On the price of insurance and the bull market in tail risk

From the people who bought you such wonderful ideas as CDOs, now comes the bull market in tail risk products. Deutsche are launching a long equity volatilty index, Citi has come up with a crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. The CBOE is planning a new index based on the skew in the S&P500.

In the past I've talked about the need for cheap insurance, and the benefits that this can bring to a portfolio in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand! You should really only want insurance when it is cheap, as this is the time when the no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset...a path to the permanent impairment of captial. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves the dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffet said holding cash is painful, but not as painful as doing something stupid!