economics

Brooks has a good one today (just read the bold stuff):

Over the past decades, we’ve come to depend on an ever-expanding array of intricate high-tech systems. These hardware and software systems are the guts of financial markets, energy exploration, space exploration, air travel, defense programs and modern production plants.

These systems, which allow us to live as well as we do, are too complex for any single person to understand. Yet every day, individuals are asked to monitor the health of these networks, weigh the risks of a system failure and take appropriate measures to reduce those risks.

If there is one thing we’ve learned, it is that humans are not great at measuring and responding to risk when placed in situations too complicated to understand.

I heard a story recently about a group of insurance executives meeting with BP’s risk manager in the 90s. She reiterated a common refrain: we don’t need insurance because we have a huge balance sheet.

Indeed.

And yet, insurance still has something to offer:

1. Individuals often overstate risk tolerance, especially with respect to organizations. I think that this is a combination of Robin Hanson’s Near vs Far bias and agency cost. People rely too much on silly capital models and not enough on anticipating the response of those individuals who (collectively) actually pay the costs (shareholders, stakeholders, etc) of risk when it goes pear shaped.

2. A market based appraisal of what the risk is worth. Sure, insurance underwriters may not understand it perfectly, but at least get a second opinion. You might miss something and the costs of that are, obviously, huge.

In spite of the fact that most risk is fundamentally incomprehensible, the insurance industry is actually quite stable. It continues to baffle me, to be honest, but I can’t argue with success.

Felix comments on El-Erian’s summary of the PIMCO global economic outlook.

Whenever I feel overwhelmed by the big picture, I retreat to my analytical roots in the insurance world.

Inflation can be dealt with fairly easily because prudent insurers will have sufficiently implemented ALM and so maturities should match payouts and so inflation will only hurt on the liability side of very long (insurance) tail lines of business. No systemic threat there.

Sovereign defaults will be tricky for insurers in those countries likely to default, but those insurers don’t matter because those economies don’t matter in a global sense.

I’d be surprised if knock-on effects of bank insolvencies for those heavily exposed to defaulting countries moved anyone’s needle.

Stagnant growth? Meh. It matters for this thing called “economic growth” but that’s mostly about opportunity cost. If my living standard doesn’t keep skyrocketing (in the historical sense), I will hardly notice. Real growth in the stock of insurable assets will slow, but insurers make their money from their leveraged bond portfolios, anyway.

Rise of the BRICs? Meh. My view is that those countries aren’t stable enough legally and don’t yet have a big and valuable enough stock of assets to protect to support globally important insurance industries.

State capitalism and bailouts? Now we’re getting somewhere. My view is that Uncle Sam prevented/delayed an insurance calamity over the last couple years. Bailouts kept the skeletons in the closet, which people would undoubtedly have wanted to claim for (thinking mostly professional liability here). A more severe recession would have triggered a load more property “oops” claims than we saw, though we did see an uptick.

More bailouts could prolong the soft market.