Tuesday, September 30, 2008

The Impossibility of Insuring Against Systematic Risks

One similarity of today's crisis with 1987 is the (failed) role of insurance. In 1987, portfolio insurance was a relatively new idea and many investors had implemented such insurance plans, either through simple things like stop-loss orders or more dynamic portfolio strategies based on options. I think it is pretty well accepted that not only did many portfolio insurance schemes not work -- because prices changed discontinously -- but also that they contributed to the very large (approx. 20% in one day) price declines.

Today we have insurance in the form of credit default swaps, which I do like to think of just as insurance. Once again, many of these insurance policies have not been effective and, because they can lead to forced selling of assets, may also be contributing to positive feedback cycles in the markets.

I recall some of my graduate econ coursework with the late Prof. Jack Hirshleifer, who used to emphasize things like the impossibility of insuring against "social," i.e., wide-scale risks. In 1987 and today, there do seem to be insurance policies taken out that would not be payable in certain states of the world.

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