Economy, insure thyself: in today's era of natural disasters and economic crises, there is a better way to manage risk.

Author:Shiller, Robert J.

The basic principle of financial risk management is sharing. The more broadly diversified our financial portfolios, the more people there are who share in the inevitable risks--and the less an individual is affected by any given risk. The theoretical ideal occurs when financial contracts spread the risks all over the world, so that billions of willing investors each own a tiny share, and no one is over-exposed.

The case of Japan shows that, despite some of our financial markets' great sophistication, we are still a long way from the theoretical ideal. Considering the huge risks that are not managed well, finance, even in the twenty-first century, is actually still rather primitive.

A recent World Bank study estimated that the damage from the triple disaster (earthquake, tsunami, and nuclear crisis) in March might ultimately cost Japan $235 billion (excluding the value of lives tragically lost). That is about 4 percent of Japanese GDP in 2010.

Given wide publicity about international charitable relief efforts and voluntary contributions to Japan, one might think that the country's economic loss was shared internationally. But newspaper accounts suggest that such contributions from foreign countries should be put in the hundreds of millions of U.S. dollars--well below 1 percent of the total losses. Japan needed real financial risk sharing: charity rarely amounts to much.

Insurance companies operating in Japan repaid some of the losses. The same World Bank study estimates that total claims accruing to insurers in Japan might ultimately cost these companies $33 billion. Clearly, the insured risks were a small part of the total risk. Moreover, much of that risk, even if insured, continues to be borne in Japan, rather than being spread effectively to foreign investors, so Japan is still alone in bearing the costs.

Before the disaster, Japan issued about $1.5 billion in earthquake-related catastrophe bonds as a risk management device: the debt is canceled if a precisely defined seismic event occurs. This design helped spread the earthquake risk from Japan to foreign investors, who could accept the risk and were enticed by higher expected yields.

Unfortunately, $1.5 billion is little better than what charity could do--and still only a drop in the bucket compared to the extent of the damage. Worse yet, even this triple disaster often did not fit the definition of the seismic event defined by the bond indentures. We need far more--and...

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