Re-Re-Re-Re Insurance: Lloyd’s Plays With Grey Swans

Re-Re-Re-Re Insurance: Lloyd’s Plays With Grey Swans

            Krugman’s account of Lloyd’s insurance company in his Losing It chapter jumped out at me for a number of reasons. First, it seemed an interesting lesson in regards to the recent financial crisis. We saw a similar problem, and with insurance companies no less! AIG would agree to insure home loans, assuming some supposedly estimable and extremely unlikely event would occur (a large number of defaults, in this case driven by a housing bubble bursting). This allowed banks and other institutions to sell of risk for what they perceived as a cheap price, and thus were encouraged to seek more risky transactions due the moral hazard associated with gaining fees and bonuses from large deal flow and not being faced with downside risk due to insurance. When AIG looked like it would be unable to make good on this insurance, there was a dramatic system shock.

            This is, in many ways, similar to Lloyd’s. Lloyd’s, losing market share in a growing competitive field decided to make risky bets as well. They again, those funding the insurance, the Names, may not have been as aware of the risk they were taking on. This information asymmetry was present in both scenario’s allowing one party, in this case Lloyd’s,  to take advantage of its reputation for ethical behavior (as some have argued that modern banks did in the opaque derivative market) to take on excessive risk in search of quick returns. In both scenarios, we see exposure to large downside risk being realized with dramatic results.

            There are of course a number differences and the analogy does break down. Lloyd’s may not have had quite as large a global impact as the US banking crisis, but it certainly had a larger effect on individual names, given the fact that it was not set up as a limited liability structure, and Names were thus liable to lose all of their possessions.

            The second thing that jumped out at me, apart from the parallels to the modern crisis, was the structure of the insurance itself. Lloyd found itself in a dangerous area, namely it was insuring very rare events, with enormous impacts. These rare, impactful events were written about extensively by N. Taleb in The Black Swan. He, along with some behavior economists and psychologists like Khaneman, have noted that people generally have trouble estimating these very rare, but very impactful events both from a mathematical and a psychological standpoint. The general idea behind Taleb’s argument is that those quantitatively analyzing risk (like those pricing insurance for Lloyd’s) have trouble estimating how “fat” the tails of the probability curve are (how common the extreme events are) (i.e. the kurtosis). Using Taleb’s definitions of these events, Lloyd’s was dealing in grey swans, large impact (remember they are insuring other insurers against risk above a certain amount—they are essentially only dealing in rare, large events!) events that were conceivable although extremely rare (although perhaps not as rare as the insurers believed). It seems likely that in addition to having issues of moral hazard and myopia in investment decisions, Lloyd’s was perhaps exposing itself to risk that is difficult to accurately estimate, namely these large tail events. Modern finance has recently recognized some of the shortcomings with attempting to fit normal distributions, or even historical distributions to future data sets, and are using stress tests and other metrics to attempt to solve these “tail event” grey swans associated with the Lloyd fiascos and the recent financial crisis.