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Acts of God and Man

Acts of God and Man: Ruminations on Risk and Insurance

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  • Book Info
    Acts of God and Man
    Book Description:

    Much has been written about the ups and downs of financial markets, from the lure of prosperity to the despair of crises. Yet a more fundamental and pernicious source of uncertainty exists in today's world: the traditional "insurance" risks of earthquakes, storms, terrorist attacks, and other disasters. Insightfully exploring these "acts of God and man," Michael R. Powers guides readers through the methods available for identifying and measuring such risks, financing their consequences, and forecasting their future behavior within the limits of science.

    A distinctive characteristic of earthquakes, hurricanes, bombings, and other insurance risks is that they impact the values of stocks, bonds, commodities, and other market-based financial products, while remaining largely unaffected by or "aloof" from the behavior of markets. Quantifying such risks given limited data is difficult yet crucial for achieving the financing objectives of insurance. Powers begins with a discussion of how risk impacts our lives, health, and possessions and proceeds to introduce the statistical techniques necessary for analyzing these uncertainties. He then considers the experience of risk from the perspectives of both policyholders and insurance companies, and compares their respective responses.

    The risks inherent in the private insurance industry lead naturally to a discussion of the government's role as both market regulator and potential "insurer of last resort." Following a thoughtful and balanced analysis of these issues, Powers concludes with an interdisciplinary investigation into the nature of uncertainty, incorporating ideas from physics, philosophy, and game theory to assess science's limitations in predicting the ramifications of risk.

    eISBN: 978-0-231-52705-7
    Subjects: Business, Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
    (pp. ix-x)

    It is a pleasure to write a foreword for this book of both scholarship and humor. It factors in the various concepts of risk, but provides both theory and practical guidance on those “aloof risks” suitable for insurance. The author manages to create a text for students of insurance while raising the deep philosophical problems in the formulation and application of probability theory.

    The division of the opus into three segments on “Living with Risk,” “The Realm of Insurance,” and “Scientific Challenges” is most appropriate to providing context and width of view, yet motivating an appreciation for the institution of...

    (pp. xi-xiv)
    (pp. xv-xviii)
  6. PART 1. Living with Risk

    • 1 The Alpha and the Omega of Risk The Significance of Mortality
      (pp. 3-19)

      The relationship between human beings and the risks of their world is both ancient and complex.² It is the stuff of myth and literature as well as philosophy and science. Wars, plagues, famines, floods, and earthquakes mark many of the turning points of the Hebrew Bible, and Greek mythology provides a generous reservoir of risk-related metaphors: Achilles’ heel, the Sword of Damocles, Pandora’s box, the Lernean Hydra, etc. In modern times, epic disasters—such as the Titanic, Pearl Harbor, Apollo 13, and Chernobyl—have assumed their own roles in our collective psychology.

      Today, problems of risk form the basis for...

    • 2 Into the Unknown Modeling Uncertainty
      (pp. 20-36)

      Every manifestation of risk is associated with one or more unknown quantities. In the case of the inevitable death of an individual, it is primarily the time of death that is unknown. In the case of damage to a building, automobile, or other piece of property, it is a combination of the incidence of damage (i.e., whether or not it occurs), along with both the timing and the amount of damage. And in the case of a financial investment, it is the sequence of future prices of the instrument involved.

      In all of the above examples, the principal reason the...

    • 3 The Shapes of Things to Come Probabilities and Parameters
      (pp. 37-52)

      In the first two chapters, we encountered a few simple probability distributions. Now, we will examine more complex distributions whose shapes make them appropriate for characterizing insurance and other financial risks. In particular, two important families of distributions will be introduced: the Pareto family and the symmetric Lévy-stable family, both of which are frequently used to model particularly “risky” random variables with heavy tails (i.e., with large amounts of weight spread over the more extreme values of the random variable).

      To describe the measurement of risk, I will begin by defining the statistical moments of a distribution, and then show...

    • 4 The Value of Experience Independence and Estimation
      (pp. 53-66)

      In Chapter 2, we considered two pairings of probability interpretations and estimation methods: (1) the frequency/classical approach, called frequentism; and (2) the subjective/judgmental approach, called Bayesianism. In the present chapter, we will explore a number of concepts and methods employed in the former approach. The latter will be addressed in Chapter 5.

      To present the standard frequentist paradigm, I will begin by defining the concept of a random sample, and then summarize how such samples are used to construct both point and interval estimates. Next, three important asymptotic results—the law of large numbers, the central limit theorem, and the...

    • 5 It’s All in Your Head Bayesian Decision Making
      (pp. 67-90)

      From certain remarks in the previous chapter, the reader will have an inkling of the serious shortcomings of the frequentist paradigm. Despite its rigorous mathematical basis, frequentism remains unable to answer some of the most basic questions a person is likely to pose when encountering uncertainty. For example, given a random sample X₁, X₂, …, Xn, one might ask: What is the probability that the next observation, Xn+₁, will be less than 10? Rather remarkably, this very natural type of question is off-limits to the frequentist statistician except in the most trivial of cases. The frequentist can offer only an...

  7. PART 2. The Realm of Insurance

    • 6 Aloofness and Quasi-Aloofness Defining Insurance Risks
      (pp. 93-109)

      The question “What is insurance?” can be approached from two very different perspectives, each of which is crucial to a complete description of the concept. On the one hand, seeing insurance as a category of financial instrument for managing risk transforms the question to: What types of risks are appropriate for insurance products? On the other hand, viewing insurance as an established sector of the financial services industry leads to the alternative: What exactly constitutes an insurance company? The first of these two queries will be addressed in the present chapter; the second in Chapter 7.

      To provide some institutional...

    • 7 Trustworthy Transfer; Probable Pooling Financing Insurance Risks
      (pp. 110-126)

      I now wish to turn to the issue of what constitutes an insurance company. From the previous chapter, it is evident that such a firm somehow must engage in financial transactions involving aloof and quasi-aloof risks. However, the exact nature of these transactions is not absolutely clear. One fundamental ambiguity is whether a firm must engage in both risk transfer and risk pooling—that is, the two fundamental risk finance transactions that have been with us since the dawn of history—to be an insurance company. As will be seen, this question is fundamental to the legal definition of insurance...

    • 8 God-Awful Guessing and Bad Behavior Solvency and Underwriting
      (pp. 127-141)

      In preceding chapters, we have considered definitions of insurance both in terms of what constitutes an insurance product and in terms of what constitutes an insurance company. To summarize, I have argued that: (1) an insurance product is a financial contract that transfers an aloof or quasi-aloof risk from one party to another; and (2) an insurance company is an enterprise engaged in the business of assuming financial responsibility for such transferred risks in an economically efficient manner by operating subject to marketplace forces.

      Of course, insurance companies throughout the world are generally subject to some form of government regulation,...

    • 9 The Good, the Bad, … The Role of Risk Classification
      (pp. 142-157)

      Although not as universal as solvency regulation, rate (or price) regulation is used extensively by many nations of the world and oft en relied on for market stability by developing countries. In the United States, the purpose of rate regulation is twofold: (1) to protect insurance consumers from excessive premiums or unfairly discriminatory premiums (i.e., premium differences that cannot be justified by differences in risk characteristics among policyholders); and (2) to protect insurance companies (and therefore insurance consumers) from inadequate premiums that may threaten company solvency.

      In the present chapter, I will offer a brief summary of the objectives and...

    • 10 … And the Lawyerly Liability and Government Compensation
      (pp. 158-174)

      The more active a nation’s civil justice (tort) system, the more significant the liability component of its property-liability insurance market tends to be. In the United States, liability insurance premiums are extremely costly for many commercial policyholders, and at times, availability crises have arisen in lines such as pollution liability, general liability, and medical malpractice. Interestingly, even personal lines policyholders have been adversely affected—primarily by the high cost of private passenger automobile liability insurance.

      The present chapter addresses several important aspects of a liability system. First, I will consider the loss event itself and how one can assign responsibility...

  8. PART 3. Scientific Challenges

    • 11 What Is Randomness? Knowable and Unknowable Complexity
      (pp. 177-190)

      Few ideas in mathematics are as mysterious as the notion of randomness. As observed in Chapter 2, random variables are commonly used to model unknown quantities, including the full gamut of risks, in the physical world. However, this generally is done without either a formal definition of randomness or even a convincing demonstration that truly random processes actually exist. Another source of mystery—the conspicuous analogy between randomness as the uncertainty of the outside world and free will as the uncertainty of the mind—offers the alluring possibility that an understanding of randomness can offer an instructive glimpse, however metaphorical,...

    • 12 Patterns, Real and Imagined Observation and Theory
      (pp. 191-206)

      When told that a particular scientific question is theoretically unanswerable, one’s initial disbelief and intellectual rebellion is likely to be followed by wonder and even a certain degree of contentment. Results such as Heisenberg’s uncertainty principle or Chaitin’s impossibility theorem are not only intriguingly counterintuitive, but also psychologically comforting in that they tell us we have reached the end of one particular road of inquiry, and so can begin another. However, when one is told that a question is unanswerable in practice because of shortcomings with empirical methodologies, there is typically more annoyance than awe. This is because we know,...

    • 13 False Choices and Black Boxes The Costs of Limited Data
      (pp. 207-221)

      In recent decades, governments, corporations, and ordinary citizens the world over have become more aware of the potential impact of extreme-event, or catastrophe, risks. Dramatic events such as the September 11 attacks (2001), the Indian Ocean tsunami (2004), Hurricane Katrina (2005), the Great Sichuan earthquake (2008), and the Tohoku earthquake and tsunami (2011) continue to raise these issues in the public mind while sending researchers from various disciplines scrambling to explain and forecast the frequencies and severities of such events.

      Extreme events are, by their nature, rare. In insurance parlance, a catastrophe can be described as an event whose severity...

    • 14 Nullifying the Dull Hypothesis Conventional Versus Personalized Science
      (pp. 222-234)

      Chapters 12 and 13 addressed two significant issues frequently encountered in empirical analysis: model selection and data availability, respectively. I now will turn to an even more fundamental issue: the soundness of the scientific method (SM) itself. Although widely touted as the most effective available guide to human understanding, the SM is imprecisely defined and inconsistently implemented. Not only is there no universally accepted method for all scientific disciplines, but also statements of such methods, where they exist, are usually only idealized descriptions of the actual practice of science. This state of affairs is rather disquieting given that the SM...

    • 15 Games and the Mind Modeling Human Behavior
      (pp. 235-254)

      If the preceding three chapters have created the impression that serious deficiencies exist in some empirical scientific research, especially in fields relying primarily on observational studies, then they have succeeded to that limited extent. And that leads to the question: What can scientists do to improve the credibility of their research if randomized controlled studies are not feasible? As mentioned briefly in Chapter 14, my principal recommendation is that researchers embrace a much broader use of mathematical modeling and statistical simulation to replicate the complex processes under study. This is because such modeling essentially permits one to conduct randomized controlled...

  9. NOTES
    (pp. 255-266)
    (pp. 267-270)
    (pp. 271-274)
  12. INDEX
    (pp. 275-284)