There’s a funny story about Ric Flair: Flair was at the height of his career making millions of dollars every year, but he knew that the good times would someday end and that he had to invest his money for retirement. He decided that he would invest in a business he knew well, and what could be a better business than a gym. Wrestling is a body business, and during his world travels as a wrestler Flair had been to all sorts of gyms to keep his physique in top shape for his matches. He knew what he liked and knew what a gym needed, so he put his money into building a high-end luxury gym in the Bahamas, then he starting dropping the name of his new gym in his promos so his legions of fans would want to buy memberships there. It was all coming together, but tragedy struck when in its very first year of operation a hurricane hit the Bahamas and wiped out Flair’s gym. Flair was distraught, but his friend tried to comfort him saying “surely you haven’t lost everything, didn’t you have insurance?” Flair shot back “what do I look like, an idiot! Why would I ever pay for insurance!”

It’s a story I like because it speaks to the mindset of many professionals, most of whom can be experts in their own field but just don’t understand how finances work. It’s easy to throw your hands up and see financial markets as a tool by evil rich people to take our money, but it’s important to know that everything in finances is just a bet or a hedge usually made in good faith. When you insure your property, you’re reducing your downside risk by ensuring you get a payout if the property gets destroyed, but in turn you reduce your upside return because you’re forced to pay for the insurance for as long as you hold the policy. The insurance company meanwhile is increasing their downside risk because they have to pay you money if your property gets destroyed, but in turn they increase their upside return by forcing you to pay them money for the policy. The insurance policy can also be seen as a kind of bet: the person paying for insurance is betting that the value of the payout will be more than the amount they pay towards the policy, aka a hurricane is more likely to hit the property. The issuer of the insurance is betting the opposite, that the payout will be less than the amount paid towards insurance. It’s funny to realize, but buying hurricane insurance is sort of like a placing bet that your property will get hit by a hurricane.

But what if the insurance company wants to reduce its own risk? There are various tools and instruments an insurance company can use to hedge its risk, in the same way a gym owner can use insurance to hedge the risk to a gym, and they all work in much the same way: one party bets than an action will happen, one party bets that it won’t, and the money goes to whoever is correct. A whole bunch of insurance policies can be securitized into catastrophe bonds for example. Let’s say Ric Flair builds a second gym and this time he insures it, in that case the insurance company can sell catastrophe bonds based on his policy. Now let’s say I buy 100$ worth of catastrophe bonds based on Flair’s insurance policy: the bond has a lifetime of 3 years, so if after 3 years no hurricane has destroyed Flair’s gym then I am entitled to my 100$ back plus some extra money known as the “coupon.” If on the other hand a hurricane does destroy Flair’s gym, then I lose my 100$ investment because the insurance company takes it to pay back Ric Flair. By buying this catastrophe bond, I am participating in a bet in which I think a hurricane won’t destroy Flair’s gym, and I make money if my bet is correct.

Now remember that a catastrophe bond is a security, it’s like any other bond that I can sell on the open market. If I need money, I can sell my bond to someone else for a fair value, but the amount I can sell it for will change as it gains or loses value based on outside forces. Say for example that scientists publish a report saying that the upcoming hurricane season will be the most destructive in history, suddenly it looks more likely that Ric Flair’s gym will get destroyed, meaning my bond won’t pay back the money, meaning the price of my bond will go down because people think it’s a less good investment. The opposite could occur too, if the Bahamas institute some national policy which mitigates hurricane risks for all residents, then it becomes less likely that Flair’s gym will be destroyed and thus more likely that my bond will pay back the money, so the price of my bond will go up. And because the price of bonds can go up or down, you can go short or long on them essentially betting on their price movement which is in part determined by the underlying risk.

Now let’s add another twist: hurricanes aren’t the only thing you can insure against, what about terrorism?

Let’s paint a scenario in which Ric Flair insures his gym against terrorism instead of hurricanes. The insurance company securitizes his policy into a bond which someone buys, I then take a short position against that bond. My short position means I’m betting the price of the bond will go down, and why would it go down? It could go down in part because people think terrorism is more likely to happen and destroy Flair’s gym, and in the aftermath of large terrorism attacks many catastrophe bonds’ prices do go down as the markets become fearful of follow-up or copycat attacks. By shorting a catastrophe bond on Ric Flair’s terrorism insurance, I make money whenever terrorism happens.

This exact situation has been seen by some as a monstrous moral hazard because since I get paid when terrorism happens I have a financial incentive to support policies that make terrorism more likely. What those policies are I won’t speculate, but some have painted grim pictures in which hedge funds could secretly move money to support terrorists in order to scare the market and make bank on their investments. In the aftermath of the Financial Crash this even led some to propose banning securitized insurance altogether, because not only was it speculative and dangerous just like the credit-default-swaps that were blamed for the crisis, but it also came with an in-built hazard in that people were incentivized to ensure terrible events happened. I feel like this is a misunderstanding of financial markets: these markets tend towards completeness. What that means is that every angle of a financial transaction tends to have space for someone to make a bet, because if there’s no monetary incentive for the price to move in every possible way then there’s less of a mechanism for price discovery. If you can securitize a loan then you can securitize an insurance policy, and if you can short a stock you can short a bond, these are just ways for companies to hedge their risk and for the market to discover the correct price of something. And note that the person shorting a catastrophe bond isn’t the only one with a financial incentive for terrorism: Ric Flair himself would have a financial incentive since he gets an insurance payout if his gym gets destroyed by terrorism. We’ve had laws to investigate and prevent this kind of thing for hundreds of years with arson and other forms of insurance and if we think people are breaking those laws then we should investigate and prosecute them, not ban an entire financial market.