Value-at-Risk (VAR) computer models - used mainly by banks and hedge
funds in "dynamic hedging" - merely compute correlations between
predicted volatilities of the components of an investment portfolio.
Non-financial companies, spurred on by legislation, emulate this
approach by constructing "risk portfolios" and keenly embarking on
"enterprise risk management (ERM)", replete with corporate risk
officers. Corporate risk models measure the effect that simultaneous
losses from different, unrelated, events would have on the well-being
of the firm.
Some risks and losses offset each others and are aptly termed "natural
hedges". Enron pioneered the use of such computer applications in the
late 1990's - to little gain it would seem. There is no reason why
insurance companies wouldn't insure such risk portfolios - rather than
one risk at a time. "Multi-line" or "multi-trigger" policies are a
first step in this direction.
But, as Frank Knight noted in his seminal "Risk, Uncertainty, and
Profit", volatility is wrongly - and widely - identified with risk.
Conversely, diversification and bundling have been as erroneously - and
as widely - regarded as the ultimate risk neutralizers.
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