Naked Economics: Undressing the Dismal Science pdfdrive com

Insuring against risk. Life is a risky proposition. We risk death just getting into
the bathtub, not to mention commuting to work or bungee jumping with friends.
Let us consider some of the ways you might face financial ruin: natural disaster,
illness or disability, fraud or theft. One of our primary impulses as human beings
is to minimize these risks. Financial markets help us to do that. The most
obvious examples are health, life, and auto insurance. As we noted in Chapter 4,
insurance companies charge more for your policy than they expect to pay out to
you, on average. But “average” is a really important term here. You are not
worried about average outcomes; you are worried about the worst things that
could possibly happen to you. A bad draw—the tree that falls in an electrical
storm and crushes your home—could be devastating. Thus, most of us are
willing to pay a predictable amount—even one that is more than we expect to get
back—in order to protect ourselves against the unpredictable.

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Almost anything can be insured. Are you worried about pirates? You should
be, if you ship goods through the South China Sea or the Malacca Strait. As The
Economist explains, “Pirates still prey on ships and sailors. And far from being
jolly sorts with wooden legs and eye patches, today’s pirates are nasty fellows
with rocket-propelled grenades and speedboats.” There were 266 acts of piracy
(or attempts) reported to the International Maritime Organization in 2005. This is
why firms sending cargo through dangerous areas buy marine insurance (which
also protects against other risks at sea). When the French oil tanker Limberg was
rammed by a suicide bomber in a speedboat packed with explosives off the coast
of Yemen in 2002, the insurance company ended up writing a check for $70
million—just like when someone backs into your car in the Safeway parking lot,
only a much bigger claim.
3
The clothing and shoe company Fila should have bought insurance before the
2009 U.S. Open tennis tournament, but didn’t. Like other such companies, Fila
endorses athletes and pays them large bonuses when they do great things. Fila
endorses Belgian tennis player Kim Clijsters, winner of the U.S. Open, but opted
not to buy “win insurance” for the roughly $300,000 in bonus money they had
promised her for a victory. (This was an expensive decision, but perhaps also an
insulting one for Ms. Clijsters.) The insurance would have been cheap; Clijsters
was unseeded, had played only two tournaments since leaving the game to have
a baby, and was considered a 40–1 long shot by bookies before the tournament.
4
The financial markets provide an array of other products that look
complicated but basically function like an insurance policy. A futures contract,
for example, locks in a sale price for a commodity—anything from electrical
power to soybean meal—at some defined date in the future. On the floor of the
Board of Trade, one trader can agree to sell another trader a thousand bushels of
corn for $3.27 a bushel in March of 2010. What’s the point? The point is that
producers and consumers of these commodities have much to fear from future
price swings. Corn farmers can benefit from locking in a sale price while their
corn is still in the ground—or even before they plant it. Might the farmers get a
better price by waiting to sell the crop until harvest? Absolutely. Or they might
get a much lower price, leaving them without enough money to pay the bills.
They, like the rest of us, are willing to pay a price for certainty.
Meanwhile, big purchasers of commodities can benefit from being on the
other side of the trade. Airlines use futures contracts to lock in a predictable
price for jet fuel. Fast-food restaurants can enter into futures contracts for ground
beef, pork bellies (most of which are made into bacon), and even cheddar
cheese. I don’t know any Starbucks executives personally, but I have a pretty

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good idea what keeps them awake at night: the world price of coffee beans.
Americans will pay $3.50 for a grande skim decaf latte, but probably not $6.50,
which is why I would be willing to bet the royalties from this book that
Starbucks uses the financial markets to protect itself from sudden swings in the
price of coffee.
Other products deal with other risks. Consider one of my personal favorites:
catastrophe bonds.
5
Wall Street dreamed up these gems to help insurance
companies hedge their natural disaster risk. Remember, the insurance company
writes a check when a tree falls on your house; if a lot of trees fall on a lot of
houses, then the company, or even the entire industry, has a problem. Insurance
companies can minimize that risk by issuing catastrophe bonds. These bonds pay
a significantly higher rate of interest than other corporate bonds because there is
a twist: If hurricanes or earthquakes do serious damage to a certain area during a
specified period of time, then the investors forfeit some or all of their principal.
The United Services Automobile Association did one of the first deals in the late
1990s tied to the hurricane season on the East Coast. If a single hurricane caused
$1.5 billion in claims or more, then the catastrophe bond investors lost all of
their principal. The insurance company, on the other hand, was able to offset its
claims losses by avoiding repayment on its debt. If a hurricane did between $1
billion and $1.5 billion in damage, then investors lost a fraction of their
principal. If hurricanes did relatively little damage that year, then the
bondholders got their principal back plus nearly 12 percent in interest—a very
nice return for a bond.
The same basic idea is now being used to protect against terrorism. The World
Football Federation, which governs international soccer, insured the 2006 World
Cup against disruption due to terrorism (and other risks) by issuing $260 million
in “cancellation bonds.” If the tournament went off without a hitch (as it did), the
investors get their capital back along with a handsome profit. If there had been a
disruption serious enough to cancel the World Cup, the investors lose some or all
of their money, which is used instead to compensate the World Football
Federation for the lost revenue. The beauty of these products lies in the way they
spread risk. The party selling the bonds avoids ruin by sharing the costs of a
natural disaster or a terrorist attack with a broad group of investors, each of
whom has a diversified portfolio and will therefore take a relatively small hit
even if something truly awful happens.
Indeed, one role of the financial markets is to allow us to spread our eggs
around generously. I must recount one of those inane experiences that can
happen only in high school. Some expert in adolescent behavior at my high
school decided that students would be less likely to become teen parents if they

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realized how much responsibility it required. The best way to replicate
parenthood, the experts reckoned, would be to have each student carry an egg
around school. The egg represented a baby and was to be treated as such—
handled delicately, never left out of sight, and so on. But this was high school.
Eggs were dropped, crushed, left in gym lockers, hurled against the wall by
bullies, exposed to secondhand smoke in the bathrooms, etc. The experience
taught me nothing about parenthood; it did convince me forever that carrying
eggs is a risky proposition.
The financial markets make it cheap and easy to put our eggs into many
different baskets. With a $1,000 investment in a mutual fund, you can invest in
five hundred or more companies. If you were forced to buy individual stocks
from a broker, you could never afford so much diversity with a mere $1,000. For
$10,000, you can diversify across a wide range of assets: big stocks, small
stocks, international stocks, long-term bonds, short-term bonds, junk bonds, real
estate. Some of those assets will perform well at the same time others are doing
poorly, protecting you from Wall Street’s equivalent of bullies hurling eggs
against the wall. One attraction of catastrophe bonds for investors is that their
payout is determined by the frequency of natural disasters, which is not
correlated with the performance of stocks, bonds, real estate, or other traditional
investments.
Even the much-maligned credit default swaps have a legitimate investment
purpose. A credit default swap is really just an insurance policy on whether or
not some third party will pay back its debts. Suppose your husband pressures
you to loan $25,000 to your ne’er-do-well brother-in-law so that he can finally
complete his court-man-dated anger management program and turn his life
around. You have grave concerns about whether you will ever see any of this
money again. What you need is a credit default swap. You can pay some other