Here's a summary of the themes from the Hacker News discussion:
Reinsurance as a Risk Spreading Mechanism
The discussion highlights how reinsurance acts as a layer of protection for primary insurers by spreading risk across a larger pool. This pool, however, is inherently smaller than that of primary insurers, leading to potential issues. There's a comparison to the "predator hierarchy," suggesting a chain of risk transfer where the ultimate bearers of risk are fewer.
MarkusQ compares the system to credit default swaps and mentions Lehrer's "We Will All Go Together When We Go," hinting at systemic risk.
Diversification and Correlation of Reinsurance Risk
A key debate revolves around whether reinsurance reduces or increases risk correlation. While MarkusQ suggests that the smaller pool of reinsurers makes risks more correlated, simicd argues the opposite. simicd contends that reinsurers, by covering diverse geographical regions and lines of business (property, casualty, life, health), actually benefit from less correlated risk. A catastrophe in one region can be cross-subsidized by premiums from unaffected regions, making reinsurers less likely to go bankrupt than a geographically concentrated primary insurer.
- MarkusQ states: "But this pool is necessarily smaller than that of primary insurers, and their risks more likely to be correlated (catastrophes can cause other catastrophes, and multiply primary insurers can be affected by the same catastrophe)."
- simicd counters: "But the risk born by reinsurers is less correlated, not more. Any given primary insurer has risk clusters (domestic market, line of business, etc.). If a large catastrophe happens in their domestic market they might go bust but what are the chances that it happens simultaneously to all markets globally?... A reinsurer which is also covering Europe, Asia, LatAm, etc. is less likely to go bankrupt. The reinsurer can cross-subsidize and use the insurance premiums from other regions to pay out the claims from the US market."
The Role of Insurance-Linked Securities (ILS) and Cat Bonds
The discussion touches upon the evolution of insurance risk transfer, specifically the emergence of Insurance-Linked Securities (ILS) and "cat bonds." These instruments allow risks, including abstract ones like pandemic risk, to be traded in speculative financial markets.
- falseprofit points out: "One aspect worth pointing out is that ILS are transferring insurance risk outside of the insurance industry. Appetite has gone up and down but e.g. hedge funds would normally not be available to assume insurance risk otherwise."
- gwern interprets the article's potential thesis as: "So I think structurally, the conclusion here is that 'cat bonds are an example of how insurers can work with abstract risks, and so any risk (such as global pandemic) could be worked with this way', and the rest of the book then examines how people are trying to actually do so with pandemic risk."
- Onavo emphasizes the long-standing nature of these instruments: "I mean eventually once you proceed down the financial tree you get reinsurance linked securities. It's been this way for decades. It nothing new."
Parametric Insurance and Data Integrity Risks
A significant portion of the conversation focuses on parametric insurance and its inherent vulnerabilities related to the source and reliability of triggering data. Parametric insurance pays out based on preset triggers (like wind speed or earthquake magnitude) rather than actual losses, which can lead to manipulation concerns.
- munificent expresses alarm: "Wow, that is absolutely begging for exploitation. Whoever controls the authority reporting these figures now controls whether these bonds pay out. That in turn means that whoever holds those bonds has a huge financial incentive to manipulate what that authority says."
- gruez draws parallels with other financial instruments: "The same incentive exists for economic figures (inflation linked bonds) and market prices (cash settled derivatives), and it's seemingly not an issue, and those are far easier to game than physical measurements like wind speed or whatever."
- jallmann highlights past issues: "Manipulation of reported economic numbers has been an issue in the past, see LIBOR."
- krisoft questions the assumption of difficulty in manipulating physical measurements: "I’m not so sure about that. I bet that we could tamper with an anemometer somewhere out in a field. Easiest is to put brushless motor with a propeller next to it and blow propwash on it. More technically difficult is to tamper with the signal between the sensor and the station, or MitM the station."
- kqr identifies data reliability as a major challenge: "Sure. Getting reliable data all parties can agree on is one of the biggest challenges to parametric insurance. The data sources I hear about most often are US governmental agencies – and this is a problem, since the US political system is not stable enough to finance its governmental agencies reliably."
- bgnn provides a real-world example from Turkey: "In Turkey the mandatory earthquake insurance for homeowners is owned by the government. It triggers parametrically (> 7 magnitude). In one case at least [1] the government office responsible for announcing the magnitude, AFAD, declared it lower than this threshold although other countries and Turkish research institues measured it as 7.0 . At the end the insurance payout was so much more limited even for people who kist their house and loved ones."
- soulofmischief invokes Goodhart's Law: "Goodhart's law continues to ring true."
- PaulRobinson proposes a solution: "The obvious counter to that is you’re going to define parameters based on multiple observers. NOAA is not the only authority on Earth who can state what a hurricane’s wind speed is."
The Interplay of Finance and Catastrophic Risk
The discussion also touches upon the broader implications of financializing catastrophic risks. The drive to make these risks "investable" raises questions about the ethical considerations and potential for perverse incentives when profit motives are directly tied to the occurrence or reporting of such events.
- vishnugupta draws a parallel to The Big Short: "This reminds me of a scene from The Big Short. Towards the end Mark Baum who has bought insurance on house index is frustrated why the index isn’t falling even as the house prices across America are plummeting and foreclosures are rising. Maybe something fishy was going on."
- dylan604 cynically links data manipulation to political motives: "Taking your point of view now makes sense on why to defund NOAA, fire everyone that's not going to toe the line, and then have those that will parrot the necessary info to keep from paying out. Make Weather Great Again, just doesn't lend itself to a hat though."