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  • Michael Lewis on Disaster-Risk Trading

    Posted by Jonathan on September 1st, 2007 (All posts by )

    This is an interesting and entertaining article, a bit long but worth reading. I’m not sure that Lewis completely understands some of the concepts here (or maybe I don’t understand them), and I think that he overpersonalizes his discussion by framing it as a narrative about mostly one person, which I suppose comes with the territory in journalism. It’s still quite a good article, however.

    The central problem with pricing disaster risk is that disasters are by definition infrequent events, and there aren’t enough data to calculate odds with a high degree of confidence. It’s like the global-warming issue. We don’t have 100,000 years of accurate data, so instead we (that is, the better risk-modelers) take accurate data from the past few decades, estimate the rest, estimate worst-case costs for particular disasters (not that hard to do), and perform Monte Carlo simulations to estimate the odds of high-cost outcomes. If you do this carefully you can generate useful estimates.

    Apparently, these techniques, which are common in finance, were applied to disaster modeling only quite recently. This happened because insurers were underpricing policies based on a few decades of quiet weather (anchoring bias), got blasted with huge claims after Hurricanes Andrew in 1992 and Katrina in 2005, and were forced to update their methods. Lewis’s hero is a quant who has been highly successful in pricing risk in the (fat?) tails of disaster-probability distributions and appears to be more street smart about trading than Lewis’s initial description of him suggests.

    Check out Lewis’s piece if you are at all interested in finance or risk modeling.

     

    8 Responses to “Michael Lewis on Disaster-Risk Trading”

    1. david still Says:

      One of the first rules of writing for popular audiences, or in journalism, is to focus upon PEOPLE. In fct, two are focused upon and the narrative is gripping enough to get the average reader to read this in an organ meant for the genral public that is fairly educted (as opposed to tabloids). As such, it does what it sets out to do, and if one is looking for something much more academic and scholarly, then don’t go to such media to begin with.

    2. Jonathan Says:

      I realize that journalists think it’s important to personalize stories, and indeed to make a story out of every issue. However, not all issues can be explained clearly using this technique. It’s better if the guy writing the explanation is an expert in the field he is explaining, and Lewis isn’t, despite his being better on financial topics than are most conventional journalists.

    3. Shannon Love Says:

      Since most of the human brain is devoted to processing information about other human beings, we tend to remember information encoded into stories about humans or anthropomorphized non-humans better than we remember “just the facts” information. Creating a “gripping” story that evokes emotional resonance in the reader/listener helps us recall the information even better. Numerous folk tales, myths, legends and even religious stories of all the world’s cultures encode not just morality but practical information about the physical world as well.

      For example, ancient Greek mythology tells the story of the giant Antaeus who killed strangers by wrestling them. As long as he kept contact with the ground (in the myth, his mother Gaea, the Greek god of the earth) he could not be defeated. Students of any martial art will instantly recognize this as a cautionary tale about the importance of keeping a firm footing. Especially in wrestling sports, loosing contact with the ground leads to a swift defeat.

      I think it clear that contemporary journalist rediscovered that personalizing a story about technical matters helps people remember and understand the technical aspects better than a just the facts approach.

    4. Don Hodges Says:

      Has nobody here read “The Black Swan”? It’s a much more compelling treatise on scalable (vs. Gaussian)risk. These guys are not running a casino, they are on the receiving end of a carnival knife-thrower doing his first show. Investors should be making small bets on the risk of positive rare events rather than “pricing catastrophe” – what does that even mean?

    5. david foster Says:

      I thought it was a very interesting article. I’ve read “The Black Swan,” which was worthwhile, but I thought the author’s earlier “Fooled by Randomness” was better.

      Somebody recently observed that collaterilized debt obligations for mortgages were really catastrophe bonds…to which I would add the obvious point that this wasn’t really understood by most of those that were buying them, and indeed by many of those that were selling them.

    6. Jonathan Says:

      These guys are not running a casino, they are on the receiving end of a carnival knife-thrower doing his first show. Investors should be making small bets on the risk of positive rare events rather than “pricing catastrophe” – what does that even mean?

      I agree. I haven’t read Taleb’s books but I think that I understand his argument. Another way to put it: don’t fight the market trend. Lewis believes that his hero has figured out a way to take the other side of bets that have open-ended risk, while undercutting other market makers. Maybe. Or maybe he is running a negative-expectation Martingale that will blow up one day and lose an amount that’s greater than his accumulated winnings to date. It all depends on the accuracy of his estimate of the shape of the returns distribution. Time will tell.

    7. juandos Says:

      Hmmm, if Lewis actually knew what he was talking about, if what he had to say had some credibility then why post it the New York Times?

    8. Jonathan Says:

      Why not? The Times publishes many good articles.