Sunday, August 26, 2007

My New Career -- Catastrophe Management

Before going to law school I studied mathematics and since law school have often wondered if there was some interesting way of combining the two. An interesting article in the New York Times today about the concept of catastrophe bonds has given me a glimmer of hope that that there might be such a career out there.

Catastrophe bonds are new type financial instrument that has been developed to help the insurance industry deal with the fact that there are now a whole range of rare, hard to predict events which will not destroy the world but will destroy the insurance industry. Hurricaine Andrew and Hurricaine Katrina are foretastes of these types of disaster -- disasters where the isurance claims run to the tens or hundreds of billions of dollars. This reflects a combination of human doings. While there may be arguments about the extent to which global warming has contributed to this, one need only walk around the water's edge in Victoria to see the real problem.

A stroll along Beach Drive in Victoria up to King George Terrace and down to Fairfield will show you one $1.5 to 5 million dollar house after another. One tsumani -- even a little one -- and in the first three blocks of Victoria likely over $100,000,000 of real estate disappears. A good solid tsunami and probably $500,000,000 dispapears before we even start adding in business losses and the claims associated with loss of life. This is in Victoria, a true economic backwater.

The Times article identifies four major types of disasters which could under the right circumstances wipe out the insurance industry as presently structured: the California earthquake, the Flordia Hurricaine, the Tokyo earthquake and the European winter strorm. In response to this risk a new type of financial instrument had to be developed to allow insurance companies to tap into the larger capital markets of the stock market and what was invented was essentially an all or nothing bet of a couple of billion dollars. On one side of the bet are insurance companies who borrow large amounts of money from the market in the form of catastrophe bonds and pay bonus interest for the honour of doing so. On the otherside are lenders, usually led by fund managers who spend a great deal of time thinking about the proper odds of the break the industry disaster. If the disaster strikes -- say the next Katrina hits Miami and washes all that prime real estate into the ocean and rebuilds the Everglades -- the insurance company wins the bet and keeps all the money it borrowed (keeps it until it pays the claims, anyway). If the disaster does not strike then the lenders get their money back and keep all that juicy interest.

The interesting career here is being guy (or woman and it seems the first person to really think about this seriously was a woman)who figures out which disasters are the right bets and at what price. What is interesting about this is that it is not the usual insurance actuarial exercise -- look at 10,000,000 car accidents over twenty years and pick out the patterns -- but instead is a reasoning exercise. It requires looking at patterns of human settlement, legal regimes, economics and science to figure out how rare events will play out. This exercise has interesting mathematical aspects but is not just mathematics: it requires thinking about how people have behaved and will behave the future.

Sadly, it also involves thinking a bit about silly government policies. You know the ones -- allowing places like Richmond and Delta to have been built below sea level on an unstable, shifting delta for example.

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