Beyond the Market: Understanding Actuarial and Binary Risk

When people think about investment risk, many will picture red numbers flashing on a stock ticker or line charts with peaks and troughs. In most cases, the risk of investing in a particular asset is largely tied to that asset’s relationship with outside economic factors, such as consumer spending or corporate earnings or interest rates. However, there is a lesser known risk that exists outside of corporate boardrooms but is ever-present for cat bond investors: actuarial risk.

At its core, actuarial risk is the difference between the occurrence or timing of an event when compared to the modeled predictions of that event occurring. Actuaries use math, statistics, historical data and financial theory in an attempt to model and calculate the chance of an event’s occurrence as they analyze design and price policies that seek to provide financial security for both the insurer and policyholder. Generally speaking, actuarial risk puts insurance companies in financial jeopardy because it represents the risk that their experts, with their complex models, were wrong.

The Math of Uncertainty

Actuaries are the unsung stewards of the insurance world. They use complex models and the "Law of Large Numbers" in an effort to predict the future. A basic mechanism of insurance is that many parties can contribute small, predictable payments (premiums) into a collective fund that in turn agrees to pay for the large, unpredictable losses experienced by a few members of that pool. It’s generally said that insuring one home against a fire is a gamble, but insuring ten million homes provides the opportunity to deal in quantifiable statistics. Actuarial risk occurs when the modeled statistics fail, and losses are wider spread than anticipated – which in this example might indicate that many more homes were lost to fire than the insurance company had anticipated. This could be due to modern climate patterns making wildfires more frequent than historical data has previously suggested.

Investors are exposed to actuarial risk when they hold catastrophe bonds, which largely exempt them from economic risk factors: a market crash will not cause losses in an asset tied to weather event-driven losses. But no asset is without risk, so by owning cat bonds, investors expose themselves to actuarial risk and are essentially betting on the ability of the issuer’s risk modeling capability.

The Concept of Binary Risk

To truly understand actuarial risk in an investment context, one must also understand binary risk. Many traditional investments incur risk on a sliding scale. For example, if you buy a share of a blue-chip company, the stock might go up 10%, stay flat, or drop 15%.

However, binary risk only has two outcomes: all or nothing. This is the risk that catastrophe bonds carry. A cat bond is structured to trigger if and only when it meets specific requirements. These can be "indemnity triggers" that are based on actual losses or "parametric triggers" that are aligned to physical characteristics of an event, like wind speed or earthquake magnitude. Let’s use a category 4 hurricane making a landfall in a certain Florida county to illustrate the difference between these two scenarios:

Outcome A: The hurricane does not hit that county over the maturity period of the bond, and the investor receives their principal back plus a very high interest rate (the premium).

Outcome B: The hurricane event does occur, and it meets the cat bond’s specific parameters. In this case, the cat bond investor loses 100% of their principal, since it’s used by the issuing insurance company to pay out hurricane-related claims.

With catastrophe bonds, there is no middle ground. The trigger is either met, or it isn't.

How Investors Can Accept "All or Nothing"

At first glance, binary risk can be intimidating. Why would anyone risk 100% of their capital on the path of a single storm? The answer lies in investor confidence in issuers to minimize actuarial risk, and the asset’s risk premium. Because the risk is binary and the potential loss is total, the yields offered on these instruments are, generally speaking, much higher than more traditional fixed income options.

Furthermore, when an investor owns a diversified portfolio of bonds, each bringing its own binary risk but collectively diversified across many geographies, event types, damage thresholds or other trigger types and metrics, the diversification helps dilute the “all or nothing” pressure.

Conclusion

Actuarial risk represents a "pure" form of investing. It strips away the noise of politics and corporate performance, replacing it with the raw, but measurable, probability of a disaster. By understanding the binary nature of these events, investors can stop worrying about what the Chairman of the Fed will say next, and perhaps build resilience into their portfolio by betting against nature.

Sources:

Investopedia

Society of Actuaries

Federal Reserve Bank of Chicago

The Motley Fool

Robinhood