A tale of two insurance/prediction markets

Chris Masse has the scoop (once again proving how indispensable he is) on a new real-money prediction market coming soon, one of the few with the CTFC’s blessing to operate in the United States: The American Civics Exchange. Their tag line focuses on the insurance angle: “Your greatest financial risks may be hiding in plain sight — market-based solutions for political risk management”.

Meanwhile, Carlos Saieh, a sharp student in Justin Wolfers’ class where I just gave a guest lecture, found an apparent pricing bug in another insurance-oriented prediction market, WeatherBill (proving how indispensable attentive students with laptops and wifi are):

WeatherBill pricing mistake

Let’s see: for a mere $770, you can purchase a contract that pays out at most $700 in the absolute best case, possibly much less. Hmm, let me think about that one.

Finally, a financial contract that makes mortgage-backed securities look good.

16 thoughts on “A tale of two insurance/prediction markets”

  1. Daniel: how can it not be? If the price isn’t capped at the max payout, it seems absurd at best, theft at worst: certainly not “insurance” in any meaningful sense.

  2. You are betting on a sure thing. What do you think the price should be? Do they not incur any expenses or transaction fees?

    Yes, it’s not really insurance, but perhaps the argument should be whether or not they should offer this contract at all, not the price. I believe they are simply trying to allow people to buy whatever they want. Maybe absurd, but at price = max payout they could be losing money.

  3. What’s interesting to me is that it may signal, there is a 10% premium above their calculated EV (Which may then be adjusted based on how much action they get.)

  4. Good point Daniel: stated that way it makes sense: this is a 10% “transaction fee” showing up in the price and an interesting way to infer their fee structure.

    According to the historical trends they listed (which unfortunately I don’t have captured), it was not a “sure thing”, although the contract was for dates in the immediate future where weather reports do come into play.

    So it seems they first compute a pessimistic EV and then add another 10%.

  5. Relatedly, on the other end of the spectrum, WeatherBill caps payouts at 25-1, which protects them against really unlikely events.

    Now, while they don’t let you bet on May snow in Las vegas, you can bet on similarly unlikely events such as ten inches of rain on a single May or June day in Las vegas. An event so improbable, no meaningful insurance might ever be feasible. If it rains ten inches in the desert tomorrow, I suspect “we” will have far greater problems than anything even a 25k-1 payout can protect against.

  6. Actually this is quite cheap for insurance. Paying out $700 in losses against $770 premium is a whopping 91% loss ratio. Compare this to auto insurance where the loss ratios are 65% give or take 15%. There are lost of expenses in offering insurance. Most auto insurers net -5% to 5% in underwriting profit. (There is also investment income on loss reserve accounts–the time-value of hold premiums till time of payout.)

    In this case, the buyer would be foolish to buy this insurance. If one has enough to buy the insurance against near certain loss, then one would do better to simply put the money in a deposit account and save it for a rainy day–or seven.

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