All posts by Jim Garven

My name is Jim Garven. I currently hold appointments at Baylor University as the Frank S. Groner Memorial Chair of Finance and Professor of Finance & Insurance. I also currently serve as an associate editor for Geneva Risk and Insurance Review and Journal of Risk and Insurance. At Baylor, I teach courses in managerial economics, risk management, and financial engineering, and my research interests are in corporate risk management, insurance economics, and option pricing theory and applications. Please email your comments about this weblog to James_Garven@baylor.edu.

Some Canadian Flu Shot Alternatives

Earlier this month, I wrote about the impact of the tort system on flu vaccine availability in the United States.  Interestingly, travel companies are now bundling flu vaccination with vacation opportunities in Canada.  Fodor’s has an interesting story about the “Flu-Shot Ferry”, a round trip between Seattle and British Columbia selling for $105 with the flu shot included.  The same story also links to an interesting Boston Globe article entitled “Business brisk as Americans stream to Canada for flu shots” which talks about the Flu-Shot Ferry as well as other flu vaccination/vacation opportunities available throughout Canada, such as a weekend plane trip from New York to Montreal.

Prediction markets assessment of the Presidential Election

Today’s Wall Street Journal article entitled “For Math Whizzes, The Election Means A Quadrillion Options” provides an overview of the various quantitative techniques being employed by geeks all over the country who typically are tenured college professors who probably have too much time on their hands.  Notwithstanding the barrage of criticism which has been leveled at the prediction markets (e.g., one commentator has described the Iowa Electronic Exchange Market as “college students playing with their lunch money”, and others have offered even more unflattering comments which will not be repeated here), I remain a fan and am looking forward to how the realized election results line up with these markets’ predictions.

Speaking of the prediction markets, the prices on the state-specific “Bush win” contracts offered on tradesports.com suggest that Bush currently (as of 10 a.m. on October 26) has a 19 electoral college vote advantage over Kerry; specifically, 253 to 234.  The basis for this assessment involved allocating electoral college votes to Bush in states with “Bush win” contract prices exceeding $60, and to Kerry in states with “Bush win” contract prices less than $40.  In my opinion, the states which are really in play are those with “Bush win” contract prices between $40 and $60.  There are five states which fit this criterion: Wisconsin, Ohio, New Mexico, New Hampshire, and Minnesota.  The following table lists the current prices for Bush contracts in these states, along with the number of electoral college votes which each state owns:

State

Electoral College

Votes

10/26/2004 “Bush win” Contract Price

WISCONSIN

11

59

OHIO

21

55.5

NEW MEXICO

5

50

NEW HAMPSHIRE

4

44.5

MINNESOTA

10

40.8

If Bush holds onto the states with contract prices exceeding $60, a win in Ohio would put him over the top.  If Bush does not win Ohio, he can still be reelected by taking Wisconsin, New Mexico, and New Hampshire.  Kerry on the other hand, will not likely win the election without taking Ohio.  Of course, various other permutations are possible.  The prediction markets data suggest the possibility of a 269-269 tie in the electoral college, which would happen if Kerry wins Ohio, New Hampshire and Minnesota, while losing Wisconsin and New Mexico to Bush.

Certainly the quantitative models are interesting, and as indicated by the Wall Street Journal article referenced above, suggest that the election may very well be somewhat of a toss-up.  However, there is probably no predictive indicator which has been as consistently accurate as the Weekly Reader poll.  Since 1956, Weekly Reader students in grades 1-12 have correctly picked the president.  As noted on the Weekly Reader website, “President Bush was a strong winner in the student poll; the only state Senator Kerry won was Maryland. Senator Kerry was also in a statistical dead heat with President Bush in New York, Massachusetts, Washington, D.C. and Vermont. President Bush won most grades, although Senator Kerry did win among tenth-graders.”  Also, results by grade are shown on the Weekly Reader website, in case if you are interested.

Daily Times Series of Closing Prices for the PRESIDENT.GWBUSH2004 and PRESIDENT.KERRY2004 Futures Contracts

Today, the Tradesports website made high, low, and closing daily price data available for the PRESIDENT.GWBUSH2004 and PRESIDENT.KERRY2004 futures contracts.  Below, I provide the graph of daily closing prices for the period August 11, 2004 (which is the first day that the Kerry contract started trading) through October 20, 2004.

“Infectious Politics” – article about the flu vaccine shortage in today’s Wall Street Journal

In today’s Wall Street Journal, there is a very interesting and insightful article entitled “Infectious Politics” that explains why flu vaccines in particular and vaccines for infectious diseases generally are in such short supply in the United States.  The contributing factors appear to involve a combination of price controls, regulation and tort lawyers.  Of course, I made the latter point (concerning tort) the other day in my blog entry entitled “Impact of the tort system on flu vaccine availability in the United States“.

Impact of the tort system on flu vaccine availability in the United States

It is well known that the U.S. tort system undermines incentives for U.S. pharmaceutical corporations to bring innovative, yet risky drugs to market.  This is particularly apparent in the case of vaccines against infectious diseases, where the “tort tax” is by far and away the most significant cost component in the manufacturing and distribution of vaccines.  With this in mind, it is interesting to consider the consequences for the United States of today’s decision by the UK’s Medicines and Healthcare Products Regulatory Agency (MHRA) to suspend Chiron Corporation’s license to manufacture influenza virus vaccine in its Liverpool facility, which in turn will prevent the company from releasing any of the product during the 2004-2005 influenza season.  This doesn’t seem like it should be that big of a deal until one considers the fact that the United States was counting on U.S.-based Chiron Corporation to provide roughly 1/2 of its total flu vaccine for the upcoming flu season.  Now that Chiron is out of the picture, the only supply source for flu vaccine for the entire United States is a French company called Aventis Corporation, and Aventis has made it quite clear that it cannot possibly scale its manufacturing to meet the needs of the United States during the upcoming flu season. (Fortunately for Baylor University students, faculty and staff, Baylor was prescient enough this past spring to contract with Aventis to provide an adequate vaccine supply this fall for the Baylor community).

Needless to say, it seems pathetic that only two (one U.S., the other French) corporations are willing to accept the risk of being sued for products liability by marketing flu vaccines in the United States.  Unfortunately, this situation has created a serious capacity constraint which in turn has given rise to a potentially serious public health problem for the United States which is now looming.  According to the Centers for Disease Control in Atlanta, GA, influenza typically accounts for as many as 140,000 hospitalizations and 40,000 deaths annually in the United States.  Since these are the statistics which obtain under more “normal” (adequately supplied) flu vaccine scenarios, one can only wonder how many more thousands of people will likely die during the upcoming flu season because the highly dysfunctional US tort liability system has persuaded most companies to not bother with trying to compete in the market for flu vaccines!

Catastrophe risk summary and recommended reading

Here is a summary of the various articles I have written concerning public policy in the context of the disastrous hurricane season suffered by the state of Florida:

  • 09.07.04: Financial Implications of Hurricanes – This article provides some insight concerning the evolution of public policy in the post-Andrew world. Because of persistent regulatory suppression of insurance rates, economic theory suggests that over time, product quality will likely deteriorate and insurers can be expected to exit the market. For all practical purposes, this is what has occurred in the Florida homeowners insurance market. Clearly, there has been a shifting of risk away from private insurers and toward government and policyholders. What has resulted is a rather ad hoc set of risk sharing arrangements which no one particularly likes and very few people understand.
  • 09.08.04: Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk – This article explains why public disaster relief, however well intentioned, may make matters worse in the long term by undermining incentives for firms and individuals to select “economically efficient” levels of private insurance and loss mitigation.
  • 09.09.04: The double deductible problem in Florida – Here, you will find my “proposal” concerning policy regulation reform; i.e., why not offer consumers a choice between the status quo policy form and an alternative policy form that enables consumers to insure against aggregate losses? This is a workable reform, assuming that the rate suppression problem can also be properly addressed.
  • 09.10.04: Reinsurance reinstatement option – This article discusses an important contractual issue that is looming in the market for catastrophe reinsurance which may end up being considerably more significant economically than the “double deductible” problem (i.e., given the amount of catastrophe exposure this season, this important aspect of “fine print” may result in quite a few insolvencies).
  • 09.17.04: More on double deductibles – This article argues that in order to “fix” the Florida insurance market, regulatory reform needs to address pricing issues as well as policy forms. Specifically, 1) the rate suppression problem needs to be properly addressed so that rates accurately reflect the expected cost of risk, and 2) consumers ought to have a broader set of choices concerning policy forms.

For people who are interested in reading more about public policy as it pertains to catastrophe risk, I highly recommend two books: 1) Catastrophe Insurance: Consumer Demand, Markets, and Regulation, and 2) When All Else Fails: Government As the Ultimate Risk Manager. Finally, I also highly recommend Martin Grace’s weblog.

As Bush Goes, So Goes Market

Yesterday (Monday, September 20, 2004), E. S. Browning (Staff Reporter of the Wall Street Journal) wrote a very interesting article entitled “As Bush Goes, So Goes Market”.  He basically makes many of the same points which I made on Saturday, September 11 in my entry entitled “Update on the relationship between stock market returns and presidential futures returns“; i.e., that the presidential futures contracts appear to be pointing to a Bush victory this coming November, and that the stock market appears to be responding favorably.  Or does the direction of causality move in the opposite direction?; i.e., as the stock market improves, this implies that investors are more confident about the economy’s future prospects which which in turn improves the electoral prospects of the incumbent president (as reflected in futures prices).  Professors Naveen Khanna and Jennifer Brooke Marietta-Westberg (both finance professors at Michigan State University) make the latter (rather compelling) argument in their paper entitled “Is it ‘Kerry up, Market Down’ or ‘Market Down, Kerry up?’ Correlation versus Causation“.

More on double deductibles

Professor Martin Grace argues that the so-called “double deductible” problem in Florida is more of a problem of high deductibles, where doubling just worsens the problem.  Why are deductibles high?  Professor Grace notes that for some time now, insurers have not been allowed to charge adequate rates, so rate regulations have provided the incentive for the private insurance industry to reduce their Florida windstorm exposure.  Since less risk is privately insured, more risk is borne by policyholders and government in various forms, including higher deductibles and state run risk pools.

Florida provides an interesting case study of dysfunctional regulatory policy.  As Professor Grace so capably documents, the regulatory process has effectively undermined the viability of private insurance and substituted in its place an ad hoc set of risk sharing arrangements which no one particularly likes and very few people understand.  Unfortunately, it appears that things may get worse before they get better.  The New York Times published an article about the “double deductible” problem the other day which enumerates some of the short term measures and longer term reforms that are under consideration.  One idea which has been floated is to provide a cash grant of $500 to everyone who has suffered unpaid insurance losses during the course of this hurricane season.  While such a measure may alleviate some of the short term financial “pain” for affected consumers, from a longer term perspective this is not sound public policy, since policies like this undermine consumer incentives to make prudent risk management decisions (see “Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk“).  Actually, this is a classic case of a policy which may have favorable political implications but carries with it rather undesirable economic consequences.  Furthermore, Mr. Tom Gallagher, who is the head of the state’s Department of Financial Services, wants to get rid of multiple deductibles and substitute an alternative policy that would enable consumers to insure against aggregate losses and therefore only pay one deductible.  There’s nothing wrong with this idea so long as insurers are able to charge a premium which reflects the added risk and cost associated with such a policy. However, why stop there? Why not provide consumers with the option to choose between a policy based upon the current policy form, and the alternative policy proposed by Mr. Gallagher? This would encourage self selection, and therefore allow for more efficient and fair pricing. Besides offering consumers greater choice, such a policy reform would also promote market efficiency and enhance the insurability of Florida windstorm risk. In order to “fix” the Florida insurance market, regulatory reform needs to address pricing issues as well as policy forms.  If not, then over time consumers and the state will continue to suffer from an insurability problem.

Update on the relationship between stock market returns and presidential futures returns

In an earlier post entitled “Kerry Up, Markets Down? A Regression Analysis“, I reported the results of the following regression equation:

(1) rS&P500,t = a + brKerry,t + et,

where rS&P500,t = daily return on the S&P 500, rKerry,t = daily return on the Kerry Futures contract, a = intercept, b = slope; and et= error term.  I was motivated to estimate this regression equation after reading a Wall Street Journal article entitled “Kerry Up, Markets Down” which claimed that “…when Kerry’s political fortunes rise, the stock market tanks.”  The evidence presented in this article for this conjecture did not seem all that robust; specifically, it was based upon graphically comparing 5 day moving averages of Kerry Futures Contract prices (available from the Iowa Electronic Markets website) with 5 day moving averages of the S&P 500 index.  A more convincing analysis is possible by running this very simple regression equation given in (1) above. I found that while there is statistically significant inverse relationship, the economic significance of the effect is rather negligible; specifically, a 1 percent change in the value of the Kerry Futures contract is associated with a -0.0389% change in the value of the S&P500 index.

It struck me that if Kerry was “bad” for the stock market, it would be interesting to find out whether Bush was “good” for the stock market, so I decided to reestimate regression equation (1) and also run a similar regression (given by equation (2) below) on the Bush Futures contract.

(2) rS&P500,t = a + brBush,t + et,

where rBush,t represents the return on the Bush Futures contract.  For both contracts, I used realized daily returns from the period June 2, 2004 through September 9, 2004, resulting in 69 daily observations for the futures contract and stock market returns.

The “new” Kerry results are given in the following table:

Kerry Regression Statistics
R2 = 0.0508
Observations: 69
a = 0.00001 (P-value = 0.9921)
b= -0.03789 (P-value = 0.0626)

Compared with the original regression results from August based upon 47 daily observations from the period June 2, 2004 through August 10, 2004, there has hardly been any change in the parameter values.  The correlation between daily returns on the Kerry Futures contract and daily returns on the S&P 500 index is -0.225, and although this inverse relationship is statistically significant (as indicated by the low “P-value” in the table above), it is not economically significant, since it implies that a 1 percent change in the value of the Kerry Futures contract is associated on average with a -0.03789% change in the value of the S&P500 index.

Next, let’s turn our attention to the parameter estimates for regression equation (2), which relates stock market returns to Bush Futures contract returns.  There, we find the following:

Bush Regression Statistics
R
2 = 0.1007
Observations: 69
a = -0.00005 (P-value = 0.9525)
b= 0.06997 (P-value = 0.0079)

The correlation between daily returns on the Bush Futures contract and daily returns on the S&P 500 index is .317, and although this positive relationship is statistically significant (as indicated by the negligible “P-value” in the table above), it also (like the Kerry contract) is not economically significant, since it implies that a 1 percent change in the value of the Bush Futures contract is associated on average with a 0.06997% change in the value of the S&P500 index.

While this represents an interesting statistical exercise, the low goodness of fit (R2) and the b values reported in these tables indicate that there are other (probably much more) important determinants of stock market returns other than the odds of who our next president will be. On the other hand, it is interesting to note that if you take the net difference in the two beta values for Kerry and Bush (0.10786) and assume an expected annual return of 7-10% on the S&P 500, Kerry “costs” investors roughly 75 to 100 basis points per year, the order of magnitude of which is comparable in many cases with the management fees that are typically charged by actively managed mutual funds.

Reinsurance reinstatement option

With the entire furor over the so-called “double deductible” problem in Florida, a contractual issue is looming in the market for catastrophe reinsurance which may be much more significant economically. Insurers writing property insurance routinely purchase reinsurance coverage for the purpose of limiting their catastrophe exposures. When insurers purchase reinsurance, they must decide whether to pay extra for an option which automatically reinstates coverage after an insured event occurs. The default reinsurance contract pays for one insured event, and then the coverage disappears unless the insurer has purchased the option to reinstate. Insurers can select how many reinstatements they wish to have. Typically, the cost to reinstate coverage is roughly half the cost of the original reinsurance premium. For example, suppose a reinsurer quotes $100 for the default reinsurance contract which does not reinstate. Then the reinsurer might quote a price of $110 for a contract which reinstates once, $120 for a contract which reinstates twice, etc. Whenever reinstatement occurs, the reinsurer would charge the insurer an additional $50 premium.
Since it is rare that multiple hurricanes strike the same properties, many insurers will prefer to purchase the default reinsurance contract and retain the risk of a subsequent catastrophe. Unfortunately, this is likely to be the most popular strategy for the smaller, less solvent companies for two reasons: 1) since the “option to default” conveyed by the legal rule of limited liability is more valuable for such firms, smaller, less solvent insurers are likely to reinsure less than larger, moresolvent insurers by not purchasing the reinstatement option, and 2) by foregoing the purchase of the reinstatement option,this results in significant reinsurance premium savings. Furthermore, given the dynamics of the Florida insurance market (where, for a variety of reasons, many of the worst risks are covered by such companies), we may be looking at a much worse insolvency scenario for the Florida insurance industry than we might have otherwise expected.
I wish to thank my good friend and colleague, Dr. Richard Derrig, for pointing this problem out to me.