Tuesday, October 09, 2007

The convergence of "risk".

"Convergence" has long been talked about in terms of ReInsurance and capital markets...an insurance contract is just a binary put option, for example. A collection of these options will likely converge (Central Limit Theorem) into stable normal distributions. But notice in the article how local (micro) knowledge regarding specific ("idiosyncratic" in the finance lexicon) risks can obviate the need for assessing risk as a truly random variable in a population.

Here is a pretty good (albeit general) discussion of how Reinsurers think about risk, it is not exhaustive by any means, but it does illustrate the fact that "risk" is not "beta" or sigma/SDEV or any single measure. "Risk" has many origins. We just choose to distill its antecedents into something more tractable.

clicky: http://tinyurl.com/2h5akb

interesting section:

"So I think volatility and liquidity concepts are concepts applicable to low-risk, relatively low-return risk classes. Casualties, reinsurance and Cat reinsurance are high-return, high-risk classes. And they demand a different set of technical tools and methodologies to accurately assess the risk and actually -- accurately price the risk.

So when I look at investment banks and I look at VAR, value at risk, which is a daily measure, and I look at [reinsurers], which is capital at risk, which is an annual measure, one measures daily volatility. One measures downside risk. I think, again, for those risks which are long term in nature, which are difficult, which are severe, you're much better off with the CAR concept than you are with the VAR concept.

We have within the organizations, all the reinsurers represented today, we have great quantitative skills. Our actuaries are as smart as the quants in many cases, in all cases. At a number of our capital markets competitors, when a math major leaves college, it can go two ways. They can either go become a quant on Wall Street, or they can become an actuary for the insurance or reinsurance industry. I haven't been able to see any kind of difference in terms of the capabilities of the people who take either one of the two paths. They tend to be very similar.

I think the difference is, is that while the math is generally the same between capital markets and reinsurers, I think the atmosphere within which they work is distinctly different. There is a long culture within insurance and reinsurance companies of asking the actuary to come up and give you the long -- the bad answer, the answer you don't want. The worst thing as a CEO is when the actuary walks into your office and says can I talk to you.

I'm not sure that that always happens sometimes on the capital markets side, where in fact it is difficult to see how the actuary or the quant has the ability to withstand the blandishments sometimes perhaps of the trader. In our shop and in most reinsurance shops, the actuary and the underwriter are coequal in terms of their analysis and coequal in terms of their authority to put the Company at risk."

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