I Do/Don’t Understand Risk

I hear this all the time and get irritated. Consider these two statements:

1. An investor at a conference: “we think that investors are good at understanding super-catastrophe risk, reinsurers are good at understanding higher frequency risk and insurers best understand high frequency risk”

2. We are looking at this marketplace and just don’t understand the risk.

What does it mean to “understand” risk? I’ll tell you: not a damn thing. If you understood it, it wouldn’t be risky, would it?

Statistics can useful at describing processes without using incorporating any ‘fundamental’ analysis of the drivers of that process.

Coin flipping? Sure, I can get my head around the probabilities in that. Aggregate cost of slip and fall accidents in Montana in 2006 being greater than 2005? Yeah, right!

So we approximate, test, get it wrong and (hopefully) refine. Nobody understands risk any better than anyone else. Those two statements SHOULD read:

1. Investors are happy with returns commensurate with insuring extremely rare events because we don’t ever expect to pay any claims and we (the managers) are happy to get fired if we do. Everything else? I have no idea how their businesses work.

2. We like markets where we think people don’t know what they’re doing and we can convince ourselves that we do. Risk is in the eye of the beholder and we can’t believe that REAL risk exists here. We must be the sucker at the poker table.

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