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Boo!

Boo!

One of my favourite blogs is the Money Illusion written by Scott Sumner. He’s risen to some prominence in the blogosphere because he’s giving a coherent, convincing narrative and counter-factual narrative of the crisis. Great stuff and highly recommended.

Except that he wants to destroy insurance companies.

Basically it seems that his point is that we need to avoid a nominal decline in GDP, even when real GDP growth is negative. I’m not an economist, so I won’t get into the macro here, but suffice it to say that he presents a very convincing argument. Tyler Cowen says this is the “best free lunch I’ve seen in years”. Yikes.

My comment is that because inflation is a transfer of wealth from creditors to debtors, insurance companies, the backstop of the world, get screwed. Massively. See here [warning, boring insurance press alert].

What’s one to think of this?

Well, I can think of a few consequences:

1. Insurance premiums go up, especially for long tail lines of business

2. Maybe we’re finally going to find that hard market.

3. There’s going to be no refuge, because Scott wants everyone to inflate simultaneously.

4. Maybe bank-insurance mega-conglomeration is the optimal strategy. The banks go mental and nearly bring the system down while old fogey insurance companies, being the last outpost of solvent capital, lose their shirts in the ensuing inflation. If they merge, at least nobody goes down.

(Giant Buzzer Sound)

ur doing it rong

Occasionally financial professionals really don’t understand insurance and it amuses me to point this out. Today, I will indulge myself on this piece. You don’t need to go much farther than the first line of the abstract for a head-scratcher:

We provide a model of the effects of catastrophic risk on real estate financing and prices and demonstrate that insurance market imperfections can restrict the supply of credit for catastrophe- susceptible properties.

Insurance market imperfections? Hmm… Let’s get back to that in a sec. First, my summary of the article: insurance markets don’t supply enough catastrophe cover, so banks don’t want to lend to businesses because they don’t want to bear the risk. There’s the usual GIGO about positive NPV projects being rejected by banks because they can’t get the cover. Well, obviously it’s positive NPV if you truncate the downside to not include it being wiped out by a natural disaster every few years. duh.

So, back to the insurance market ‘imperfections’. Turns out our intrepid academic didn’t figure this one out on his own, but cited a few papers that did the work for him. I’ve chosen two papers that seem to discuss this, first this (gated, sadly, so I’ve only read the outline), and this one. It appears that the authors conclude that there is an undersupply of insurance because the insurance industry can’t pay for 100% of losses and, puzzling over this fact, suggest that the problem lies in market power of reinsurers (price-gouging?) and inadequate supply of capital.

Think Swiss Re agrees?

Here’s the logic:

Insurers are overcharging, the evidence being that someone’s fancy little model says so and, lo, insurers don’t have 100% coverage (no margin at which customers are happy to run the risk?). Presumably this would lead to higher profits, but wait, capital markets don’t want to invest in insurance because all those excess uncorrelated excess returns are just so unwelcome.

Um, right.

The Money of Power (Generators)

blog_drawing_scam_artist

I’ve said it before: innovation is tough to come by in financial services. It’s all about research and producing more and better information. Usually what is called innovation is a shell game of repackaging data and finding suckers.

Why, for instance, would oil companies, these global conglomerates with gigantic operations and balance sheets to match, ever buy anything from a highly leveraged financial institution that they dwarf? They don’t even have the Florida government to shield their virgin eyes from the real market cost of insuring big expensive structures in an incredibly dangerous neighborhood.  So if they had any real need for insurance, they’d have to buy, right? But instead they’ve been starving the market of demand recently, after cleaning the insurers’ clocks a few times over the years (Katrina, Rita, Ivan, Ike, Gustav…).  Could it be that they’re just waiting for a sucker?

Enter Willis.

Artemis is right in that we don’t know of the details of this transaction. Maybe they’ve successfully reinvented the wheel. Maybe they’ve figured something out that none of the rest of us have. Maybe they found some suckers.

Location, Location, Location

follow the leader

follow the leader

Jolyjonpatten recently went to a seminar put on the by the lawyer that won the decision for the reinsurers in Wasa v Lexington.

Le jist? Well, Lex wrote a property policy for Alcoa, who got the Uncle Sam Smackdown for 40-odd years of polluting. Whew, at least we have insurance.  Obligingly, the courts decide that the insurers were all jointly and severally liable for decades of muck-raking. Lex waves around its fac policy.

Declined, natch.

To the courts.

The problem is that pesky ruling that Lex and its brethren are jointly liable for decades of wrongdoing, pitching the period clauses in their policies out the window, which, apparently, is cool in PA, but not in the UK. Final ruling? Reinsurers are off the hook because under UK law Lex wouldn’t be jointly liable. The interesting thing is that the fac policy is chock-a-block with follow the fortunes references, etc. Don’t matter, though. Jurisdictions matter. Ouch.

It’s a powerful reminder that capital regulations and tax law aren’t the only reasons to go jurisdiction shopping. Why don’t we think more about it, then? Well, my gut says that finance geeks and top-line cowboys are much more likely to hit the corner office than anyone who cuts his teeth on cathedral-like multi-generational insurance litigation.

You might honor the gods with that well argued case, but the shareholders that hired the underwriter who wrote that policy are gone. Long gone.

Science!

Scienceblogs has a nice review of a book called Unscientific America. Here’s the money quote:

Whereas good science is rewarded for being painstaking and nuanced, politics is the enemy of subtlety–political battles are fought in sound bites, decided in up or down votes. In this context, the politician often suspects that the scientist cannot see beyond his or her narrow specialty and spends too much time on minutia.

I actually think politics unfairly gets the monopoly on ridicule here. Or, at least, the behaviour of politicians is unfortunately all that is represented by the term “politics”.

Reinsurance professionals live in the awkward middle territory between ‘science’ (if actuarial analysis can be called such) and ‘commercial reality’. Sometimes the ‘science’ is right and sometimes it is wrong. Most times it is horribly, needlessly complicated and, perhaps tellingly, the people that ultimately make the decisions are not ‘scientists’ (though this is slowly changing).

Politics happens when you have the opportunity to exploit imperfect information. There’s a quote out there (Feynman? Einstein?) that goes: “if you can’t explain it to a 6-year-old, you don’t understand it”. Since 6-year-olds probably don’t understand much about actuarial pricing theory, I imagine there’s a pretty fair degree of error in it.

The message? Science can be overrated and, because of that, anyone with a view on something is a politician.

Are you Joking?

Good One

Good One

So there are a pile of earnings releases coming out now and there’s an interesting common theme: even though rate increases aren’t here yet, they’re just around the corner.

Yeah, right.

The only way rates go up in the P&C market is if something goes horribly wrong and capacity leaves the market. If you talk about hardening rates, you need to have a reason why they’re going to harden. What happens to make people suddenly actually NEED to charge more?

Something nasty has to happen out there. AIG going down would have done it. Didn’t happen. That’s the scale we’re talking about, though.

Rating Berkshire

 
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So Moody’s downgraded Berkshire a while back, which prompted this misunderstanding from Felix Salmon:

Reinsurers used to feel that they needed a triple-A rating because that connoted utter safety: you could reinsure your catastrophe risk with Berkshire safe in the knowledge that the risk of Berkshire being unable to meet its obligations was significantly lower than the risk of, say, a hurricane hitting New York.

Felix went on to add this bit:

Update: My commenters are saying that insurers don’t hedge their counterparty risk to reinsurers. Either you trust a reinsurer or you don’t; if you do, you don’t hedge counterparty risk, and if you don’t, you don’t do any business with them at all. Maybe insurance regulators should be looking into this.

Felix’s commenters are correct in that the rating is a difference of type rather than one of degree. Felix doesn’t like this for some reason, which is beyond me. The issue is twofold: first, policyholder claims are senior to credit claims (this is why insurer ratings are higher than debt ratings) and, two, insurers go into ‘runoff’, not insolvency, and start negotiating with the holders of their liabilities (policyholders, not bondholders). Policyholder obligations are immense compared with bondholder obligations and the consequences of negotiating down bondholders are probably far worse. Why bother when you have a bigger, easier target? Especially for reinsurance companies.

One of Felix’s commenters directs us to the awkwardly named BRAVE Partners, LLP, who have written a paper on protecting reinsurers credit risks with some product they claim gets arond the CDS issue.  They have two key terms in the agreement, it seems: 1. pre-agreed IBNR calculation methods; and, 2. claim triggered only if the name is “unable to pay”.

I’ll leave #1 alone, even though it’s basically a promise to go to arbitration, and skip to #2. How do you define “unable to pay”?  Obviously a company has enough cash in the bank to pay one counterparty’s claims. What about the IBNR on all the other counterparties? Do you apply your magic formula from #1 to all of the company’s liabilities? Will they let you audit their entire portfolio to make sure they can’t pay? Sorry, guys. Nice try, at least.

Back to Berkshire, who has now sold part of its stake in Moody’s. I wonder what the temporal ordering of these events were. Did BRK tell Moody’s they were going to drop their stake and Moody’s responded or is this a retaliation for the downgrade?

All sorts of hat tips to Felix.

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