The always fascinating Michael Lewis (Liar Poker and more) goes back to his Wall Street for an article on catastrophe bonds - bonds linked to earthquakes, hurricanes and the like - as part of the financial markets evolution in response to Katrina.
However... in the course of neatly illustrating a point about pricing two independent events, Mr. Lewis and the star of his article, Mr. Seo (a hedge fund manager in Westport, CT) provide an example which is over-simplified to the point of glaring inaccuracy. I have no doubt Mr. Seo spotted the error immediately; I suspect that Mr. Lewis was also aware of the problem, but pressed on in pursuit of a broader point.
But we don't press on in pursuit of broader points around here - if "No nit left behind!" is not already the unofficial site motto, it will be soon. So let's discuss on Sunday what Mr. Seo's clients will be ribbing him about on Monday:
The logic is what Seo stumbled upon back in 2000 at Lehman Brothers after someone handed him a weird option to price. An industrial company had called Lehman with a problem. It operated factories in Japan and California, both near fault lines. It could handle one of the two being shut down by an earthquake, but not both at the same time. Could Lehman Brothers quote a price for an option that would pay the company $10 million if both Japan and California suffered earthquakes in the same year? Lehman turned to its employee with a reputation for being able to price anything. And Seo thought it over. The earthquakes that the industrial company was worried about were not all that improbable: roughly once-a-decade events. A sloppy solution would be simply to call an insurance company and buy $10 million in coverage for the Japanese quake and then another $10 million in coverage for the California quake; the going rate was $2 million for each policy. “If I had been lazy, I could have just quoted $4 million for the premium,” he says. “It would have been obnoxious to do so, but traders have been known to do it.” If either quake happened, but not both, he would have a windfall gain of $10 million. (One of his policies would pay him $10 million, but he would not be required to pay anything to the quake-fearing corporation, since it would get paid only if both earthquakes occurred.)
But there was a better solution. He needed to buy the California quake insurance for $2 million, its market price, but only if the Japanese quake happened in the same year. All Seo had to do, then, was buy enough Japanese quake insurance so that if the Japanese quake occurred, he could afford to pay the insurance company for his $10 million California insurance policy: $2 million. In other words, he didn’t need $10 million of Japanese quake insurance; he needed only $2 million. The cost of that was a mere $400,000. For that sum, he could insure the manufacturing company against its strange risk at little risk to himself. Anything he charged above $400,000 was pure profit for Lehman Brothers.
Hmm. So Lehman pays $400,000 for a policy that will pay off $2 million if an earthquake hits Japan. If there is such an earthquake, they will then take the $2 million and buy $10 million of coverage for California. If no earthquake hits California, Lehman breaks even; if a subsequent earthquake does hit California, Lehman collects $10 million on the conventional California policy and pays $10 million on the double-whammy policy. Fair enough, but - what happens if the first relevant earthquake that year hits California?
As I read it, Lehman is underinsured - if an earthquake hits California, Lehman will then want an additional $1.6 million to top up its Japan policy from $2 million to $10 million. Where is that coming from?
As a first pass to the correct answer, let's extend Seo's strategy a bit - in addition to the $400,000 premium paid to buy $2 million of protection in Japan, let's double up and also buy enough California insurance to provide for a $2 million payout if a quake hits California; the intention is that the proceeds will be used to buy $10 million of coverage in Japan following a California quake.
That suggests a final answer double that presented here, but a further adjustment is necessary. If a first quake hits in Japan, the Japanese policy will provide enough to buy $10 million of coverage in California. But Lehman will have already bought $2 million of coverage in California, so there is a $2 million of excess coverage here. The right answer will have Lehman buying something less than $10 million in each market.
In fact, given the relative simplicity of this problem, since the payouts are 5 times the premium, Lehman ought to buy 1/6 the target coverage amount for both Japan and California, or roughly $1.67 million for each. Then, if a first earthquake hits at one site Lehman can buy 5 * $1.67 = $8.33 million for the other site, add it to the $1.67 million already held, and have a total of $10 million in insurance for the as-yet unhit site.
By that reckoning, the correct premium would be for coverage of $3.33 million, or $666,666 - a devilishly clever answer indeed.
Obviously, this strategy does not work if the independence of the events break down. For example, if insurers decide that Pacific rim earthquakes are geologically correlated, or that (based on the experience of the first quake) building codes have been inadequate throughout the region, an earthquake in Japan might increase pricing in California, or vice versa.
PUNS WE WOULD NEVER DARE, UNLESS, WELL... : Did I read this in the Times? Props to Mr. Lewis for sneaking it past the editor:
First, we get some of Mr. Seo's family history:
But when John [Seo] told [his mother] that he was leaving the university for Wall Street, she wept. His father, a hard man to annoy, said, “The devil has come to you as a prostitute and has asked you to lie down with her.”
Quite a colorful dad. In the next paragraph:
Tail risk, broadly speaking, is whatever financial cataclysm is believed by markets to have a 1 percent chance or less of happening. In the foreign-exchange market, the tail event might be the dollar falling by one-third in a year; in the bond market, it might be interest rates moving 3 percent in six months; in the stock market, it might be a 30 percent crash. “If there’s been a theme to John’s life,” says his brother Nelson, “it’s pricing tail.”
Pricing what, and who is lying down with whom now? Geez, what kind of clown would slip that into a seemingly-serious endeavor?
From: Hit and Run
Sent: Monday, August 27th, 2007 2:45 PM
To: Waxman, Henry
CC: Fielding, Fred;
Subject: Subpoena Duces Tecum
Dear Congressman Henry A. Waxman:
I will turn over all emails requested. Except any from Karl Rove, which I am not saying there are any, and I'm not saying there are not. But if such emails did exist, and you don't know if they do because I am not saying, I would not give them to you. I will neither confirm nor deny their existence, but do hereby confirm that I would deny your ability to see them, if they existed.
By the way, what does the "A." stand for? Is it anatomical in nature?
At your service,
hit and run
Posted by: hit and run | August 27, 2007 at 04:27 PM
"Another defendant in the case, oilman David Chalmers, owner of Houston-based Bayoil (USA) Inc., filed a separate request asking Chin to exclude evidence that might find him guilty."
Posted by: danking70 | August 27, 2007 at 04:50 PM
Deeeeeeeeeevious dems. I'm in VA 2nd district. Just got a recorded call from Thelma Drake - someone is calling everyone in the district inviting us to a townhall meeting with Thelma Drake - and she isn't having any townhall meeting.
She said it's MoveOne.org using her name without her permission.
Posted by: SunnyDay | August 27, 2007 at 04:58 PM
MoveOne.org = MoveOn.org
Posted by: SunnyDay | August 27, 2007 at 05:00 PM
I have been in the cat reinsurance businesss. I liked Lewis's article, but that example was not particuarly realistic, for several reasons.
One is that EQ coverage normally includes "1 reinstatement at 100%." That means if a company bought $10m of reinsurance for $2m and the reinsured event occurred, they would collect only $8m, becauase $2m would be deducted from their $10m recovery to pay for insurance against the next covered catastrophic event.
Also, the reinsurance market has long sold "Second Event" covers. As the name implies, this type of reinsurance covers the second event in the reinsured layer, but not the first event. The price of a second event cover is much less than the price of a first event cover.
A third problem is that the solution of only buying coverage after the first event occurred is that it would leave the risk that the second event occurred so quickly that additional reinsurance couldn't be put in place in time.
A fourth point related to Lewis's hypothetical plan is that if the first event occurred half way through the policy period, it would cost less to buy more coverage, since it would only apply for around half as long a period.
A 5th picky point is that the buyer needed to worry about two large EQs in the same country, as well as a large one in each of 2 countries.
Posted by: David | August 27, 2007 at 05:43 PM
Moody's just downgraded the NYT to negative from stable.
And Durham is in a lot of trouble:
"DURHAM - The spectre of massive civil lawsuits has put the future of a special committee probing the police’s handling of the Duke lacrosse case in limbo.
The city’s insurance provider advised last week that continued investigation by the panel could provide ammunition for a civil lawsuit, Mayor Bill Bell confirmed Monday.
Falsely accused Duke lacrosse players David Evans, Collin Finnerty and Reade Seligmann have hired powerful attorneys in anticipation of suing the city.
Seligmann has retained Barry Scheck, a prominent New York City lawyer whose high profile clients include O.J. Simpson and British nanny Louise Woodard. Evans and Finnerty have hired Brendan Sullivan Jr. and Chris Manning of Washington D.C.
The former players’ attorneys will meet with City Attorney Henry Blinder and other legal advisers next week.
Based on the outcome of those meetings, City Council members then will decide whether to allow the committee to continue or to suspend their activities indefinitely, Bell said.
“The nut of it is they’re suggesting we might want to stop right now,” he said.
Durham has a $5 million liability policy with The Insurance Company of the State of Pennsylvania with a $500,000 deductible.
A clause in the city’s insurance policy says that there will be no coverage if the city “ elect[s] a third party to investigate, defend or settle such claims or suits"
http://www.newsobserver.com/news/story/684138.html
It's a lovely day here.
Posted by: Clarice | August 27, 2007 at 05:44 PM
here is more on the diary notes --
Posted by: Topsecretk9 | August 27, 2007 at 06:42 PM
and more background
Posted by: Topsecretk9 | August 27, 2007 at 06:58 PM
--I have been in the cat reinsurance businesss.--
Wouldn't it just be cheaper to put them in a burlap bag with some rocks and, well you know...
Posted by: Barney Frank | August 27, 2007 at 07:18 PM
Barney,
I think it's the nine lives thing.
You can only be sure they're really gone when you receive the insurance check.
Posted by: Rick Ballard | August 27, 2007 at 07:34 PM
Rocco could probably make better sense of this but
---------
-------
all via fedora and piasa, industrious freepers
Posted by: Topsecretk9 | August 27, 2007 at 08:42 PM
What a joke this place has become.
shame.
Posted by: freeper | August 27, 2007 at 08:51 PM
ts...have you seen anything connecting Bayoil to Ritter yet? Forgive me if this is redundant. (I couldn't find the original article from the FT.)
Posted by: Rocco | August 27, 2007 at 09:02 PM
What a joke this place has become.
?????
Posted by: Sue | August 27, 2007 at 09:04 PM
A copy of a handwritten fax dated July 10 2000, the same month that Mr Khafaji began funding Mr Ritter's film, shows Mr Giangrandi passing on Mr Khafaji's contact details to Mr Chalmers.
The note says: "Dear David. This is the partner of S. R. with whom I am negotiating now the 5M B-L. He is a very influential person here, and we can do many things in the future with him. Regards, A. G."
Mr Giangrandi confirmed that "S. R." referred to Mr Ritter.
Mr Ritter insists he was never offered any allocations by the Iraqi
government. But he does relate an incident when an Iraqi official from the UN mission in New York said he might be able to get funding for his film by "sending an oil contract through a French oil company". Mr Ritter says he "terminated the conversation at this point".
Mr Ritter was having trouble finding a backer for his documentary until he met Mr Khafaji at a congressional hearing...
... "I called him and asked him," says Mr Ritter. "He said he had never received any money. He said it's all BS. He said he doesn't know why his name is on there."
"I choose to believe (him) over anyone else ... Until someone demonstrates
this man has done something wrong, he is a hero in my book."
Asked how he would characterise anyone suggesting that Mr Khafaji was offering allocations in his name, Mr Ritter replied: "I'd say that person's a fucking liar. Quote unquote. And tell him to come over here so I can kick
his ass."
Chalmer's of Bayoil pled guitly a few weeks ago...
Al Khafaji admitted to the Financial Times to selling oil he received from Hussein's government to Italtech, an Italian company which then sold the oil to Bayoil, a Houston company. The newspaper estimated he made around $1.1m from the oil for food programme.
Posted by: Topsecretk9 | August 27, 2007 at 09:18 PM
What do mean "become", freeper?
Posted by: Ralph L | August 27, 2007 at 09:45 PM
fixit
Posted by: Barry | August 27, 2007 at 09:50 PM
Posted by: Rick Ballard | August 27, 2007 at 10:01 PM
What a joke this place has become.
_________________________________
Well some of the most informed, passionate, mature, well mannered and witty people blog here..In my opinion.
It has been my great pleasure to read and learn from the JOM community these last 6 months or so.
They support and inform those that ask.
They defend American values.
They defend our troops in more than words, but with prayer and deed.
The sitemeter records citizens of the world visit here often..So i'd say they are global. ( They care about our world.)
I believe they often speak truth without predjudice to others.
Those values are rare anywhere..and i'm proud to have been welcomed here.
Unlike many left learning sites..all posts are generally allowed.. unlike say FDL where a moderator only allows like-minded postings..wanna be a lemming? go there.
This blog is a living testiment to the dreams, thoughts and ambitions of all america..not just one view of america.
If that's a joke...then we all need more jokes in our world.
Posted by: hoosierhoops | August 28, 2007 at 01:37 AM
"freeper" is a troll no doubt.
Posted by: Jane | August 28, 2007 at 07:28 AM
I like turtles.
Posted by: boris | August 28, 2007 at 08:34 AM
Well, hit and run jr started kindergarten today. Quite the big boy and all.
Of course, then my joy at this event is greeted by this post in the Corner, from Peter Robinson:
I Question The Timing.
And yes, I've googled it, there is no record of the phrase "flotsam of their own infecundity" having been used before.
Posted by: hit and run | August 28, 2007 at 09:40 AM
From the Boy's Own Book of Outdoor Sports (early 1900s):
"Trolling with dead bait." Yep, just the phrase I was looking for...Posted by: cathyf | August 28, 2007 at 09:42 AM
Good one.
Posted by: Extraneus | August 28, 2007 at 10:27 AM
"flotsam of their own infecundity"
Dammit, H & R, I tossed that in the ol' metamixer and now its jammed tighter tighter than Dick's hatband. I hold you personally responsible for this 24 carat trainwreck.
Posted by: Rick Ballard | August 28, 2007 at 11:12 AM
Thnkx for posting that HIT. You should have seen my son's face when at 2 1/2 he learned that preschool wasn't a one day thing like a birthday party. He asked how many more years of this he had to endure and boy was he pissed to learn the truth.
Posted by: Clarice | August 28, 2007 at 12:11 PM
TSk9-
One entry says Wyatt persuaded Sen. Edward Kennedy, a Massachusetts Democrat, to deliver a speech against the Iraq war, Shargel wrote. A Kennedy spokeswoman didn't immediately return a call seeking comment...
Its nice to know that Sen. Kennedy can be rented out by Big Oil, when the firm is allied against the US.
Posted by: RichatUF | August 28, 2007 at 01:15 PM
No, no, Rich, you've got it mixed up. Sen. Kennedy can be rented out by Little Oil. Big Oil gets so much attention, it's way harder for them to approach the levels of corruption that their relatively anonymous counterparts can manage.
Posted by: cathyf | August 28, 2007 at 01:40 PM
TSK9-
Its been a while since I've followed the ins-and-outs of the OFF trials, but IIRC, the current guilty pleas involved Chalmer, Dionissiev, and BayOil and the Wyatt charges are scheduled to go to trial sometime in September.
Posted by: RichatUF | August 28, 2007 at 01:42 PM
"a small fish generally, or its representative"
This experiment in republican government has gone too far.
Posted by: Ralph L | August 28, 2007 at 04:35 PM
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