The Limits of Diversification

Diversification can reduce risk. In some cases it can eliminate it. But these cases are not typical, because there are important limits to diversification. We can see the most important reason for these limits by returning to Lloyd’s one more time.

In Lloyd’s early days, there was one important hazard facing British shipping other than pirates or storms: war. Between 1690 and 1815, Britain fought a series of wars, mainly with France (which, among other things, went to war with Britain in support of the American Revolution). Each time, France would sponsor “privateers”—basically pirates with official backing—to raid British shipping and thus indirectly damage Britain’s war effort.

Whenever war broke out between Britain and France, losses of British merchant ships would increase. Unfortunately, merchants could not protect themselves against this eventuality by sending ships to different ports: the privateers would prey on British ships anywhere in the world. So the loss of a ship to French privateers in the Caribbean and the loss of another ship to French privateers in the Indian Ocean would not be independent events. It would be quite likely that they would happen in the same year.

Two events are positively correlated if each event is more likely to occur if the other event also occurs.

When an event is more likely to occur if some other event occurs, these two events are said to be positively correlated. And like the risk of having a ship seized by French privateers, many financial risks are, alas, positively correlated.

Here are some of the positively correlated financial risks that investors in the modern world face:

When events are positively correlated, the risks they pose cannot be diversified away. An investor can protect herself from the risk that any one company will do badly by investing in many companies; she cannot use the same technique to protect against an economic slump in which all companies do badly.

An insurance company can protect itself against the risk of losses from local flooding by insuring houses in many different places; but a global weather pattern that produces floods in many places will defeat this strategy. Not surprisingly, insurers pulled back from writing policies when it became clear that extreme weather patterns had become worse. They could no longer be confident that profits from policies written in good weather areas would be sufficient to compensate for losses incurred on policies in hurricane and drought prone areas.

So institutions like insurance companies and stock markets cannot make risk go away completely. There is always an irreducible core of risk that cannot be diversified. Markets for risk, however, do accomplish two things: First, they enable the economy to eliminate the risk that can be diversified. Second, they allocate the risk that remains to the people most willing to bear it.

!worldview! ECONOMICS in Action: When Lloyd’s Almost Lost It

When Lloyd’s Almost Lost It

At the end of the 1980s, the venerable institution of Lloyd’s found itself in severe trouble. Investors who had placed their capital at risk, believing that the risks were small and the return on their investments more or less assured, found themselves required to make large payments to satisfy enormous claims. A number of investors, including members of some very old aristocratic families, found themselves pushed into bankruptcy.

The overwhelming number of asbestos claims faced by Lloyd’s make it clear that insurance companies cannot completely eliminate risk.
Thinkstock/iStockphoto

What happened? Part of the answer is that ambitious managers at Lloyd’s had persuaded investors to take on risks that were much larger than the investors realized. (Or to put it a different way, the premiums the investors accepted were too small for the true level of risk contained in the policies.)

But the biggest single problem was that many of the events against which Lloyd’s had become a major insurer were not independent. In the 1970s and 1980s, Lloyd’s had become a major provider of corporate liability insurance in the United States: it protected American corporations against the possibility that they might be sued for selling defective or harmful products. Everyone expected such suits to be more or less independent events. Why should one company’s legal problems have much to do with another’s?

The answer turned out to lie in one word: asbestos. For decades, this fire-proofing material had been used in many products, which meant that many companies were responsible for its use. Then it turned out that asbestos can cause severe damage to the lungs, especially in children. The result was a torrent of lawsuits by people who believed they were injured by asbestos and billions of dollars in damage awards—many of them ultimately paid by Lloyd’s investors.

Quick Review

  • Insurance markets exist because there are gains from trade in risk. Except in the case of private information, they lead to an efficient allocation of risk: those who are most willing to bear risk place their capital at risk to cover the financial losses of those least willing to bear risk.

  • When independent events are involved, a strategy of diversification can substantially reduce risk. Diversification is made easier by the existence of institutions like the stock market, in which people trade shares of companies. A form of diversification, relevant especially to insurance companies, is pooling.

  • When events are positively correlated, there is a core of risk that cannot be eliminated, no matter how much individuals diversify.

20-2

  1. Question 20.3

    Explain how each of the following events would change the equilibrium premium and quantity of insurance in the market, indicating any shifts in the supply and demand curves.

    1. An increase in the number of ships traveling the same trade routes and so facing the same kinds of risks

    2. An increase in the number of trading routes, with the same number of ships traveling a greater variety of routes and so facing different kinds of risk

    3. An increase in the degree of risk aversion among the shipowners in the market

    4. An increase in the degree of risk aversion among the investors in the market

    5. An increase in the risk affecting the economy as a whole

    6. A fall in the wealth levels of investors in the market

Solutions appear at back of book.