The Law of One Price holds that if two investments are identical in terms of risk and reward, they will trade at the same price. If they don’t, two pricing dynamics appear, which re-establish natural order: arbitrage and demand. Those dynamics restore one price. But do they apply to insurance?
First, let’s explore those dynamics.
The first: arbitrage
If two identical investments trade at different prices, the first result is arbitrage, which is the practice of taking advantage of a price difference. Let’s say the same asset sells as Investment A and as Investment B, but Investment B is cheaper. I can buy Investment B at its current price and then sell it at the price of Investment A. I’ve just made a profit with no risk and minimal effort.
The second: Demand
The easy money yielded by arbitrage triggers the second pricing dynamic, demand. Because Investment B is a better value and because some buyers will recognize the arbitrage potential, more buyers will want Investment B. As demand rises for Investment B, the price increases. Likewise, as demand falls for Investment A, its price will drop. Eventually, the prices for Investments A and B will meet, and the Law of One Price will prevail.
This increase in demand is why arbitrage opportunities are rare in the stock market: If an investment is priced too low, demand surges and the efficient market quickly eliminates the price difference. But is that true of insurance?
The Law of One Price assumes that assets are easily traded. In your experience, would you say insurance is easily traded?
The risk transfer market is not liquid, and these opportunities are not obvious. Because they are so difficult to see, the second pricing dynamic, demand, does not follow. Demand does not increase quickly, and market corrections are slow.
The upside of risk transfer market complexity is that arbitrage opportunities don’t disappear quickly. They’re not all that rare; rather, they’re just hidden. When we apply the language and techniques of finance and treat insurable risks as a portfolio, we reveal these hidden opportunities. You can break the Law of One Price and reap the profits.
Lisa Lipuma is a Director with Willis Towers Watson Risk and Analytics.