

Michael Lewis: In Nature's Casino (How Wall Street is trying to quantify the risk of catastrophic weather) - toffer
http://www.nytimes.com/2007/08/26/magazine/26neworleans-t.html?ex=1345780800&en=c254334073d350b0&ei=5090&partner=rssuserland&emc=rss

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giardini
I have a problem with the example, which I quote at length:

"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."

My question:

Shouldn't the text instead read "Anything he charged above $2,400,000..."?
Suppose the CA earthquake occurs _before_ the JP earthquake. After the JP
earthquake the insurer receives $2M but it's too late to buy CA insurance on a
past event.

To use one policy to pay for another, the insurer must buy both policies at
the same time. Otherwise the risk of an uncovered event would occur.

It would be cheaper to merely buy $10M worth of either CA or JP insurance
alone (but not both), since, certeris paribus, either would cost only $2M.

Am I missing something?

~~~
oblomov
You are missing something, but so is the article. Not only is the conclusion
misleading as stated, but the math is incorrect as well.

Here's where the conclusion is unclear : it says "The cost ... was a mere
$400,000." However, according to the article's math, that's the cost -per
factory-. The policy for the entire company would cost $800,000.

However, that's not quite right either. In order to return $10M total, you'd
only have to buy about $334,000 of insurance on each factory (I'm rounding the
numbers for convenience). Since the example operates under the assumption that
you can always use the proceeds from one policy to pay for the other -- ie,
there's never a perfectly simultaneous event at both locations -- I'll take
that as a given.

Let's say that Factory A gets hit first (California or Japan, it doesn't
matter). We collect our insurance payment of $1,670,000 ($334,000 _5) and
spend the total amount on additional insurance for Factory B. When Factory B
gets hit, we receive $8,350,000 ($1,670,000_ 5) from that supplementary
purchase. So where does the missing $1,650,000 come from? Remember that we
couldn't know which factory would be hit first, so we initially bought
$334,000 policies on -both- factories ... and that policy is still in effect
on Factory B. It returns $1,670,000, which brings our total to just over the
$10M target (remember, I'm rounding for clarity). So the total that we need to
spend on insurance is ($334,000 * 2 =) $668,000 per year.

~~~
giardini
But you _can't_ apply the gains from one incident to buy additional insurance
for the second, because the two incidents could happen simultaneously (before
you had purchased additional insurance). And this is not merely a theoretical
situation but a practical one, since there are delays between first incident
and payout and between purchase of additional coverage and coverage applied.

IOW all purchases of insurance must be done beforehand at the same time.
Purchases of insurance cannot be contingent, although the gains may be. So you
can't wait and see if one incident occurs to decide whether to buy more
insurance.

~~~
oblomov
I agree. _Pace_ Nassim Taleb, this is where the Fat Tonys of the world take
the Dr Johns to the cleaners.

Dr. John (he of the bag lunch and the actuarial degree) says "well, the
reporter says that Seo actually planned on using the proceeds from one policy
to purchase additional insurance on the other factory. So this must be the
scenario, and we should take that as a given." Well, as I wrote above, even
with that assumption, the article's math is still wrong.

Fat Tony (of the Brooklyn accent and custom suits) says "This Seo guy isn't
covered nearly as much as he thinks he is. If the two earthquakes happen on
the same day, he's screwed. Heck, they'd better not happen less than a month
apart ... have you seen how long it takes an insurance company to get a policy
written up? If he thinks he's gonna have that second policy the next day after
the first earthquake, he's dreaming." And he's right. The reporter has
misrepresented the solution in some fundamental way -- either it didn't play
out like this, or it's purely a hypothetical deal.

So which error is more egregious? I dunno; both aspects of this article
bothered me when I read it. Not only does the reporter almost certainly
misrepresent the terms of the deal, but he doesn't even get the math right on
the terms he presented.

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dpapathanasiou
I'm a fan of Michael Lewis's writing, but this product placement is just ugly:

 _She faxed the numbers to insurers, then walked to Au Bon Pain. Everything
was suddenly more vivid and memorable. She ordered a smoked-turkey and Boursin
cheese sandwich on French bread, with lettuce and tomato, and a large Diet
Coke._

Is the NYT so hard-up for revenues they're asking their authors to slip these
in?

I can't imagine Lewis wrote that on his own.

~~~
ctkrohn
The woman they're talking about said "everything was suddenly more vivid and
memorable." Presumably the event was so important that she remembered trivial
details around her that she normally would have forgotten. It happens to
everyone.

------
ctkrohn
Yet another example of how derivatives are transforming financial markets for
the better by transferring risk to those best able to handle it. It's also a
great example of how mathematical and computer-driven models are helping us
understand the world in practical ways.

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falsestprophet
more Seo spam...

~~~
rms
Is someone getting optimized here other than the NYT? Their pagerank doesn't
need much help.

~~~
falsestprophet
oh come on, the man's name was Seo

