SKOPJE, Macedonia, May 24 (UPI) -- Some insurance companies -- and corporations, such as Disney -- have been issuing high yielding or catastrophe bonds since 1994. These lose their value, partly or wholly, in the event of a disaster. The money raised underwrites a reinsurance or primary insurance contract.
According to an article published by Kathryn Westover of Strategic Risk Solutions in "Financing Risk and Reinsurance," most CATs are issued by captive Special Purpose Vehicles, SPVs, registered in offshore havens. This did not contribute to the bonds' transparency -- or popularity.
An additional twist comes in the form of Catastrophe Equity Put Options, which oblige their holder to purchase the equity of the insured at a pre-determined price. Other derivatives offer exposure to insurance risks. Options bought by SPVs oblige investors to compensate the issuer -- an insurance or reinsurance company -- if damages exceed the strike price. Weather derivatives have taken off during the recent volatility in gas and electricity prices in the United States.
The bullish outlook of some re-insurers notwithstanding, the market is tiny, less than $1 billion annually, and illiquid. A CATs risk index is published by and option contracts are traded on the Chicago Board of Trade. Options were also traded, between 1997 and 1999, on the Bermuda Commodities Exchange.
Risk transfer, risk trading and the refinancing of risk are at the forefront of current economic thought. An equally important issue involves "risk smoothing." Risks, by nature, are "punctuated" -- stochastic and catastrophic. Finite insurance involves long-term, fixed-premium, contracts between a primary insurer and his re-insurer. The contract also stipulates the maximum claim within the life of the arrangement. Thus, both parties know what to expect and -- a usually well known or anticipated -- risk is smoothed.
Yet, as the number of exotic assets increases, as financial services converge, as the number of players climbs, as the sophistication of everyone involved grows, the very concept of risk is under attack. Value-at-Risk computer models -- used mainly by banks and hedge funds in "dynamic hedging" -- merely compute correlations between predicted volatilities of the components of an investment portfolio.
Non-financial companies, spurred on by legislation, emulate this approach by constructing "risk portfolios" and keenly embarking on "enterprise risk management," replete with corporate risk officers. Corporate risk models measure the effect that simultaneous losses from different, unrelated, events would have on the well being of the firm.
Some risks and losses offset each other and are aptly termed "natural hedges" Enron pioneered the use of such computer applications in the late 1990s -- to little gain it would seem. There is no reason why insurance companies wouldn't insure such risk portfolios, rather than one risk at a time. "Multi-line" or "multi-trigger" policies are a first step in this direction.
But, as Frank Knight noted in his seminal "Risk, Uncertainty, and Profit," volatility is wrongly -- and widely -- identified with risk. Conversely, diversification and bundling have been as erroneously -- and as widely -- regarded as the ultimate risk neutralizers. His work was published in 1921.
Guided by VAR models, a change in volatility allows a bank or a hedge fund to increase or decrease assets with the same risk level and thus exacerbate the overall hazard of a portfolio. The collapse of the star-studded Long Term Capital Management hedge fund in 1998 is partly attributable to this misconception.
In the Risk annual congress in Boston two years ago, Myron Scholes of Black-Scholes fame, Nobel Prize and LTCM infamy, publicly recanted, admitting that, as quoted by Dwight Cass in the May 2002 issue of Risk magazine: "It is impossible to fully account for risk in a fluid, chaotic world full of hidden feedback mechanisms." Jeff Skilling of Enron publicly begged to disagree with him.
Last month, in the Paris congress, Douglas Breeden, dean of Duke University's Fuqua School of Business, warned in the same magazine issue, "'Estimation risk' plagues even the best-designed risk management system. Firms must estimate risk and return parameters such as means, betas, durations, volatilities and convexities, and the estimates are subject to error. Breeden illustrated his point by showing how different dealers publish significantly different prepayment forecasts and option-adjusted spreads on mortgage-backed securities ... (the solutions are) more capital per asset and less leverage."
Yet, the Basle committee of bank supervisors has based the new capital regime for banks and investment firms, known as Basle 2, on the banks' internal measures of risk and credit scoring. Computerized VAR models will, in all likelihood, become an official part of the quantitative pillar of Basle 2 within five to 10 years. Moreover, Basle 2 demands extra equity capital against operational risks such as rogue trading or bomb attacks. There is no hint of the role insurance companies can play -- as in "contingent equity". There is no trace of the discipline which financial markets can impose on lax or dysfunctional banks -- through their publicly traded unsecured, subordinated debt.
Basle 2 is so complex, archaic, and inadequate that it is bound to frustrate its main aspiration: to avert banking crises. It is here that we close the circle. Governments often act as reluctant lenders of last resort and provide generous safety nets in the event of a bank collapse.
Ultimately, the state is the mother of all insurers, the master policy, the supreme underwriter. When markets fail, insurance firm recoil, and financial instruments disappoint -- the government is called in to pick up the pieces, restore trust and order and, hopefully, retreat more gracefully than it was forced to enter.
(This is the third part of a three-part analysis of the risk business. Part 1 ran Wednesday, Part 2 Thursday.)