September 23, 2012


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!