agency and diversification: some implications for …...currency portfolios ” by froot, et al,...
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Agency and Diversification:
Some implications for catastrophe risk
Ken Froot
Harvard, FDO Partners, and State Street Associates
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Vote
• You would like to try out some uncorrelated new investment
ideas.
• You open an account with 1% of your wealth for this purpose.
• An idea’s expected return improves rapidly with the time you
spend on it. There are no diminishing returns.
• How many ideas should you include in the portfolio at any
given time?
4/20/2012 © Ken Froot 2
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Vote
• I’m an investment manager.
• You are a paid employee of an endowment, and
contemplating giving me 1% of the endowment to manage.
For this, I charge a fee.
• I can generate multiple uncorrelated investment ideas at any
given time. An idea’s expected return improves with the time
spent on it. There are no diminishing returns
• How many ideas do you want me to include in your portfolio
at any given time?
4/20/2012 © Ken Froot 3
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Responses
• Can differ based on the perceived interests of each player
• Since principle / agent interests are less than perfectly aligned
there will be inefficiencies in the ultimate portfolio
• Questions
– Are these effects important?
– Are they relatively more measurable in certain contexts?
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Outline
• Generic examples of agency in investing
• Cat risk – general facts
• A framework to explain cat prices
• Diversification and cat prices
• Agency issues may make reinsurers inefficient. But are other
solutions better?
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Generic Example 1:
Risk appetite of retail vs. institutional investors
• Retail investors evince Kahneman and Tversky styles
disposition effects
• What about their agents, institutional investors?
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Retail vs Institutional investorsDisposition vs dynamic loss aversion
• Weight relative to benchmark
Investor position Asset price move
Institutions Short Loss buy back Gain hold
Retail Long Gain sell Loss hold
Up down
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Investor Behavior
• Investors may be sensitive in their decisions, all else equal, to
their own past performance
– Retail investors tend to exhibit disposition effects, cutting their
flowers and watering their weeks
– Institutional investors broadly seem to be on the other side of
this trade (“dynamic loss aversion”), cutting their weeds and
watering their flowers
• While on average retail investors lose money to institutions,
during times of large PNL losses, institutions cut risk more
indiscriminately
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Dynamic Loss Aversion
and Stress Trading
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• Investors react to profits and losses with a
change in risk appetite.
• Institutions react in an opposite way from
individuals, cutting risk after losses
• Multiple frames of reference impact risk appetite. Position, portfolio and aggregate profit/loss each play a role in determining risk aversion.
• More recent losses weigh more heavily
• Past losses matter only if the position is still on
the books.
• See “How institutional investors frame their
losses: Evidence on dynamic loss aversion from
currency portfolios ” by Froot, et al, Journal of
Portfolio Management, 2011.
Aggregate Global
Aggregate Currency
Portfolio
Position
Risk Appetite
1Three class (positive, negative, no change) logistic regressions of the sign of change in risk appetite on past profit and losses, plus a constant term (not
reported). Independent variables are volatility standardized prior to regression. Number of observations: 8,510,215. Risk decrease probability deltas
indicate the change in the probability of a decrease in risk appetite due to a positive PNL change.
Change in Probability of Risk Reduction Due To Profit/Loss1
Currency/Fund PNL Fund PNL Currency PNL Universe PNL
Level Slope Level Slope Level Slope Level Slope
∆ prob –0.22% +0.11% +0.08% –0.06% –0.44% +0.14% –0.63% +0.37%
t-stat –9.4 4.9 3.3 –2.3 –20 6.0 –29 17
Source: State Street Global Markets
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Stress Trading Indications
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• Foreign exchange stress trades occur when the likelihood of a change in risk appetite due to past losses is high.
• Indicator helps understand the linkages between past currency movements, holdings, and future market dynamics.
• Can be used as a measure of investor dislocation, providing a potential risk filter to quantitative currency models.
• Coverage:
DM: AUD, CAD, EUR, JPY, NZD, NOK, SEK, CHF, GBP and USD
EM: KRW, BRL, MXN, PLN, CZK, SGD, HUF, ZAR, INR, TWD, IDR and TRY
Global Average Likelihood of Risk Decrease
Likelihood of Risk Decrease, Sept. 12, 2008
Source: State Street Global Markets
Source: State Street Global Markets
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Generic Example 2:
Concentration of bets away from benchmark
• Institutional investors are hired to beat a benchmark
• Benchmark deviations are their bets as agents
• Some preliminary evidence from 25,000 institutional portfolios
– Build analytic benchmarks for each
– Measure deviations as over/underweights
• Evidence that concentration has fallen over time, so that in that sense, diversification has increased over time.
• Not clear whether this is excessive or specifically due to agency.
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Institutions seem to have become more
diversified since late 1990s
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for
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A Spectrum of Agency Issues
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Clients Intermediaries
Firm/Fund-level
Internal
Management
PM/Trader Career
Risk
Management
Funding
Costs
Pressures,
Difficulties in
raising, keeping
funds
Financing charges,
Haircuts, dead-
weight costs of
external capital
Charges,
Peer pressures External and
Internal
Reputation,
Personal
SatisfactionFunding
ConstraintsPull funds
Risk or value
based margin call,
debt overhang &
financial distress
Position
reduction
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Outline
• Generic examples of agency in investing
• Cat risk – general facts
• A framework to explain cat prices
• Diversification and cat prices
• Agency issues may make reinsurers inefficient. But are other
solutions better?
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Cat Reinsurance
• Big advantage
– Small relative to other markets
– Cat uncorrelated with other financial assets.
• Risk averse principals using expected utility act as though risk
neutral for small allocations
• No shortage of agents: insurers, brokers, reinsurers,
regulators, rating agencies, investment managers
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Cat Risk General Facts
Market Components
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InstrumentAnnual Notional
TradedDuration Barriers to entry
Catastrophe Bonds $ 4 B 2-3 years Very low
ILW (Industry Loss Warranties) $ 6 B 6-12 monthsMore difficult than bonds, but easiest of OTC instruments
Traditional reinsurance $ 150 B 12 monthsHigh barriers: must have broad sourcing resource, analytical
capabilities
Retro $ 5 B 12 months More difficult than ILWs, much easier than traditional reinsurance
Private transactions (e.g. County Weighted Industry Loss ‘CWIL’)
$ 10- $ 20 B 12-24 monthsVery high barriers, need significant size and superior creditworthiness
to participate (Berkshire, collateralized)
Quota Share or “ILS Portfolios” n/a 12-24 months Low barriers, as simply paying a reinsurer to access their platform
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Cat Bonds Provide Market-based ReturnsCab Bond Index Performance
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Recent Cat Bond Index Performance
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But Cat Bond Notionals Small
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Cat Reinsurance Shocks
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Figure 4b: Price of Reinsurance Relative to Actuarial Value, 1989-2000
0
1
2
3
4
5
6
7
8
1988 1990 1992 1994 1996 1998 2000
Mu
ltip
le o
f A
ctu
ari
al
Fair
Valu
e
.
ROL
Price
U.S. Cat Property Price and Quantity transacted U.S. Cat Property Price of Reinsurance Relative to Actuarial Value
• Observation: A negative shock to intermediary risk capacity, results in an increase in the
cost of reinsurance AND a decline in the quantity of reinsurance consumed.
• Over time, capital flows in to arbitrage opportunities
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Model Uncertainty and Updates
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Post-event Patterns PersistImpact of KRW on Rate on Line
Region Strike Expected Loss 2005 2006
US hurricane $50B 2.5% 1.4x 6x*
US hurricane $30B 4.9% 1x 5.1x
US hurricane $20B 8.1% 1.4x* 4x
US earthquake $15B 4.3% 1.7x 3.5x
US earthquake $20B 3.2% 1.8x 3.6x
US 2nd event $10B 5.2% 1.4x 4.8x
US 2nd event $20B 1.2% n/a 10.4x
Pricing shown as a spread to risk-free (typically 3m UST)
Expected losses shown as market standard model output (not NCL estimates)
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Post-event Patterns PersistImpact of KRW on ILW
$ 20bn $ 40bn (Katrina) $ 50bn
Sp
rea
d in
%
0 %
5 %
10 %
15 %
20 %
25 %
30 %
35 %Pre Katrina
2006 Peak Pricing Post Katrina
2008
2009
2010
2011
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Post-event Patterns Persist
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Post-event Patterns Persist
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Region Strike price Pre-Event price Post-Event price
Japan Quake $ 10B 4.75 % 15 %
Japan Quake $ 25 B 3 % 8 %
Japan Quake $ 50 B n/a 5 %
USA Quake $ 20 B 7.25% 10.5%
USA Quake $ 30 B 5% 7.75%
Post Japan Earthquake ROL Pricing, ~40bp expected loss
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“Cold Spot” Earthquake Pricing
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Recent Insured Cat Losses
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Quantity of intermediary capital
Sh
ad
ow
re
turn
on
in
term
ed
iary
ca
pit
al Demand
Supply
Figure 1
Equilibrium in the market for intermediary-supplied capital
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Quantity of intermediary capital
Sh
ad
ow
re
turn
on
in
term
ed
iary
ca
pit
al Demand
Supply
Figure 1a
A negative shock to the demand for intermediary capital
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Quantity of intermediary capital
Sh
ad
ow
re
turn
on
in
term
ed
iary
ca
pit
al Demand
Supply
Figure 1b
A negative shock to the supply of intermediary capital
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Facts So Far Suggest
• Average risk adjusted returns are high
• Risk adjusted returns follow a cycle subsequent to industry
stress
Implied inefficiencies
in the supply of capital
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How are Agency Issues Linked?
• Costly external finance and high prices
• Diversification by principals
– Ultimate principals don’t or unable to supply enough capital
• Familiarity bias
• Reinsurer capital levels chosen by agents, not principals
• Risk within reinsurers is concentrated rather than spread
– Deadweight costs of external finance result in inefficiencies
• Deadweight costs of corporate intermediation
– Conflicts between shareholders and managers may result in high capital charges
and correspondingly excessive incentive to diversify
– Additional agency layers (rating agencies, regulators, etc.) further encourage
reinsurers to manage risk, not return
– The broader spectrum of agency issues among institutional investors
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Outline
• Generic examples of agency in investing
• Cat risk – general facts
• A framework to explain cat prices
• Diversification and cat prices
• Agency issues may make reinsurers inefficient. But are other
solutions better?
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Deadweight Costs of Capital
• (Re)Insurers face costs of hording capital because
– Its inefficient to warehouse unused capital in taxable
corporations
– It can be dangerous and risky to give managers additional
capital subject to their discretion
• (Re)Insurers also face costs of depleting capital because, once
depleted
– It’s expensive to raise it
– It discourages customers, who want a riskless not ‘probabilistic’
insurance product
• In the world of classical finance, these costs don’t exist
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Costs of Hording Capital:
Tax and agency issues
• Theory
– Capital markets prefer limits on managerial discretion, imposed by using less capital and/or debt finance (Jensen, Miller, many others)
– In classical finance, managers act just like owners
• Evidence
– Nonfinancial firms with greater managerial discretion seem to diversify too much (Wruck)
– Bidder stock prices fall and targets rise in takeovers (Ruback, many others)
– Value increases less than one-for-one when well-funded firms receive surprise legal awards (Shleifer and Vishny)
– Closed-end funds are on average worth less than their net assets (Lee, Shleifer and Thaler, Pontif, Bodurtha, Kim and Lee, Hardouvelis, La Porta, and Wizman)
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Costs of Depleting Capital:
Capital market imperfections
• Theory
– Costs of running below target levels of capital. ‘Bankruptcy’ or ‘underinvestment’ costs result because external funds are costly, making risk management a potentially valuable activity (Myers, Myers and Majluf, Froot, Scharfstein, Stein, and Froot and Stein, Doherty).
– In classical finance, if you are running low on capital, go get more from the market at the fair price
• Evidence
– Many studies suggesting that firms cut back on profitable investment and other spending when cash is tight (e.g., Gilson, Gertner and Scharfstein, Andratti, Kaplan and Zingales, Lamont).
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• Definition – Risky payoffs discounted more severely by customers than by rational investors (not true in
classical finance)
• Theory: – Behavioralist: Zechauser’s Roulette introspection and Prospect theory
– Rationalist: costly customer diversification, state contingent marginal utility, and ‘hassles’
– Incorporated into insurance models by Zanjani, Cummins and Danzon, Cummins and Sommer, Taylor, and Hoerger, Sloan, and Hassan.
• Evidence– Linkage of insolvency risk to pl premiums - Evidence that profitability is positively related to
surplus/assets (Sommer)
– NY and FL homeowners pay higher premiums to better rated insurers, particularly for exposures above those guaranteed (Grace, Klein, and Kleindorfer)
– Higher Best rated firms grew faster after ratings change (Epermanis and Harrington)
– Survey evidence (Wakker, Thaler and Tversky)
– Price discounting is 10x-20x (Philipps, Cummins, and Allen)
Costs of Depleting Capital:
Probabilistic insurance
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A simple framework, step 1:
Classical finance
Market Value
0 Insurer Surplus (given firm size)
Slope = 1
In classical finance, there are no costs of depleting or hording capital. Each additional dollar of surplus contributes an additional dollar of market value.
Hurdle rates are equivalent to required returns in the capital market.
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A simple framework, step 2:
Costs of hording capital
0
With costs of hording capital, each additional dollar of surpluscontributes less than an additionaldollar of market value.
Expected returns inside the firm dif-fer from those in the capital market
Slope = δ < 1
Slope = 1
Market Value
Surplus (given firm size)
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A simple framework, step 3:
Costs of depleting and hording capital
0
Required returns inside the firm exceed thosein the capital markets for low capital leves
Mechanisms are the result of both product and capital markets
Raises the shadow cost of capital. Createsappearance of risk aversion. Encouragesexcessive diversification
Slope = 1
Slope = δ < 1
Market Value
Surplus (given firm size)
With costs of depleting capital, value falls off increasingly quickly as surplus reaches levels too low to support firm-wide risk.
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4/20/2012 (c) Froot 41
A simple framework, step 4:
Market value before vs. after risk outcome
0
Value
Market value afteroutcome is known.
The “M” curve
Surplus (given firm size)
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4/20/2012 (c) Froot 42
0
To get current market value, average acrossmarket values after outcome is known
Value
Probability distributionof outcomes
Surplus (given firm size)
A simple framework, step 4:
Market value before vs. after risk outcome
Market value afteroutcome is known.
The “M” curve
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4/20/2012 (c) Froot 43
0
Value M curve
To get current market value, average acrossmarket values after outcome is known
Probability distributionof outcomes
Surplus (given firm size)
A simple framework, step 4:
Market value before vs. after risk outcome
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4/20/2012 (c) Froot 44
A simple framework, step 5:
Properties of market value
0
Value
Market value beforeoutcome is known is
reduced by risk
Surplus (given firm size)
M curve
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4/20/2012 (c) Froot 45
A simple framework, step 5:
Market value before outcome is known
0
Value
Market value improves by more
than δ with additional excess return
Surplus (given firm size)
M curveSlope = δ
Slope > δ
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4/20/2012 (c) Froot 46
A simple framework, step 5:
Market value before outcome is known
0
Value
The probability weighted average of market values before
outcome: the “EM” curve
Surplus (given firm size)
EM curve
M curve
M and EM curves merge at very high
levels of capital
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4/20/2012 (c) Froot 47
A simple framework, step 5:
Market value before outcome is known
0
Value
Each new financial decision represents a
revision of the EM curve
It shows the effective company risk aversion:
how much return is required to offset risk
Surplus (given firm size)
EM curve
M curve
M and EM curves merge at very high
levels of capital
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4/20/2012 (c) Froot 48
Costs of depleting and hording capital
0
Slope = 1
Slope = δ < 1
Market Value
Surplus (given firm size)
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4/20/2012 (c) Froot 49
• Incremental required returns on risk positions are driven by a
three factor model, where the factors are: a) standard market-
wide factors (e.g., CAPM); and b) internal factors that measure
the impact of the incremental risk on insurer capital:
If risk distributions are normal, optimal policies
have closed form solutions
( ) ( ) ( )I
jN
I
P
I
jN
C
jNfjN GwGFMr ,,,, ,cov~
,cov),cov( εεεεβµ ++++=
Insurer’s required return on a position
Price and quantity of systematic risk in the position
External CAPM premium above
riskfree rate
Internal premium for
covariance with firm-wide
skewed risks
Internal premium for
covariance with firm-wide risk
F: sensitivity of customers to firm-wide risk
G: sensitivity of investors to firm-wide risk
: sensitivity to firm-wide risk skewnessG~
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4/20/2012 (c) Froot 50
• The optimal amount to hold of an individual risk positions is
also driven by three factors: a) the minimum-variance risk
allocation; b) the excess risk-adjusted return; and c) the
skewness-adjusted covariance with existing exposures:
Optimal amount
of a position
firm risk tolerance
Skewness-adjusted
covariance with pre-existing exposures
Excess risk adjusted excess
return
( ) ( )
+−
−
++
−
)var(
,cov~
)var(
),cov(1
)var(
,cov
,
,
,
,,
,
,*
I
jN
I
jN
I
P
I
jN
C
jNjN
I
jN
I
jNj
jGF
GM
GF
w= n
ε
εε
ε
εγµ
ε
ε
Amount of risk in the minimum-
variance portfolio
Skewnessimportance times firm
risk tolerance
Hedge out preexisting exposure
Tilt toward exposures that
outperform
Avoid risks that overly
accentuate extreme losses
If risk distributions are normal, optimal policies
have closed form solutions
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Evidence among (re)insurers consistent with
these imperfections
4/20/2012 © Ken Froot 51
Coefficientsa
-9.31E-04 .003 -.346 .732
1.835E-03 .001 .423 2.624 .014
-2.61E-03 .001 -.334 -2.068 .048
(Constant)
MeanROE
LNSTDROE
Model1
B Std. Error
UnstandardizedCoefficients
Beta
Standardized
Coefficients
t Sig.
Dependent Variable: Alphaa.
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Outline
• Generic examples of agency in investing
• Cat risk – general facts
• A framework to explain cat prices
• Diversification and cat prices
• Agency issues may make reinsurers inefficient. But are other
solutions better?
4/20/2012 © Ken Froot 52
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Diversification:
Evidence of Overconcentration?
P eril
US hurricane
US earthquake
Japan earthquake
Japan Typhoon
European windstorm
Austra lia
Avia tionSate llite
Loss (
$ b
illio
ns)
$ 0
$50
$100
$150
$200
$180B
$90B
$52B
$42B$32B
$24B
$3B $1B
Approximate insured loss from 0.40% expected loss by region/peril
PerilUS
hurricaneUS
earthquakeJapan
earthquake1Japan
TyphoonEuropean
WindAustralia Aviation Satellite
Risk 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Premium 6% 4.5% 3.5% 3.25% 3% 2% 1.5% 1%
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Reinsurers’ struggles
• Costs of capital
– Deadweight costs
– Beta
• Pressures to diversify from related agents
– Ratings agencies
• Bests BCAR ratings difficult to interpret, but
– Industry complains of pressures to diversify
– Pressures even to diversify premiums rather than limit
– Regulators
4/20/2012 © Ken Froot 54
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Beta
4/20/2012 © Ken Froot 55
60
80
100
120
140
160
180
200
Dec
-04
Feb
-05
Apr
-05
Ju
n-0
5
Au
g-0
5
Oct
-05
Dec
-05
Feb
-06
Apr
-06
Ju
n-0
6
Au
g-0
6
Oct
-06
Dec
-06
Feb
-07
Apr
-07
Ju
n-0
7
Au
g-0
7
Oct
-07
Dec
-07
Feb
-08
Apr
-08
Ju
n-0
8
Au
g-0
8
Oct
-08
Dec
-08
Feb
-09
Apr
-09
Ju
n-0
9
Au
g-0
9
Oct
-09
Closing Price ($)
Market Value Weighted Stock Price For Publicly Traded Insurance Companies
Wholly
Devoted
Other
S&P500
Composite
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From Insurance Insider, 9/2011
4/20/2012 © Ken Froot 56
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Industry commentary
4/20/2012 © Ken Froot 57
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Industry commentaryAJ Dowling, IBNR #30, 18
4/20/2012 © Ken Froot 58
insiderquarterly.com
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Outline
• Generic examples of agency in investing
• Cat risk – general facts
• A framework to explain cat prices
• Diversification and cat prices
• Agency issues may make reinsurers inefficient. But are other
solutions better?
4/20/2012 © Ken Froot 59
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Agency Problems
Don’t End with Corporate Reinsurers
• Cat exposures can be tapped outside the closed-end
corporate format of reinsurers
• Many “funds” now, some managed by reinsurers themselves
• Allow investors (principals and their investing agents) to invest
directly in a book, without locking up their capital over many
years
• These investors also appear too risk averse and
overdiversified
• Perhaps less extreme than reinsurers, but no test of this
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Preferred Habitats and Cat CDO tranches
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Loss Exceedance Curves(Nephila Funds, 2011)
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Loss Exceedance Curves(Nephila Funds, 2011)
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Approx US stocks (mean zero)
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Loss Exceedance Curves(Investor defined Funds, 2011)
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Investor offerings highlight diversification
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Investor offerings highlight diversification
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Investor offerings highlight diversification
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Investor offerings highlight diversification
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The Spectrum of Agency Costs
• Most portfolios contain too much diversification within an already-diversified asset class, diluting the alpha for asset allocations that are almost always small. Yet also are undiversified with respect to that asset class.
• No agent wants responsibility large drawdowns, if ex ante smart– Representatives of asset owners/beneficiaries
– Internal or external management team
– Individual trader or manager within the team
• Result - agency-based relative capital shortage for larger risk exposures like US wind and quake.
• How big is this? Is it smaller than that for reinsurers?
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Conclusions
• (Practically) everyone is an agent. Agents incentives imperfectly alighned with their principals
• Investments generally and cat risk transfer in particular feature lots of agency
• Results may be inefficient portfolio construction. Equilibrium is worse if there are also deadweight costs to intermediation.
• Corporate reinsurers appear inefficient in ways vs. investment funds. Tests of this hypothesis?
4/20/2012 © Ken Froot 70