Winner's curse
When a risk of uncertain value is put out to competition, the business goes to whoever underestimated it most: winning is itself a sign of having been wrong.
The winner's curse describes a trap specific to auctions for an object whose value is common but uncertain. Each bidder estimates it with an error; even if those errors are zero on average, it is the most optimistic estimate that wins, so the winner has, on average, overpaid. Three oil industry engineers described it in 1971 in connection with offshore leases in the Gulf of Mexico, whose winners proved consistently disappointing. Underwriting is exposed to it in every tender: when several insurers price the same risk with imperfect models, the one who writes the line is the one whose price was lowest, often because its estimate was the most wrong. The remedy is to estimate better, and to adjust the estimate itself for the number of competitors and the uncertainty of the risk.
In 1971, E. C. Capen, R. V. Clapp and W. M. Campbell, engineers at Atlantic Richfield, published “Competitive Bidding in High-Risk Situations” in the Journal of Petroleum Technology. They showed that the more bidders there are for an uncertain lease, the more the winner must bid below its own estimate to avoid losing money on average.
Follow the research
One letter a week. First, the week's underwriting note, when one is published: a dated, argued decision, signed by Paul Bernardski. Then what the observatory published on cyber risk, political risk and insurance. No account, no tracking.
No spam, one-click unsubscribe, no data ever sold.