The Rules of Risk: A Guide for Investors
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The Rules of Risk: A Guide for Investors

by Ron S. Dembo, Andrew Freeman

An innovative framework to understanding risk management
The Rules of Risk takes the reader from the present to the future of risk management. Combining a novel approach to risk management with the tools of mathematics, finance, computer science, and an understanding of capital markets, authors Dembo and Freeman present their framework of a new risk paradigm


An innovative framework to understanding risk management
The Rules of Risk takes the reader from the present to the future of risk management. Combining a novel approach to risk management with the tools of mathematics, finance, computer science, and an understanding of capital markets, authors Dembo and Freeman present their framework of a new risk paradigm that peers into the risk-taking of tomorrow to enhance our ability to make choices and manage risk. The implications of their visionary work are far-reaching, affecting the future of investing, the financial institution, the economy, and beyond. The Rules of Risk provides investors not only with an applied vision of the future of risk, but with a knowledge of what risk management is and the thinking behind it.

Editorial Reviews

Business Week
"As a how-to book about managing risk, it's a worthwhile follow-up to Peter L. Bernstein's best-selling 1996 history of the field, Against the Gods: The Remarkable Story of Risk." --Business Week

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9.00(w) x 6.00(h) x 0.62(d)

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Read an Excerpt

Chapter One

    We have mentioned Paul Reichmann in our earlier comments.The Reichmanns are property moguls who bestrodethe world until their huge empire collapsed in 1991.They provided rich material for one of the twentieth century's greatbusiness stories. Less well known is the fact that, in 1994, they verynearly pulled off a miraculous comeback. A few well-informed readersmight recall that they entered a joint venture with George Soros, thefamed speculator whose market-moving abilities have caused majorcontroversies from Britain to Malaysia. But only a tiny number of peopleknow that the Reichmanns disastrously blew a second chance torescue themselves from oblivion, and they destroyed their venture withSoros in the bargain.

    Having made and lost a fortune redeveloping vast swaths of citiessuch as New York, Toronto, and London, the humbled Reichmannslooked further afield in the early 1990s. In search of a new deal thatwould relaunch their operations, they hopped smartly onto a hottrend—the rise of new economies and so-called "emerging markets."Their dream was a multibillion-dollar development in the capital ofone of the fastest-growing economies in the world. Mexico appearedpoised on the brink of emergence into an established and acceptedeconomic force. Its trade links with America and Canada were aboutto be ratified and liberalized via the North American Free TradeAgreement (NAFTA) treaty (signed by President Bill Clinton in 1993).But the city had very few modern office buildings, and rents were highin those that did exist. What could be more appropriate than torevamp a chunk of the sprawlingcapital city and erect some of theReichmanns' signature skyscrapers?

    The Reichmann-Soros venture almost succeeded. The Reichmannsfollowed their typical development process. The venturebought two parcels of land, one of which was on a prime site in theheart of the city. The land was bought on favorable terms from the government,on the promise that it would be developed into a top-ratesite. By investing a relatively small amount in architects' drawings andmarketing, the Reichmanns hoped to lure a local partner into a 50:50joint development venture. A giant publicity fanfare led to widespreadinterest among big construction firms. ICA, a large local firm, boughta 50 percent stake in the first parcel of land on the outskirts of the city.In bidding for the second parcel, ICA proposed to be the builder aswell as a joint developer.

    It seemed like a sure thing. ICA's cash would fund the entire development,leaving the Reichmanns and Soros with no downside exposurebut potentially tremendous upside prospects in the event that the projectwas a success. A further attraction for the Reichmanns was that theyhad already dealt with ICA and felt that a deal could be closed quickly.

    Unfortunately, the Reichmanns, like much of the rest of the world,were overly convinced that Mexico's leaders, trained in American businessschools, knew what they were doing. In 1994, the Mexican economywas under increasing pressure. Although inflation had fallen from180 percent in 1987 to around 8 percent, growth was sluggish. TheMexican currency was the victim of sudden bouts of nerves amongtraders, which forced the government to intervene heavily in foreign exchangemarkets. The need to support the currency grew, and Mexico'sforeign exchange reserves dwindled from $25 billion in late 1993 to amere $6 billion a year later. But because the interventions had kept theexchange rate fairly stable, few people watching the market had any ideathat big trouble was around the corner. If you were looking at the exchangerate to guide, say, an investment such as the Reichmanns', recenthistory would have given you little idea of what lay ahead.

    The key to the peso's relationship to the dollar was a tight bandwithin which the government insisted that it would stay. On December20, 1994, the Mexican government announced that it had widened thatband. The peso immediately fell by 10 percent, in a move that shockedtraders and investors alike. On December 23, the band was removed altogether,and the peso went into free fall against the dollar, losing 50percent of its value within just a few days. In addition, interest ratesquadrupled over the same period. In the months that followed, it becameclear that Mexico had suffered a major economic crisis.

    How did the Reichmanns and George Soros react? Their deal withICA was supposed to be signed and sealed on December 20. Mysteriously,in the days before that date, ICA began to stall. Perhaps it sensedthat the currency was vulnerable. When the two sides met on December21, ICA had changed its position. It wanted the 10 percent fall in thepeso to be reflected in new terms for the deal. This was not entirelyunreasonable; ICA had to use pesos to fund an investment that, in dollars,had suddenly become more expensive.

    Ironically, the Reichmanns' partner might have thrown a lifeline, ifonly its right hand had known what its left hand was doing. GeorgeSoros's canny hedge fund traders had long since sold their peso holdings,believing the currency to be risky. But Soros's property arm hadno such insight. It carried on as if everything was normal. No warningwas sent to the Reichmann-Soros venture, which consequently had littlesense of the ugly scenario that was about to unfold.

    Assume the deal with ICA had been successfully renegotiated.What would have been the Reichmanns' position? Arguably, becausethe original deal had been a rich one, the new terms were simplyslightly less rich. The Reichmanns still stood to make an extremely favorabledeal with great upside. By signing a contract with ICA, theywould have ensured that the project went ahead. They would thenhave recovered their sunk costs and been largely insulated from furtherfalls in the peso. In effect, most of the future financial risk in thedevelopment would have been shouldered by ICA. The best scenario forthe Reichmanns was a return of the peso to its former value, whichcould have added 10 percent to their upside. The worst scenario wasthat the peso would continue to fall and the deal could be lost altogether—alarge downside.

    Paul Reichmann, the family's most influential member, refused todeal. He would not allow any alteration to ICA's terms. Then thingshappened very fast. As the peso went into free fall after December 23,ICA saw that its timing for the development was lousy—the returns indollars were insufficient to make the project worthwhile. Not surprisingly,it abruptly lost its appetite. The Reichmanns' comeback was off.

    Imagine the scene in Mexico City on December 21. The Reichmannshad to ask themselves whether the initial peso devaluation wouldbe the end of the matter, or whether there was more trouble to come.They might have done a simple analysis: What were financial marketstelling them about the likelihood of further devaluations of the peso? Aquick look at the currency options markets would have shown thattraders indeed expected more bad news. Locking in terms at a 10 percentlower rate for the peso might turn out to be a bargain if it fell anadditional 40 percent. However, a naive look at the past eighteen monthsof stable U.S./Mexican exchange rates would lull one into thinking thatthe current drop in rates was an aberration.

    Instead, the Reichmanns chose a more subjective analysis, perhapsbecause they were committed to the idea of making a comeback. Theyconcluded that the peso's troubles were temporary and that theyshould not make any concessions to ICA.

    The point is that the Reichmanns bet everything on a single outcome.In effect, they were gambling that a single outlook for the pesowould turn out to be correct. In fact, anything could have happened tothe peso, so it really made sense to consider several possible outcomes.This is a key point about proper risk management that is often overlooked.When we plan around a single view of the future, we are actuallygambling. Sensible planning requires us to consider a multitude ofpossible events and explore how each one might cause us to react.

    Sources close to Paul Reichmann report that he carried on, tryingto revive the deal and hoping that things could be ironed out. When itbecause clear that it would take many months to solve the problems inMexico, Reichmann because more reclusive than ever and showedsigns of rapid mood swings. He was clearly suffering from serious Regretthat he had so badly misjudged the situation.

    Even though we may not always be conscious of it, we are all riskmanagers. As we navigate daily life, we must make a host of decisionsthat more or less explicitly reveal our attitude toward risk. Shall I travelby plane or train? Which detergent has fewer noxious chemicals?Which over-the-counter drug is less harmful? Should I buy a lotteryticket instead of a sandwich? Should I invest in mutual funds, stocks,or bonds? Which securities should I buy, and how long should I planto own them? Should I give up smoking? Our views of risk are surprisinglyidiosyncratic—one person's pleasure is another's poison. Hencethe diversity of economic and business life.

    There is a rich contemporary debate about the fine line between anacceptable and an unacceptable risk. From nuclear safely to food additives,we are bombarded with often contradictory and confusing informationabout risks. Is the tiny risk from using the chemical Alar onapples a price worth paying for its otherwise beneficial effects? If consumershad known more about ValuJet's safety record, would the airlinehave folded before the crash in the Everglades that killed so many persons?If the American money market funds that invested disastrously incomplicated but supposedly yield-boosting derivatives in 1994 had beenfrank about the risks they were running in order to deliver slightly higherreturns, would an investor boycott have forced the fund managementfirms to change the funds' approach before an expensive bailout becamenecessary? Would people have signed up to be "Names" at theLloyd's insurance market in London if they had known how muchdownside risk was involved? Would so many banks have lent money(which they subsequently lost in large amounts) to Robert Maxwell ifthey had known more about the British tycoon's shaky finances? Whydid many of the same banks then take a further bath when they lent anotherfortune to the Eurotunnel, the project to build a tunnel under theEnglish Channel that was as successful in engineering terms as it washopeless in financial ones? The list of such questions is endless.

    The list is also daunting, for these broad inquiries point to a centralconfusion about risk management. At a societal level, we rely on governmentsto maintain or introduce regulations that are designed toprotect us from many excessive or unwarranted risks. The ban, in somecountries, on smoking in public is an obvious example, as are rulesabout handling nuclear waste or processing uranium. Alternatively,institutions such as mutual societies and credit unions have arisen to extendaccess to risk management to large numbers of people. (Mutualfunds achieve the same purpose by virtue of their transactional efficiency.)In developed economies, these forms of "insurance" havehelped to spread financial security and well-being far more widelythan was previously the case.

    But they have also helped to obscure a central and fundamental aspectof risk: each individual's attitude toward risk can often be at oddswith the attitudes of other people. In the blunt language of investingand finance, how we feel about a particular risk depends greatly on ourunique circumstances, not the least of which is how rich or poor weare, and whether (or when) we will need to get our hands on hard cashas opposed to paper assets that represent real money in the future. Ourcircumstances are unlikely to be precisely the same as everyone else's.Even if two people end up making the same investment decision—forexample, to buy $1,000 worth of Citicorp stock—they will probablyhave quite different reasons and motives for doing so. Further, there isa common misperception that risk is purely an active concept, that itonly involves assuming danger in the hope of reward. In fact, riskcomes in other guises. If we have $1 million but choose to leave itunder the mattress, then we are avoiding many risks. But we are just ascertainly assuming others. There is risk in doing nothing, just as thereis risk in taking action. Indeed, perhaps striking a balance between actionand inaction is the essence of risk management.

    From just this preliminary exploration, it should already be clearthat risk is a remarkably subtle notion. Its meanings and boundariesshift constantly, making it difficult to pin down. An acceptable risk onone day might appear a foolish gamble on the next day. As we shall see,a way of thinking about risk that encompasses this subtlety has eludedgenerations of thinkers and researchers. Even in this age of high-techcomputing, the basic architecture of risk management remains primitive.It is as if all that fancy technology is stored in the intellectualequivalent of a wooden shack.

    Much has been written about risk in recent years. Indeed, an unprecedentedamount of intellectual firepower has been directed at thesubject, particularly in the field of finance. We only have to look at therecipients of Nobel prizes for economics during the past decade to seethat great store is now set on the challenge of unmasking risk and explainingits finer points. Why does risk remain so elusive? One answer isthat, for all of our sophistication, we sometimes shy away from askingsimple questions, as if this avoidance makes it easier to grapple withdifficult ones. Because great minds have battled with the meaning of risk,it seems presumptuous to suggest that we might need to start from firstprinciples. Another answer is more humdrum. Rather than seek a comprehensiveapproach to risk, people have chosen "fit for purpose" solutions—therisk management equivalent of "quick and dirty" computercodes. For many business problems, that approach is sensible enough.But when investment and financial risks are involved, it borders on thecavalier. Why embrace an approach to risk that may be flawed, whenthe outcome could be disastrous? No professional gamblers would adoptsuch an approach; they know too much about ruin!

    In Against the Gods (New York: John Wiley & Sons, 1996), PeterBernstein describes how our understanding of risk and risk managementhas developed over the centuries. Until some central problems in mathematicsand probability theory were solved, our ability to define andmanage risk was necessarily limited. Moreover, developments in risktheory have been uneven. For generations, little would happen; then aburst of innovation and activity would bring thinking to a new plateau.

    Bernstein asks rhetorically: What distinguishes thousands of years ofhistory from what we think of as modern times? Human history hasbeen chock full of brilliant individuals whose technological and mathematicalachievements were astonishing; think of the early astronomersor the builders of the pyramids. The answer, suggests Bernstein, is ouracceptance of risk: "... the notion that the future is more than a whimof the gods and that men and women are not passive before nature.Until human beings discovered a way across that boundary, the futurewas either a mirror of the past or the murky domain of oracles and soothsayerswho held a monopoly over knowledge of anticipated events."

    With helpful skepticism, Bernstein asks whether the fancy mathematicsand computer wizardry of today are dangerously analogous tothe graven images and idols before which earlier generations madetheir genuflections. If we rely too heavily on clever models and "blackboxes," might we not be succumbing to an updated version of the faiththat ancestors placed in deities and shamans? Indeed, might the false"science" of risk management be a dangerous illusion that itself hidespotentially catastrophic risks?

    Recent history tends to support this view. Until the dangers of riskmanagement began to emerge during the 1980s, few ordinary peoplehad heard of financial derivatives, for example—those infamous futuresand options that supposedly caused a series of corporate blowupsand disasters in the early 1990s. Few television-watching householdshave escaped at least a passing familiarity with derivatives. In Britain,for instance, the collapse in 1995 of Barings, an august and snobbishbank, led to the equivalent of a countrywide education program inmodern finance.

     Similarly, voters in Orange County, California, had an unexpectedcrash-course in finance in 1994, when their investment pool was so severelydamaged that the county chose to declare itself bankrupt. Howdid this disaster happen? Robert Citron, the county's elected treasurer,had recklessly used "leverage," hoping to boost returns. In effect, thismeans taking on risks that are orders of magnitude larger than the underlyingstake. He was found out by a big reversal in financial markets.

    Some of the biggest and most respectable names in finance andbusiness have fallen afoul of risk management in recent years. Andthere is no local or geographical monopoly on such disasters. Think ofBritain's National Westminster Bank; Germany's Metallgesellschaft;America's Gibson Greetings, Merrill Lynch, and Bankers Trust; Japan'sDaiwa Bank, Sumitomo, and IBJ—to name a few. Plenty of other firmshave had problems, but they have chosen to cover them up rather thanlose face and public confidence. Many banks, for example, have lost afew million dollars here and there as they have acquired trading and operatingskills in the notoriously difficult options business.

    One big bank was even the silent victim of an audacious robbery.Clever but criminal staff got inside an options pricing model and usedtiny changes to skim off a few million dollars of profits for themselves.They were eventually caught, but the bank elected not to prosecutethem. It feared (probably correctly, in light of other banks' experiences)that the revelation of the swindle could wipe out hundreds of millionsof dollars of its overall value as nervous investors decided to place theirmoney elsewhere.

    It is impossible to calculate the real cost of risk management failuresamong businesses, but it certainly runs to many billions. In 1995 and1996, documented losses were some $12 billion. Moreover, there arefew signs that firms' reliance on mathematics and machines is diminishing.In the trading rooms that are the temples of modern finance,some of the world's brightest brains are competing to attain, howeverbriefly, the strongest grip on risk. Therein lies competitive advantage—toput it crudely, the ability to wring huge profits from less-equipped rivals.These are the "model wars," a kind of intellectual and financialarms race that promises fat rewards to the victors.

    Is there a danger of relying too much on models and not enough oncommon sense? We do not think there is too much reliance on models,for two main reasons. First, the past few decades have witnessed suchrapid developments in finance theory and such growth in the worldeconomy that the fact that many firms have occasionally fumbled is notsurprising. The banks that have lost big money in options trades, forinstance, have undoubtedly learned painful lessons. The best ones haveadjusted their practices and grafted new rules and precautions ontoolder and sloppier systems so that they will not be similarly embarrassedin the future. For example, in 1987, Merrill Lynch, arguably theworld's biggest investment bank, was embarrassed when it lost $377million trading mortgage-backed securities. Since then, having installednew risk systems and maintained a careful watch over its trading,there has been no significant mishap.

    Firms like Merrill Lynch probably have also absorbed the lessonthat a risk might pop up somewhere else, quite unexpectedly. Theycan never relax; occasional losses, sometimes even big ones, are inthe nature of life and business. That is why firms have money setaside as a cushion. It is known as equity, and it is there to fall back onin bad times. That is also why regulators require financial firms to setaside capital. Arguments about how much capital is the right amountare the main reason for the continued flourishing of risk management.Those who need the least capital to run the same risks canenjoy a profound competitive advantage. What we have seen to datein financial risk management at this level is perhaps best characterizedas a series of related lessons about the dangers of innovation. Butit is not a sign that there is some fatal flaw in modern efforts to improveour approach to risk. Indeed, it seems almost self-evident that ifthe costs of risk management really outweighed the massive benefitsbrought by a variety of new risk-sharing techniques, then the techniqueswould quickly have been rejected.

    Our second reason for thinking that, in machines and mathematics,we have not reached a dangerous dead end is that thinking about riskhas never been more widespread and has never been conducted at ahigher level. The inadequacies of many existing approaches to riskhave triggered a flourishing and fundamental debate, to which thisbook is a contribution.

    Arguably, for the first time, risk is undergoing a comprehensivedissection, a process that simultaneously informs us in new detail and allowsus to adopt and invent new techniques for risk sharing. Both inour ability to map and understand risk, and in our ability to buildmechanisms that allow us to manipulate risk, far from being at a deadend, we are in an era of rich, astonishing, and (thanks to technology)possibly unprecedented progress.

Sharing the Risk

The idea of risk sharing is important but often neglected. As the votersin Orange County found out, a big loss, when spread among thousandsor millions of people, causes only moderate or inconsequentialpain for individuals. But where risks are concentrated, the results canbe disastrous. Citibank nearly blew itself apart as recently as 1991 becauseit had made far too many loans to the real estate industry. It nowcarefully monitors its lending to avoid concentrations that could inflictsimilar damage. And it can use new financial instruments—credit derivatives,for example—that allow it to transfer to other banks, and toinvestors, risks that make it uncomfortable.

    Consider an entrepreneur who has a 60 percent stake in her successfuland fast-growing company but is overexposed to its fortunesand would be ruined if the firm failed. She would like to reduce thatconcentration by investing some of her paper wealth in other assets,and modern finance has come up with several ways to help her do justthat. By giving up to other investors some of the upside potential of herstake, she can shelter her finances from an extreme negative outcome,such as her firm's going bust.

    Risk sharing has a long history. Early financiers used the idea as thebasis of today's insurance industry. Merchants and traders quicklylearned that while they could be ruined individually by the loss of asingle ship, they could quickly get rich if they joined together andformed fleets of ships that would not suffer unduly because of occasionalwrecks. More than a century ago, mutually owned life insurancefirms in America and Europe were able to extend the benefits of risksharing to the masses, changing millions of people's lives.

    A desire to manage risk and to profit from superior insight was just asprevalent among our ancestors as it is today. A random, simple, andintriguing example should suffice. In the fall of 1807, a group of middle-classwomen who lived in Arbois, a small town near Besancon,regional capital of the Jura, a rugged and little-known area of Francethat borders Alsace and Switzerland, undertook an amazing riskmanagement transaction. The women ran a charitable concern, distributingfood and material aid to poor people in the town and its surroundingvillages. They laced their charity with a not-so-subtle dose ofreligion in the form of moral education. But theirs was a lay organizationthat functioned largely beyond the formal reach of the CatholicChurch. The women displayed an acute sense of financial managementin the conduct of their affairs. They sought out the best interestrates for any funds they collected, and they negotiated fiercely withlocal contractors to ensure that they were getting full value for theirmoney when they purchased food.

    In the course of their work, they traveled extensively in the town'senvirons. And they observed in 1807 that a rash of bad weather, followingwhat had hitherto been a good growing season, had left much ofthat year's crop rotting in the fields. Instead of wringing their hands,they did something remarkable. They bought a futures contract thatwould lock in the price of grain that they would pay over the comingwinter months. They paid 4 francs per measure for some 200 measures,rather than the 3 francs, 12 centimes that was the current marketprice. In that way, they knew that their charitable activities could continuein the harsh months when they contributed most in terms of welfareto the community. The fact that, had they been speculating, theywould also have locked in a fat profit, probably did not occur to them.Today, the women can be imagined running their own investmentclub and, on the back of their successful trade, starring in their ownpublic television investment show!

    Better risk-sharing mechanisms could help many people to mutethe effects of similar risks on their lives. For instance, if there were amarket in housing derivatives (contracts that allowed us to bet onmovements in house prices), someone worried about missing out on abig rise in prices could purchase options that would, in effect, pay outcompensation to the nonowner. Similarly, owners could buy optionsthat would give them downside protection in the event that the valueof their house fell below the carrying cost of their mortgage.

    Why don't such markets exist already? There are still plenty of practicalbarriers standing in their way. For instance, although the real estatemarket is far better understood these days, it remains relativelyopaque, and prices are set rather arbitrarily. There is not yet sufficientreliable and regular price information to allow a meaningful derivativesmarket, particularly one that would be suitable for individuals.Also, there is no easily defined "standard house" that might be the basisfor pro forma financial contracts. A home that one person thinks is apalace is an ugly pile to someone else. Similarly, before there could bea smoothly functioning market in "country risk," there would have tobe a common definition of economic performance and some means ofstandardizing how each country measured its output.

    It is likely, or perhaps inevitable, that such markets will be developedin the future, to satisfy the compelling power of risk sharing. Indeed,the idea of risk sharing—insurance—is central to our newframework for risk. We are not suggesting that insurance is the samething as risk, or that, of itself, insurance is all that is needed foreffective risk management. Our framework is more flexible than that.Rather, we want to suggest that if a risk can be understood, then, usingmodern financial techniques, it should be possible to devise ways ofhedging/distributing that risk. And once that can be done, risks can bemanaged in two directions. Some people will be keen to take on morerisk, and others will be glad to pay a premium to shed some or all of it.These responses to risk form the basis of a market in which a naturalcompetition between buyers and sellers creates real and transparentprices. Where plenty of risks are traded with transparent prices, it iseven possible for individuals and firms to "optimize" their riskexposures—that is, they can select those exposures that, for an equivalentlevel of risk, are likely to produce the highest returns, and they can selltheir less efficient assets.

    This is not pie in the sky or wishful thinking. In June 1997, forinstance, a novel transaction launched in America attracted huge interestfrom investors around the world. Ask most investors if they wouldlike to share the hurricane damage risk of a big insurer and they wouldprobably balk—all that talk of "El Nino" might have been a tad unnerving.But consider the following bet that was offered by a leadinginsurer: you buy a one-year security that yields 11 percent (well aboveyields on bonds that carry similar credit ratings); in return, you buyinto an 80 percent share of the risk that a single hurricane season willcause the insurer losses of more than $1 billion but only up to $1.5 billion.In other words, if the worst happens during a single hurricaneseason, you will lose all of your principal. Once the insurer has lostmore than $1 billion, you will be on the hook for your share of the$400 million maximum exposure. Would you take this bet?

    On the face of it, the answer is unclear. So before you decide, youmight ask a few questions. How much have past hurricanes cost the insurer—inthis case, United Services Automobile Association (USAA), afirm that specializes in insuring members and veterans of America'smilitary and their families? Hurricane Andrew, the worst storm to hitFlorida and the southern coastal states in recent history, cost USAA$555 million of losses in 1992. Fine; but how much would, say, the horrendousstorm of 1926 cost USAA if it happened again today? Using acomputer simulation to model that storm's impact, the answer is $800million. There would be no loss on your stake. So the bet is beginningto look reasonably attractive. Indeed, do some fancier computer modelingto generate possible storms that could occur in the future, and letthe virtual weather rage for 10,000 years, and you find that the likelihoodof USAA's experiencing a loss greater than $1 billion is less than 1percent. The chance of a loss of more than $1.5 billion is less thanfour-tenths of 1 percent. By now, you might be reaching for your checkbook.

    That is just what some sixty institutional investors, including banksand mutual funds, did. From mid-June 1997 until the end of that year'shurricane season, they were avid watchers of the Weather Channel; foras long as the hurricane season lasted, they were exposed to a uniqueform of risk. Were USAA required to pay damages, some $313 millionof investors' money was at risk; an additional $164 million was tied upin a second set of securities that carried a lower return but guaranteedthe principal amount for less-risk-seeking folk. For a deal that startedout trying to raise $150 million, that represented a huge success.

    One reason for its success was that the attraction of the securities forinvestors went far beyond the probabilities of the single bet they wereoffered. Until such deals began to appear—the first widely syndicatedoffering was launched in December 1996 for a broad portfolio of risksunderwritten by St. Paul Re, subsidiary of a big insurer based inMinnesota—investors could only gain exposure to the reinsurance (that is,the insurance of the existing insurance risk) market by buying theshares of reinsurers. However, that is an inefficient and unreliable wayof capturing reinsurance risk.

    Because they are uncorrelated to the returns from financial markets,the returns from pure reinsurance risks such as those offered in theUSAA deal are highly desirable for investors who are otherwise limitedto financial assets. When share and bond prices might be tumbling,chances are that reinsurance returns will hold up fine. Adding reinsurancerisk to a portfolio should therefore significantly lower its overallvolatility—which, after all, is one of the basic tenets of modern portfoliotheory.

    For this important reason, investment bankers have high hopes forthe nascent market in so-called catastrophe insurance bonds, and therest of us should take note. The technique expands the overall abilityof insurers and reinsurers to spread risk around. At present, they playa sophisticated game of "passing the parcel" among professionals. Butif they can offer pure insurance risks to investors, they can tap vastnew demand while avoiding the unnecessary expense of buying coverfrom their competitors. In time, that should make insurance cheaper(because less volatile) and hence more ubiquitous. Insurance riskwill, in effect, become a new asset class alongside shares, bonds, andcommodities.

    Another impact of catastrophe reinsurance has perhaps the greatestpotential to change financial markets. At present, large industrial firmshave a constant insurance dilemma. It would be too costly to insureevery bus, truck, and piece of equipment they own. Consequently,many companies choose to "self-insure." An oil refiner, for example,will assume all of the risk that one of its plants might be destroyed by adisastrous fire, betting that, over time, the returns from its other assetswill cover the loss more cheaply than if it were to buy continuous cover.Insurance bonds can change that. A refiner might choose instead topackage some of its business risk and offer it, in the form of securities,to investors. It would, in effect, strip away that risk from its underlyingoperations, which would, in turn, affect the risk profile of its other issuedsecurities. (By implication, the price of its shares should rise.) Inessence, the financial technology creates reinsurance bonds can beused to develop a class of risk that was previously undiversifiable. Providedthe risks are carefully defined and can be priced to attract investors,there should be no lack of demand for such bonds.

    Anyone who can understand these related ideas is well on the way tograsping the essences of modern finance, even if the arcane language ofderivatives and portfolio theory still seems foreign. In the chapters thatfollow, we will explore these ideas in more detail. But our next stepmoves backward. Before we explain a new framework for managing risk,we need to lay out the basic building blocks of risk and risk management—thepieces that we need if we are to understand and control risk.

Meet the Author

DR. RON S. DEMBO is President and CEO of Algorithmics, Inc., a leading provider of innovative financial risk management software. Prior to founding Algorithmics in 1989, he managed a risk analysis group at Goldman, Sachs, and served on the academic faculties of several universities, including Yale University.
ANDREW FREEMAN manages and edits the financial services division of the Economist Intelligence Unit. From 1994-1997 he was the American Finance Editor for the Economist in New York.

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