Financial Markets for Unknown Risks

Abstract

New risks seem to be an unavoidable in a period of rapid change. The last few decades have brought us the risks of global warming, nuclear meltdown, ozone depletion, failure of satellite launcher rockets, collision of supertankers, AIDS and Ebola.^l A key feature of a new risk, as opposed to an old and familiar one, is that one knows little about it. In particular, one knows little about the chances or the costs of its occurrence. This makes it hard to manage these risks: existing paradigms for the rational management of risks require that we associate probabilities to various levels of losses. This poses particular challenges for the insurance industry, which is at the leading edge of risk management. Misestimation of new risks has lead to several bankruptcies in the insurance and reinsurance businesses.² In this paper we propose a novel framework for providing insurance cover against risks whose parameters are unknown. In fact many of the risks at issue may be not just unknown but also unknowable: it is difficult to imagine repetition of the events leading to global warming or ozone depletion, and, therefore, difficult to devise a relative frequency associated with repeated experiments.

We are grateful to Peter Bernstein, David Cass and Frank Hahn for valuable comments on an earlier version of this paper.