The Unholy Trinity: Fat Tails, Tail Dependence, and Micro-Correlations

Abstract

Recent events in the financial and insurance markets, as well as the looming challenges of a globally changing climate point to the need to re-think the ways in which we measure and manage catastrophic and dependent risks. Management can only be as good as our measurement tools. To that end, this paper outlines detection, measurement, and analysis strategies for fat-tailed risks, tail dependent risks, and risks characterized by micro-correlations. A simple model of insurance demand and supply is used to illustrate the difficulties in insuring risks characterized by these phenomena. Policy implications are discussed.

Keywords: risk, fat tails, tail dependence, micro-correlations, insurance, natural disasters

JEL Classification: Q54, G22, C02