Secondary Risk Markets

This idea is half-baked; it has some nice properties but doesn’t seem to me like a solution to the problem I most care about. I’m publishing it because maybe it points someone else towards a full solution, or solves a problem they care about, and out of a general sense that people should publish negative results.

Many risky activities impact not just the person doing the activity, but also bystanders or the public at large. Governments often require ability to compensate others as a precondition for engaging in the risky activity, with requirements to have car insurance to drive as a common example.

In most situations, this works out fine:

  1. A competitive insurance market means that customers aren’t overcharged too much (since they’ll switch insurance providers to whoever estimates their risk as being the lowest).

  2. Accidents are common enough that insurance companies that are bad at pricing quickly lose too much money and adjust their prices upwards (so customers aren’t undercharged either).

  3. Accidents are small enough that insurance companies can easily absorb the losses from mispriced insurance.

  4. Accidents are predictable enough that insurers can price premiums by driver moderately well.

  5. Drivers are common enough that simple prediction rules make more sense than putting dedicated thought into how much to charge each driver.

Suppose we adjust the parameters of the situation, and now instead of insuring drivers doing everyday trips, we’re trying to insure rare, potentially catastrophic events, like launching nuclear material into orbit to power deep space probes. Now a launch failure potentially affects millions of people, and estimating the chance of failure is well worth more than a single formula’s attention.

As a brief aside, why try to solve this with insurance? Why not just have regulators decide whether you can or can’t do something? Basically, I believe that prices transmit information, and allow you to make globally correct decisions by only attending to local considerations. If the potential downside of something is a billion dollars, and you have a way to estimate micro-failures, you can price each micro-failure at a thousand dollars and answer whether or not mitigations are worth it (if it reduces the microfailures by 4 and costs $5,000, it’s not worth it, but if it’s 6 microfailures instead then it is worth it) and whether or not it’s worth doing the whole project at all. It seems more flexible to have people codesign their launch with their insurer than with the regulator.

But the title of this post is Secondary Risk Markets. If there’s a price on the risk that’s allowed to float, then it’s also more robust; if Geico disagrees with State Farm’s estimates, then we want them to bet against each other and reach a consensus price, rather than the person doing the risky activity just choosing the lowest bidder. [That is, we’d like this to be able to counteract the Unilateralist’s Curse, by replacing an inexploitable market with an exploitable one.]

For example, suppose Alice want to borrow a fragile thousand dollar camera to do a cool photoshoot, and there’s some probability she ruins it. By default, this requires that she post $1,000, which she probably doesn’t want to do on her own; instead she goes to Bob, who estimates her risk at 5%, and Carol, who estimates her risk at 9%. Alice offers to pay Bob $51 if he puts up the $1,000, with $1 in expected profit for Bob.

If Bob would say yes to that, Carol would want to take that bet too; she would like to give Bob $51 in exchange for $1,000 if Alice breaks the camera, since that’s $39 in expected profit for Carol. And Bob, if actually betting with Carol, would want to set the price at something more like $70, since that equalizes the profit for the two of them, with the actual price depending on how quickly their price changes in the presence of counterparties.

So how do we get Alice to pay $70 instead of $51?[1]

My proposed scheme is as follows:

  • The regulator estimates the potential damages of the activity at $X.[2]

  • The person doing the activity has to post $2X as a bond. X is held in reserve to pay out to victims if the risk materializes and returned if the risk is avoided. The other X is posted for sale on a secondary market as ‘synthetic risk’ according to some predefined schedule (ask offers from 0% to 100%, effectively, tho the poster can immediately buy as much as they like).

  • Anyone can post a bond to create more synthetic risk tied to the activity and sell it for whatever price they like.

Continuing the example, Bob now needs to post $2k, with $1k set aside for the ‘natural risk’ and the other $1k for sale. Bob immediately buys the $50 of synthetic risk that’s available at prices of 5% or below, and now Carol would want to buy the $40 of synthetic risk available between 5% and 9%, which was listed for sale for $2.80. Note that Bob anticipates gaining 80 cents on that deal with Carol, if he sticks with his initial estimate; 5% of the time he has to pay out $40 which costs him $2, but Carol paid $2.80 for it. Bob can create more of that synthetic risk and put it for sale, for as long as he and Carol want additional exposure to that bet. [And Dan, if he also thought Carol was overestimating the risk, could create bonds and sell them to Carol as well.]

But this is how we get a market price of 7% risk, not how Alice pays $70. Either Bob could have set the initial insurance contract with Alice such that she pays the market price once it stabilizes,[3] or Bob could have had Alice pay to post the synthetic risk bonds, or so on. From society’s perspective, it doesn’t matter too much whether Alice pays for the increased risk or Bob does, so long as someone enabling the action does.

Importantly, this system transfers from worse predictors to better predictors instead of from optimists to pessimists. If Alice in fact only breaks the camera in 5% of worlds, on expectation Carol will be transferring resources to Bob.

I think this is basically magnifying the consequences of rare events, both for good and for ill. More money riding on the derivatives of the events will sharpen society’s estimate (and ensure there’s a public record of it), and also cause insurers to ‘update faster’. Rather than simply $1k moving based on Bob’s estimate of 5% risk, $1.4k will be moved if Bob and Carol end up with a $400 side bet. This also means that the standard laws against insurance fraud will be that much more strained by the pressures of profit; here I propose mandating as much synthetic risk as actual risk, but you could easily swap out the 2 in 2X for any other number, or the supply schedule for another schedule, or so on. (Most of the listed offers will never be bought under this scheme, for example.) This makes risky business like this more capital-intensive, which is the main price being paid for the increased accuracy in estimates.

  1. ^

    The overall hope, here, is to have Alice only do projects that make sense once the unilateralist’s curse has been accounted for. If borrowing the camera is worth $80 to Alice, this project should still happen even tho it seems like a bad idea to Carol; if it’s worth $60 to Alice, this project shouldn’t happen even tho it seems like a good idea to Bob.

  2. ^

    This could probably also be done with a market rather than by fiat, but I don’t think that will materially change the analysis in this post.

  3. ^

    Doesn’t this take a lot of the value of this away from Alice, since she was hoping to de-risk this whole affair and now the risk is back? Some, since Alice now has to pay an unknown premium instead of a known one, but it’s still substantially better than having to post the $1k herself. But also if we imagine this as being one-off events like rocket launches instead of much more common events like getting in the car, it seems much more plausible that Alice can call off the photoshoot if the premiums get too high.