global market where risk is less concentrated, the state would have to go to its own taxpayers if a huge storm struck.
Now whether or not the state should bear the risk of weather-related property damage is in my opinion a political debate. What I find appalling is not that a democratically elected government decides (or not) to underwrite this risk, but that they do so in a completely reckless, opaque and market-distorting way. By not allowing the market to work - by pricing risk appropriately based on the market-determined probabilities of certain outcomes - the result is that the economy cannot optimally allocate resources and that the true cost of any subsidy is at once much higher (than it would otherwise be) and completely opaque. Furthermore it is unaccounted for: I doubt that the Florida government accounts reflect the enormous contigent liability they have committed their citizens to.
Just as physicists and chemists have conservation of mass and energy, so to are risk quarks ‘conserved’. Risk transfer and optimization is highly useful and increases overall wealth and utility in an economic system. But risks - like mass and energy - must be conserved. Call it the 1st Law of Financial Dynamics. (Park’s Law? anyone? anyone? … 
) One of the fundamental problems of the current risk management paradigm, is that it encourages - often with regulatory and governmental connivance - the dissimulation of ‘inconvenient’ high energy risk quarks.
What do I mean by ‘inconvenient’ risk quarks? These are the elements of risk in any system that when ‘removed’, allow all (or at least all incumbent) constituencies to have only positive outcomes. My contention is that risk is conserved so these elements are never truly removed, but only hidden from view. Worse, frequently the financial physics of segregating and obscuring these elements most often leads to an expensive and suboptimal distribution of risk throughout the system. Indeed -whilst I don’t know whether he would agree with any of my analysis - I believe that Warren Buffet’s view of (financial) derivatives as weapons of mass destruction, is credible only in the context of their (derivatives) bastardized deployment within a system that does not want or allow them to exist unfettered or transparently. The existing industry and governmental complex is applying the rules of classical finance to a new quantum world. With alarming consequences.
And don’t even get me started on sub-prime… (Remember always that gambling is illegal in the US. Well…only as long as it is done in a transparent and robust fashion. Embed it, hidden, within the existing fabric of business and of course it’s ok. Messy yes. But not threatening to the existing socio-institutional paradigm.)
August 21st, 2007 at 2:36 pm
Sean, you are spot on with with your comment that Buffet’s WMD analogy is credible in the context of obfuscated and opaque derivative structures.
The general argument in favor of Citizens is that there is market failure and the government must step in to ensure affordable and available insurance. This is deja vu for anyone who has been watching US agricultural risk policy over the last few years. Consider the following excerpt from a 1999 paper by Young, Schnepf, Skees, and Lin on the topic of government involvement in crop insurance:
“The argument that Federal intervention is crucial to overcoming a failure by the private sector to provide affordable, universally-available multi-peril crop insurance has muted distortion-related concerns in the past. However, growing levels of subsidy outlays combined with certain design aspects of federal crop insurance intervention suggest that there exists the potential for significant unintended market effects.”
Source: http://www.ers.usda.gov/Briefing/FarmPolicy/PDFs/ffc_insurrance.pdf
Another effect of the impact of government subsidization of Citizens (lower than market premiums are a type of subsidy) is that the subsidy will get bid into land prices. A house in a hurricane prone area naturally has more value if subsidized insurance is available. This is intuitive since people take risk for a price, the government lowers the potential severity of property loss, so naturally the property becomes more valuable. So I wonder if folks in less hurricane prone parts of FL understand that they are subsidizing land values for the coastal hurricane areas? That is in addition to your primary point of gambling the state coffers opaquely on natural disaster. *
I hope that someone in Florida State Government remembers Robert Citron in Orange County CA who also got involved in opaque derivative structures. Below are comments by Kurt Sjoberg, the CA state auditor following the investigation of why Orange County filed bankruptcy in 1994:
“The former treasurer, Robert Citron, employed an investment strategy that violated the basic tenets of sound investing.
…
by July 1994, he had leveraged his portfolio by nearly 3 to 1 and held almost half of his investments in derivatives and other structured notes that went down in value as interest rates rose. However, it was only when these two strategies came in contact with the 300 basis point rise in interest rates experienced in 1994, that the mixture erupted. Unfortunately, the treasurer had $13 billion in reverse repurchase agreements coming due, but the value of the derivative investments purchased with these borrowed funds had plummeted.”
source: http://www.nasact.org/techupdates/downloads/Testimony/Octest.pdf
While the instruments are different between FL and Orange County, CA, the principle of opaque derivative structures is the same. As you have pointed out before, risk quarks have similar properties whether or not they are market traded, OTC, or insurance.
Bringing this back to your points above, I think the root of your first law of Financial Dynamics might be something along the lines of risk mitigation having value and that value is conserved (even if the mitigation is given away for free). The conservation of risk value is illustrated in my example above about the risk protection being bid into land values (either agricultural or coastal). The mitigation has real value and that value ends up being conserved through the transfer of value from the state government to land holders in proportion to their hurricane risk.
Good stuff Sean. I like playing in your risk thought sandbox.
Footnote:
* For thinking about the role of spatial correlation, the intrastate transfer where less hurricane areas subsidize the more risky areas is the idiosyncratic or lower spatial correlated risk. The roulette wheel risk where the state blows up as a result of weather risk is the more highly spatially correlated component.
August 27th, 2007 at 9:29 pm
Yes JD! I’m glad you highlighted the ‘conservation of risk value’ in your Florida house price example; indeed I was thinking just this when I wrote the post but was too lazy to articulate it as an example.
As to the argument (for state sponsored insurance) that there is a market failure, while I would not say the market is infallible, market failures are far fewer and farther between than most politicians (and business leaders) would have us think. There is a difference between a market that won’t provide a price (or a price that is extortionate/usurious with respect to the intrinsic value of the underlying) and a market that prices (in the Florida property example) insurance against losses arising from property damage caused by severe weather at 20% of the insured value because that’s the best estimate of expected damages going forward!!! ie It’s not so much a market failure, as a failure of nature to adapt to Floridians’ desire to build expensive and vulnerable homes in the path of hurricanes and storm surges…
Indeed, if the market was allowed to operate efficiently, many of these homes would never have gotten built and/or their pricing would reflect the (NPV) of the (very high) annual ‘running costs’ (implicit, insured or realized) of the likely average annual storm damage.
Government saving us from ‘market failure’ in this case is just another example of one of Bastiat’s many great truths:
“Government is the great fiction through which everybody endeavors to live at the expense of everybody else.”
August 29th, 2007 at 3:10 pm
Great Bastiat quote. Thanks for letting me participate in your discussion. Political economy related to risk is a very very interesting area to me. I guess that is obvious from the length of my post above.
September 21st, 2007 at 5:33 pm
[…] Secondly - and this point is specific to Northern Rock - I have been disappointed and frankly surprised at how the Northern Rock management team, both executives and non-executives seem to be succeeding with their Alfred E. Neuman - Who, What me? - defense. While at the same time Messrs. King and McCarthy are being hung out to dry. Now I am not suggesting that these last two and the organizations they represent are blameless; in particular it seems the FSA seriously underestimated the risks Northern Rock was running with their aggressive funding policies, but come on! Regulation does not excuse management from running their own firm. They messed up. In a big big way. And they knew it. Any banker who has covered them in the last decade I’m sure has suggested at one time or another that they “term out”, “extend the maturity” of their funding. This is a jargon for borrowing on longer terms. Again most people would have no trouble understanding that were they to take a Northern Rock approach to their own finances, they would be taking significant risks - let me frame it. Imagine you have a £100,000 mortgage on your home. But only for a month. So every month you go back to your banker and ask for another 1 month loan. Most of the time - most not all - this would be easy, after all if they lent it to you last month, why not this month? But what if - for whatever reason - they didn’t. They ask for their money back. All the sudden your situation flips from perfectly fine, to deep shit. That’s why most mortgages are taken out with 10 year or more maturities. Northern Rock had the equivalent of a one month mortgage on their house - it was cheaper and so gave them bigger profits. But in simplistic terms - the 1st law of Financial Dynamics (Park’s Law): the conservation of risk - the spread, or difference in cost, saved by borrowing for one month vs ten years in fact is the market’s implicit estimation of the probability of liquidity drying up - of not being able to ‘roll-over’ the one month loan. There is no free lunch. Either Northern Rock’s management did not know this or they chose to ignore it and reap the short term returns at the risk of long term failure. Either way, completely unacceptable. […]
October 16th, 2007 at 2:49 pm
[…] At the risk of sounding patronizing, I would only suggest that the banks behind this fund don’t forget the law of conservation of risk: the underlying risks - the fundamental risk quarks - remain immutable. This does not diminish the potential value that can be created by rearranging and recombining this risk into different shapes and sizes, however the likelihood of this ultimately succeeding is in my opinion increased significantly if this ‘financial law’ is explicitly acknowledged by the financial professionals doing the engineering. Historically this has not always been the case (and has in my view been a key factor in creating some of the problems this fund now seeks to repair.) I imagine that Mr. Turner is thinking along these same lines: (from the Guardian article) Some economists doubt, however, whether the plan will work. Graham Turner, of GFC Economics, said: “It is little more than a confidence trick that does not go to the heart of the matter - namely how to prevent the downward spiral in property prices and escalating foreclosures feeding off each other.” […]