A few weeks ago I had lunch with a cat bond manager who was crowing about buying and selling a particular bond at a solid profit in a single day.
The bond was Mariah Re, which is at risk of being triggered by tornado losses this past quarter in the US. It hasn’t triggered yet, but it’s close.
My bond manager friend figured that, since Tornado Season is over, the fact that the bond was trading at a steep discount at the time meant it was a steal. And it was. He sold half of his position for a tidy little profit and figures he’ll ride the rest out at the great yield he’s secured.
He’s looking a bit less smart today.
He’s actually probably ok, but this made me once again appreciate the power of IBNR.
IBNR is a classic Rumsfeldian phenomenon:
[T]here are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some things we do not know.
But there are also unknown unknowns – the ones we don’t know we don’t know.
Claims happen with uncertain cost. Ok, that’s the set of unkowns.
Some claims get reported reasonably promptly, even if the ultimate cost is still uncertain. These are the known unknowns.
The unknown unknowns is the IBNR. It can be estimated, but you need lots of good data. Anyone who hasn’t looked at a lot of portfolios over a long period of time will struggle with this.
Even then, it’s a horribly difficult concept to keep in your mind. People appear to be hard-wired to think that things in the past are in the past and can’t hurt us in the future.
Not so.
Not Unreasonable 