Who is Insuring the Insurance and re-Insurance companies guess?
By Melvin J. Howard
The smaller government argument that's the theme some have chosen
to hold as their platform motto this year. Let me tell you why that’s hypocritical
and not really honest. If it were not for the government’s intervention in this
crises America would have never been the same. For that matter the global
financial market system would have vanished. In today’s climate risk transfer is not what
is use to be. Citizens pay taxes to ever expanding governments in return for a
variety of "safety nets" and state-sponsored insurance schemes. Taxes
can, therefore, be safely described as insurance premiums paid by the
citizenry. Firms extract from consumers a markup above their costs to
compensate them for their business risks.
Profits can be easily cast as the premiums a firm charges for the
risks it assumes on behalf of its customers - i.e., risk transfer charges.
Depositors charge banks and lenders charge borrowers interest, partly to
compensate for the hazards of lending - such as the default risk. Shareholders
expect above "normal" - that is, risk-free - returns on their
investments in stocks. These are supposed to offset trading liquidity, issuer
insolvency, and market volatility risks.
In his book, "When all Else Fails: Government as the Ultimate
Risk Manager", David Moss, an associate professor at Harvard Business
School, argues that the all-pervasiveness of modern governments is an outcome
of their unique ability to reallocate and manage risk. He analyzes hundreds of
examples - from bankruptcy law to income security, from flood mitigation to
national defence, and from consumer protection to deposit insurance. The
limited liability company shifted risk from shareholders to creditors. Product
liability laws shifted risk from consumers to producers.
Export and credit insurance schemes - such as the African Trade
Insurance Agency or the more veteran American OPIC (Overseas Private Investment
Corporation), the British ECGD, and the French COFACE - shift political risk
from buyers, project companies, and suppliers to governments. Risk transfer is
supposed to be the traditional business of insurers. But now with no other
alternative governments are in direct competition not only with insurance
companies - but also with the capital markets. Futures, forwards, and options
contracts are, in effect, straightforward insurance policies. Companies
collaborated with insurance firms - specialize in converting derivative
contracts (mainly credit default swaps) into insurance policies. Investors
assume risks by buying those contracts. Financial players first promoted the
risk-reducing role of derivatives. Banks, for instance, lend more - and more
easily - against hedged merchandise. Hedging and insurance used to be disparate
activities, which required specialized skills. Derivatives do not provide
perfect insurance due to non-eliminable residual risks (e.g., the "basis
risk" in futures contracts, or the definition of a default in a credit
derivative). But as banks and insurance companies merged so did their hedging
and insurance operations the result a big mess as your witnessing today!
You might ask yourself if the powers of government are indeed
commensurate with the scope of its risk transfer and reallocation services -
why should it encourage its competitions? The greater the variety of insurance
a state offers - the more it can tax. Why would it forgo such benefits? Isn't
it more rational to stifle the derivatives markets or at the very least
regulate it? This would be true only if we assume that the private sector is
both able and willing to insure all risks - and thus to fully substitute for
the state. With all the recent turmoil in the financial markets we now know
that can never happen at least in the foreseeable future.
Insurance companies cover mostly "pure risks" - loss
yielding situations and events. The financial markets cover mostly
"speculative risks" - transactions that can yield either losses or
profits. Both rely on the "law of large numbers" - that in a
sufficiently large population, every event has a finite and knowable
probability. None of them can or will insure tiny, exceptional populations
against unquantifiable risks. Now in is this market failure climate the rise of
state involvement is unavoidable. Consider the September 11 terrorist attacks
with their mammoth damage to property and unprecedented death toll. According
to "The Economist", in the wake of the atrocity, insurance companies
slashed their coverage to $50 million per airline per event. EU governments had
to step in and provide unlimited insurance for a month. The total damage, now
pegged at $70 billion - constitutes one quarter of the capitalization of the
entire global reinsurance market. Despite this public display of commitment to
the air transport industry, by January that year, no re-insurer agreed to
underwrite terror and war risks. The market came to a screeching halt. AIG was
the only one to offer to underwrite it maybe we shouldn’t be to harsh on AIG.
Then Allianz followed suit in Europe, but on condition that EU governments act
as insurers of last resort.
Even Warren Buffet and Kenneth Arrow - called on the Federal
government to step in. Some observers noted that the state guarantees full
settlement of policyholders' claims on insolvent insurance companies in the
various states. Federal programs already insure crop failures and floods. In
Israel, South Africa, and Spain, terrorism and war damages are indemnified by
the state. Germany also has similar state sponsored coverage.
Insurance companies in the face of stiff competition to dominate
or to re-establish themselves. Started insuring hundreds of billions of dollars
in pools of credit instruments, loans, corporate debt, and bonds -
quality-graded by third party rating agencies. Which now we know were flawed
with their rating criteria. Insurance companies became backdoor lenders through
specially-spun "monoline" subsidiaries. Collateralized debt
obligations - the predominant financial vehicle used to transfer risks from
banks to insurance firms - are "synthetic" and represent not real
loans but a crosscut of the issuing bank's assets. Here is where the problem
started unravel. Insurance companies started refusing to pay up on specific
credit derivatives - claiming not to have insured against a particular
insurance events.
This excursion of the insurance industry into the financial market
was long in the making. Though treated very differently by accountants they see
little distinction between an insurance policy and equity capital. Following
the 1987 crash on Wall Street - leading insurers and their clients started to
"self-insurer" through captives. Blurring the boundaries between
insurance and capital is most evident in Alternative Risk Transfer (ART)
financing. It is a hybrid between creative financial engineering and ad hoc
insurance. It often involves "captives" - insurance or reinsurance
firms owned by their insured clients and located in tax friendly climes such as
Bermuda, the Cayman Islands, Barbados, Ireland, and in the USA: Vermont, Colorado,
and Hawaii.
Risks, by its very nature, are - stochastic and catastrophic.
Finite insurance involves long term, fixed premium, contracts between a primary
insurer and his re-insurer. The contract also stipulates the maximum claim
within the life of the arrangement. Thus, both parties knew what to expect and
or anticipated. Yet, as the number of exotic assets increased, as financial
services converged, as the number of players the very concept of risk was under
attack. Value-at-Risk (VAR) computer models - used mainly by banks and hedge
funds in "dynamic hedging" the so called used by geniuses. Merely
computed correlations between predicted volatilities of the components of
investment portfolios. The witness collapse of Long Term Capital Management (LTCM)
hedge fund in 1998 is partly attributable to miscalculations of their computer
models. It is impossible to fully account for risk in an ever changing quantum
world full of hidden possibilities and probabilities. Governments often act as
reluctant lenders of last resort and provide safety nets in the event of a bank
collapse.
Ultimately, the state is the mother of all insurers, the supreme
underwriter. When markets fail, insurance firm recoil, and financial
instruments disappoint - the government is called in to pick up the pieces,
restore trust and order and, hopefully, retreat more gracefully than it was
forced to enter. But this time around the state would, do well to watch all
financial instruments: deposits, derivatives, contracts, loans, mortgages, and
all other deeds that are exchanged or traded, whether publicly (in an exchange)
or privately. Because the next time we have to ask Uncle Sam to bail us out he
may need to ask his cousin and his two ugly step sisters for help!
