Tuesday, September 17, 2013

EE vs. PP: Insuring Insurance.

Recall for a moment that there are three types of unknowns: known unknowns (risks) unknown unknowns (uncertainty) and unknowable unknowns (non-ergodicity).

Three pouches sit in front of me, each accurately labeled.

The pouch on the left reads "fair six-sided dice". If I reach in and select a die at random, there is a 100% chance that when I roll it, I'll obtain any number on the interval [1,6] with probability 1/6. I know the outcomes and I know the probability function. This is risk.

The pouch in the middle reads "six-sided dice, half fair, half loaded". If I reach in and select a die at random, there is a 50% chance that when I roll it, I'll obtain any number on the interval [1,6] with probability 1/6 and a 50% chance that when I roll it, I'll obtain the weighted value with probability > 1/6 and any other value with probability < 5/6. I know the outcomes, but I don't necessarily know the probability function. This is uncertainty.

The pouch on the right has a embroidered diacritical glyph that looks suspiciously like the symbol of KORROK from David Wong's hit novel (and motion picture) John Dies at the End. You don't know what's in the bag, but you suspect it might contain clockwork spiders powered by a universal undercurrent of seething envy borne by the shadow people who live in the corners of madness like you'd find in the abandoned places of the earth. Then again, it could be filled with delicious candy as far as you know. You don't know the outcomes, and you don't know the probability function. This is non-ergodicity.

Taken broadly, the purpose of insurance is to transfer and aggregate risk. Yes, some insurance firms (notably, Lloyds of London) will sell exotic insurances covering uncertainty, but the typical insurer employs a brigade of actuaries, armed with toothsome spreadsheets and penny dreadful Markov matrices all artfully deployed to finely tune risk assessment and price. The individual flavors of insurance introduce some color, some vivacity to the broader enterprise. Clever customers who can be felled by but one arrow of outrageous fortune can sell all sorts of risks to elephantine firms not so easily slain by (non-systemic) unusual events. It's very easy to understate the importance of insurance. With it, farmers can guard against unknown future summer spot prices for the crops they want to plant in the spring. Motorists can ensure they won't be bankrupted if they get sideswiped by an inattentive teenager. Oil derrick workers can provide income for their bereaved in the event of wellhead explosion.

Insurance is good, right? It's therefore wise to encourage the creation of new insurance schemes, right?

Well, the funny thing about language is that even by keeping the underlying arrangement the same and just altering what something is called can warp folks' moral intuition. One man's "insurance" is another's "speculation" is yet another's "gambling". You don't have to be a moral theorist to know of strong proscriptions against gambling. Opponents of new insurance markets merely have to invoke moralizing language to turn public (and more importantly, legislative) opinion against de novo operations. Heck, look at what happened to Intrade (yes, that was a "prediction market", but every rose by any other name has its thorns).

Now, I can't say for sure what the genesis of the general aversion to gambling is. It might be aesthetic, it might be rooted in EE conditions (esp. regret), but thanks to a combination of the lingering influence of prudential morality and the imprudence of the gambler archetype, it isn't unreasonable to expect the aversion to be stubborn. This is a bit unfortunate, since the meta-market for insurance (that is to say, the creation of new insurance markets) is non-ergodic. The Precautionary Principle employs an efficacy criterion: if your proposal can't be shown to enhance welfare, the state won't let you have at it. If insurance is gambling (and recall that life insurance vendors had to struggle with rebranding to overcome this association), then it's a priori not welfare-enhancing. Hey presto, your request for a business license cannot be shown to be in the public interest. Sorry pal, but have you considered packing sand for a living?

But here's the thing: just like markets in credit, what insurance (call it what you will) does is liberates producers to focus on what it is they're good at. Instead of fretting over exchange rate risk, just hedge that provision using currency forwards. Instead of second-guessing next year's molybdenum price, just buy a futures contract. Instead of hoarding your savings in the event you get hit by a bus, you buy a life insurance contract. Instead of... fill in the blank. Or more accurately, in the case of markets yet to be invented, don't get in the way of people trying to fill in the blank. That's the nature of the KORROK bag. We don't know what's in it, and even after we pull something out of it, there's no telling whether folks will find it useful. The precautionary principle sews the mouth of that bag shut, to our detriment, since every good thing we love so dearly came out of that bag.

The precautionary principle might... might be valid when there's a clear risk of entangled catastrophic failure. Any other use robs society the opportunity to discover new ways to help make life more enjoyable for each other.

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Do you have suggestions on where we could find more examples of this phenomenon?