The Limits of Securitization on a Hot, Flat Planet1 Micro-correlations, Fat Tails and Tail Dependence

Aggregation is a key feature of traditional risk management strategies. Financial institutions securitize assets and property insurers hold bundles of policies across many lines of business. With independent assets and risks with thin tails, the law of large numbers (LLN) and the central limit theorem (CLT) assure risk benefits from aggregation: the standard deviation of the sum increases slower than the mean of the sum and the tails of the aggregation become normal, that is, thin-tailed. These benefits are the foundation of much of the banking and insurance industry. Recent events, from Hurricane Katrina in 2005 to the financial crisis of 2008, however, demonstrate that assumptions of independence and thin tails are no longer warranted in a world that is, in the words of Thomas Friedman, “hot, flat, and crowded.” Both globalization and climate change are linking previously independent systems and are altering the frequency and/or the magnitude of extreme events.