Disaster Futures: Can a Country Take out Financial Insurance Against Macro-Risks Like Currency Instability or Global Terrorism?

Professor Avinash Persaud explains the link between insurance and financial futures markets, specifically getting into the concept of disaster futures– objections to the idea, and possible benefits.

In one of last week’s Whiskey essays, we looked at the future of risk. More specifically, the future of insuring against kinds of risk that are currently uninsurable. You may recall the hollow fury erupting from certain senators in the fall of 2003. They were outraged at the idea of a Policy Analysis Market (PAM).

The PAM was quickly dubbed “terrorist futures,” mainly because it was designed to give a market price for future geopolitical events, including terrorism. It didn’t help that the idea was the spawn of Adm. John Poindexter (of Iran-Contra infamy). But lost in the crass political posturing was a serious debate over whether such a market would actually give policymakers an idea of the probability of future geopolitical events.

The essay below–again by professor Avinash Persaud–takes up the issue, but not so much as a way of hedging risk against actual future disasters (man-made or otherwise). Instead, he looks at it as the creation of a market for information that would (if the market participants had real knowledge) be a leading indicator of said events. It’s particularly timely in the context of the disaster to hit Southeast Asia last week.

Right now, the closest thing we have to “terrorist futures” are crude oil futures. One way of looking at them is as a loose proxy for the sell-by date on the Saudi monarchy. For example, oil prices above $44 would be a function of geopolitical instability, and not just the bullish supply-demand dynamic.

Short of a showdown over Iran’s impending announcement that it has a nuclear weapon, it’s the tottering of the Saudi monarchy and the interruption of Saudi oil production that will power oil prices higher. Thus, crude futures as an indicator of a geopolitical event.

It’s neither radical nor stupid if you look at it that way. Futures prices convey information in its raw form. They tell you what individual participants are betting on and how they’re evaluating risk.

But they don’t speak in the Queen’s English. Only prices. And prices don’t tell you what’s going on inside the heads and hearts of market participants. They only tell you what the market price is at any given time.

Still, is there a role for the marketplace in hedging risks currently outside the reach of our financial system? Professor Persaud takes up the case below in a lecture he delivered last year at Gresham College.

Best regards, 

Dan

P.S. You can see pictures of Gresham College over at the Whiskey & Gunpowder blog (www.strategicinvestment.blogspot.com) The college has been providing free public lectures for over 400 years. Thomas Gresham, the founder, played a central role in the development of England’s financial institutions. And Avinash Persaud, the author of two recent Whiskey essays, is the current lecturer on economics at the college. He also has an excellent book out called Liquidity Black Holes. More on that in a future edition.

And by the way, last week I referenced Robert Shiller’s book, The New Financial Order: Risk in the 21st Century. 

Can a Country Take out Financial Insurance Against Macro-Risks Like Currency Instability or Global Terrorism?
by Professor Avinash Persaud

Good evening, ladies and gentlemen. I would like to begin today by discussing the link between the personal insurance you and I take out every day and financial futures markets. I will then turn to a proposal to establish a terrorism futures market and how that would work. I will address the moral objections to such a market and its possible benefits to our democracy. It should be a thought-provoking tour.

How do you feel when you take out life insurance for yourself or your partner? I always feel a little uncomfortable. It is bad enough to have to think about the possibility of your own death to also have to consider how it could drive your family into penury. But it makes sense most of the time, and we all tend to be underinsured, or at least that’s what the insurance companies say…

Travel insurance makes me feel only slightly better, especially when you turn over the booklet and read on the back page how they value each of your limbs…There are some things that insurance companies do not wish to insure, not because of any moral qualms, but because they find it hard to price–perhaps the insured event and consequences are hard to define–or perhaps they feel susceptible to adverse selection, where the fact that someone wants insurance is a sign that the premiums are too low given their superior knowledge of the risk. Adverse selection is a particular problem for medical insurance.

In many cases, governments step in, either to offer insurance themselves or subsidize it. This is often the case in a flood-prone area or after Sept. 11, for instance, insuring airlines against a terrorist attack.

In this case, the government is acting as an insurance broker, and it is the taxpayer that is writing the insurance. As long as the government takes some responsibility in sharing the burden of life-changing events, be it benefits for unemployment or disability, then the government and taxpayers are writing insurance all the time. It is, of course, not often seen that way, and governments seldom, if ever, treat their payments and reserves in the way an insurer would and should.

Disaster Futures: Financial Futures Markets Are Insurance Markets

Insurance is commonplace. As individuals, we take out insurance against the worst possible events that may occur to ourselves or our families, and as taxpayers, we are insuring many others against sudden losses.

Financial futures markets are just insurance markets too. When you buy a 10-year mortgage, where the mortgage rate you pay is capped above a certain level, like 6%, you are insuring yourself against future rate rises above 6% and higher mortgage payments. The insurance premium you have to pay for this protection is either an upfront charge or, more usually, because it is less transparent and more spread out, stuck onto the mortgage rate you pay. Your mortgage company in turn is insuring itself against the possibility that interest rates do rise above 6%, pushing up the cost of its borrowing from the money markets while your mortgage payments stay the same. It insures itself in the futures markets, or at least it should be doing so.

An oil-fired power station can insure itself against a benchmark oil price rising any further from its current level over the next two years by purchasing the right to buy oil in the future at today’s price, or any other. The cost of purchasing that right is an insurance premium. Consensus expectations about the future will determine the cost of the premium. If everyone in the market thinks that oil prices are going to rise further because of instability in the Middle East, strikes in Venezuela, or further rapid economic growth in China, then the cost of this insurance, the premium, will be high. If everyone is worried about an economic slowdown or convinced that peace will break out, then the premium will fall.

Indeed, because oil price futures reflect all these variables, they are often used as measures of these events happening and as hedges or insurance against them happening.

It is estimated that some $10-15 on the price of a barrel of oil, which is around $44 this afternoon, so 20-25% of oil prices today, reflects not the demand and supply reality but expectations of oil supplies being interrupted by terrorism or other factors in the near future.

Markets reflect the balance of forces, however, and if you were that endangered species, the British manufacturing exporter, and you believed that the global economy would slow, perhaps due to the collapse in the U.S. dollar or interest rate rises in China, then there are few better ways to hedge your company’s future revenues and its payroll than buying the right to sell oil at its current price.

Financial futures markets are just insurance markets. Where they are liquid and they have many different types of players and actors involved, they are also surprisingly accurate. As anyone who ever watched Trading Places will know, the best weather forecast in Florida is the price of frozen orange juice futures. If you want to know the result of an election today, you are better off checking the financial markets than you are checking the polls.

The reason why they are more accurate is that they are markets for information. They enable people to profit from having better information than reflected in the market price. This creates an incentive for people to find better information, but by taking advantage of this information in the financial markets, by buying or selling, they in effect distribute that information to everyone.

Let me explain. There is a financial futures market on the date of the next election: the number of seats the different parties will achieve and the name of the next prime minister. The presence of this information market means that there is an incentive for someone to obtain and research better knowledge on the likely turnout of different voters or the economic conditions at the time of the election. Let us say that information tells you that the winner will be the same as currently expected, a record third term for the Labour Party, but that the Liberal Democrats will do better than expected. You could exploit that knowledge by selling the predicted number of Labour seats and buying the predicted number of Liberal Democrat seats. Your activity will change the price, and so while you potentially profit from your research, the changing market price distributes the results of your research to others.

Pure information markets are good at providing incentives for the private sector to do research into near events and for everyone to benefit from the results of that research.

To ensure that there are enough people willing to participate in the market to make it liquid, they have to be standardized and based around certifiable events. Consequently, some markets do not exist, and most require some initiative to establish, some agency to establish standardization, certification, and clearing of transactions.

Disaster Futures: The Objections

Moral indignation has been raised at the prospect of the U.S. government establishing a terrorism futures market. The original initiative was called the Policy Analysis Market and led by the infamous Adm. John Poindexter. Let me choose some choice quotes from Sen. Byron Dorgan’s response to the idea. Sen. Dorgan is from North Dakota: “A market for the future of the Middle East is a sick idea…unbelievably stupid…that combines the worst of all our instincts.”

This was my initial response. But one of the things I have learned mixing around financers is that crazy people can have good ideas, and while I would prefer to call it a disaster insurance futures market, let us forget about names and try to peel back the initial instinct to see whether this would be a good idea or not.

What are the objections?

The main objection to this idea is that it is immoral to trade human misery, to profit from calibrating disaster. And this might allow terrorists to profit financially from their dirty deeds.

It would be unethical to profit from a disaster that you made happen. It also happens to be illegal. But insuring yourself, or your family, or your firm, or your country against a disaster you do not wish to happen but may happen, with large consequences, is something almost all of us do with our life, health, and travel insurance.

That would be the principal purpose of the market. That said, the market would work better, offering better-priced insurance the more people were involved in it, even people with nothing to hedge but an interest in analyzing the probability of disaster.

Here is another way to look at it. The alternative is that the government sets aside money for research into this area–we would all welcome that. Then they decide to outsource this research to a private company specializing in terrorist analysis–many would welcome that too. Then they ask a range of researchers to estimate the probability of a terrorist attack, and they average these probabilities–few would object to that. The government then promises to award a separate large contract to those whose probability of a terrorist attack was more accurate than others–few would object to that, either–and yet that is what this market is, just more inclusive, probably more accurate, and more public.

You would, of course, have to make sure that terrorists are not involved in this market. You would not have to resort to insider dealing rules, as terrorism and profiting from it is illegal already. You would need permission to trade in that market, permission that would be based on a more aggressive version of the know-thy-customer rules that already exist, requiring you to provide sufficient information and money trails to ensure that there is no criminal activity behind the trades, only people looking to hedge themselves and people with a view. Terrorists are unlikely to risk giving themselves away or warning the authorities by buying disaster insurance before an event.

Disaster Futures: How the Market would Work

How would this market work?

There are a number of possibilities, but in short, and in danger of making you as uncomfortable as I get when filling out my life insurance form, it would have to be based around a certifiable event, such as a human disaster that accounted for a greater-than-specified number of civilian casualties, in a specific place, caused intentionally, within a specific time period.

You would have buyers of disaster insurance and sellers. The seller would have to pay out, say, $1 per contract if the event occurred within the time period. You could buy as many contracts as the market would bear. Let us say that you were convinced that the invasion of Iraq had raised the likelihood of a terrorist attack in the United States: You would be a buyer of disaster futures. Let us say that your company depended on air services being uninterrupted: You may hedge yourself by buying disaster insurance futures. If you had an opposite view or ran a security company in a potential target place, you could hedge your company’s revenues by being a seller on the other side of these trades.

To the uneasy, I promise just one more moment discussing the workings of this market. The price of the disaster futures would represent the probability of a disaster occurring. Let us say that for the first quarter of next year, the price was 35 cents. That would imply that the market felt there was a 35% probability of a disaster striking in the first quarter. If the price rose, it would imply that the market felt risks of a human disaster had risen. If the price fell, that risks had receded. The point is that it would be very easy to interpret.

The advantages–at best, you may feel a little ambiguous about this market, but what influenced me are some of the less obvious benefits.

One of the reasons why governments have declared a “war on terrorism” is that wars allow governments to use fear to get people to agree to things they would not otherwise agree to and they can take greater liberties with the truth.

How many times have we heard that we must trust the government’s intelligence, which cannot be revealed, and that there is no alternative to abandoning hard-won rights such as no detention without trial, charges, or due legal process? And we have reluctantly agreed, because we live in fear. And how many times have we heard that the sacrifices we have made have been worth it and the government is winning the war on terrorism through its actions…now we would have an independent measure.

What would happen if, following the Iraqi tragedy and the capture of Saddam Hussein and the insistence by the governments on both sides of the Atlantic that the world was a safer place, the price of disaster futures rose?

Information markets are excellent ways of getting the private sector to carry out research and letting us all benefit from the results. The alternative is the taxpayers pay for the analysis and they agree to sacrifices on the basis of the government’s assessment of the results, but the analysis is kept from them.

When disaster insurance prices fall, they will find it harder to increase defense budgets and undermine our civil liberties; when the prices rise, they will have to explain why their actions have failed and what they plan to do instead.

Disaster insurance futures will help individuals and businesses to hedge themselves against one of the most important risks of modern day life. But one of its main attractions for me is that the first casualty of war is truth, and disaster insurance futures will help to keep governments honest, focused on the tasks at hand, and will guide them better than a look over the shoulder to the polls on where they should be doing more, or perhaps less.

Regards,

Avinash Persaud
January 6, 2005