Category / Insurance and Actuarial Practice

Practising Stalinism and the Regulatory Paradigm March 16, 2014 at 6:17 pm

No, this isn’t a ‘call it Stalinist when you want to trash it’ post. Rather, it’s about thoughts stimulated by reading Sheila Fitzpatrick’s review of J. Arch Getty’s Practising Stalinism: Bolsheviks, Boyars and the Persistence of Tradition in the LRB.

Fitzpatrick gives us an insight into Getty’s view of how Russians in the 70s and 80s

organised their lives, using personal contacts to get things done, enmeshed in a network of reciprocal favours, contemptuous of state bureaucracy and skilled at evading its demands

That description reminded me of Italy a decade later, by the way. It suggests a state that

was nothing more than a mirage, and ‘official institutions … just collections of people whose public façade was better than most at convincing people to obey them’. Observing his friends, [Getty] concluded that ‘few people trusted or even believed in institutions; they believed in people. Everything was personal … Was the modern [Russian] state, as in Pierre Bourdieu’s suspicion, creating itself through my reading of it?’

One could suggest that there is a spectrum ranging from states where governmental (Federal) power is, predominantly, obeyed (Switzerland, the UK, perhaps much of the US?) to ones were it is systematically evaded (Italy, Russia). Note that issue here isn’t subsidiarity – a lot of power is held at the Cantonal level in Switzerland, and at the State and local level in the US – but rather what happens when the Federal (for want of a better word) government tries to do something: are they obeyed?

A number of legal theorists and political scientists are starting to view regulatory structures using the same tools they use to analyze states, prominently Julia Black at LSE and Kevin Young now at Amherst. (See also Meredith Wilf at Princeton.) One of the things these folks point out is that a totalizing narrative of regulatory power does not explain the facts: things are not just agreed by the powerful then passed down and implemented, but instead power is contested and polycentric. Policy may be agreed internationally, but it is always subject to renegotiation, diverse implementation, and interaction with the facts on the ground. Financial regulation, then, is not completely at the ‘obey’ end of the spectrum.

A particularly interesting example of this is US insurance regulation. Before the crisis, insurance in the US was state regulated, with each state having an insurance commissioner: these commissioners then collaborate through the National Association of Insurance Commissioners. The Dodd-Frank Act mandated the creation of the Federal Insurance Office to review the actions of the commissioners rather than replace them.

Needless to say there is a good deal of friction between the state commissioners and the FIO: a recent article in Risk outlining the views of Thomas Leonardi, head insurance regulator for Connecticut, is a good example. To say that Leonardi is not enamored of Federal intervention in insurance regulation is, perhaps, to under-state the case.

For these purposes at least I don’t want to take a position on whether the FIO is right or not. What’s interesting, rather, is how contested its authority is. Yes, Dodd Frank says that it has certain powers and responsibilities. No, it is not being allowed to exercise them without considerable push-back, not just from the regulated, but other regulators. Indeed, the latter seem rather more vocal than the former. It’s very much, for the moment anyway, at the Russian end of the spectrum.

One final thought. The Bourdieu point is important. As he said with the characteristic lucidity of the twentieth century French philosopher:

Official language, particularly the system of concepts by means of which the members of a given group provide themselves with a representation of their social relations … sanctions and imposes what it states, tacitly laying down the dividing line between the thinkable and the unthinkable, thereby contributing towards the maintenance of the symbolic order from which it draws its authority.

Think of that the next time you start to read the text of a new regulation…

Nothing to see here, move right along February 6, 2014 at 9:40 pm

Dear me, can’t a billionaire write a bunch of long-dated exotic derivatives without those pesky kids sticking their noses in? Warren is getting a rough ride from Dan McCrum repeatedly, and today from Matt Levine, and he doesn’t quite deserve it. Here’s why.

  • First, level three assets are not necessarily toxic. They can just be hard to value precisely. Even if Warren had just sold 20 year plain vanilla equity index puts, they would be level three, as there is no ready market in twenty year implied vol (although you can make a pretty decent guess from where the ten year is).
  • Warren is naked short. Black Scholes and related approaches are valuation techniques which work if you are hedging (and you can indeed replicate the derivative by following your model’s hedge ratios). There is actually quite a good theoretical argument (if not an accounting standards one) for him not to mark to market – an argument that would be more convincing if he has written an insurance policy that is then transformed into a derivative via an SPV. We don’t know that he hasn’t done this. But we do know for sure that Warren’s strategy is to write insurance and invest the premiums. As long as he collects enough premium and his risks are diversified, he’s happy: for him, at least at 50,000 feet, the business model is all about collecting premiums and investing them. Writing long-dated puts is a good way to raise cash – as long as you don’t have to post collateral (which Warren didn’t).
  • Even if he has written a worst-of put, this was not a particularly exotic derivative in 2006-7. Back then people were playing with a whole range of basket options (see for instance the mountain range trades originated by Soc Gen’s traders and rapidly taken up by the rest of the street). While these trade types might not be in options 101, they haven’t been cutting edge for twenty years.
  • One of the hard things about running an equity derivatives book is getting enough long-dated vega. No one wants to sell it; everyone wants to buy it.
  • So the reason there was a trade is the age-old two people wanting different things. Warren wanted cash, and saw the premium as good compensation for the insurance he was writing. His counterparties saw cheap vega that was hard to buy any other way, and a good credit. Two well informed parties with different takes on the world trading with each other is not, I am afraid, a scandal.

Pricing far out of the money derivatives in the P measure January 24, 2014 at 12:03 pm

OK, not the most attractive title in the world I know but bear with me.

Most derivatives are priced in the Q, or risk neutral measure. This is the right thing to do when you are willing and able to hedge. Essentially in the Q measure the cost of a derivative is identified with the price, according to your theory, of hedging it.

You can’t do that sometimes, often because the necessary hedge instruments are not available. This is one practical distinction between derivatives and insurance: derivatives are hedgeable, insurance isn’t. Therefore you shouldn’t price insurance in the Q measure: instead you care about the real world (as opposed to the risk neutral) distribution of outcomes.

This is important when we think about things like Warren Buffett’s basketball trade. Buffett has written insurance (not a derivative*) to protect Quicken Loans against the risk that someone will correctly predict the winner of every game in the National Collegiate Athletic Association’s men’s basketball tournament – something Quicken has offered a billion dollars for.

This is actually an interesting thing to price. If you view the tournament as IID coin tosses, then of course the insurance is worth nothing. But of course it isn’t, partly because some teams are better than others, and partly because there will be entrants to the competition with private information. It isn’t much of an edge to know that a star player is off form, but excluding a favourite team skews the distribution for very unlikely outcomes, especially if you let insiders collude by assuming, say, that someone knows the outcome of every game involving, say, ten specific teams. Moreover, you don’t just need enough premium for this insurance to pay for the expected loss; you also need enough to pay for your cost of capital supporting unexpected loss, which will be a lot as the distribution is very fat tailed. Add in the cost of actually doing all this analysis, and pretty quickly you get to a multi-million dollar premium. Indeed, something I call (after a long-retired trader) Stavros’ law probably applies: never sell any put for less than a cent of premium, no matter what the model says it is worth.

*Don’t get me started, though, on the hypocrisy of Buffett’s public statements about derivatives vs. what Berkshire actually does.

A sign that US insurance regulation needs to change September 16, 2013 at 7:30 am

The captive reinsurer problem is kicking up, thanks mostly to Benjamin Lawsky, NY state insurance commissioner. Lawsky is withdrawing from the new National framework on captives, saying that it did not work and was, in fact, making the “gamesmanship and abuses” in the industry even worse.

Now, I haven’t studied this issue in detail, but Metlife’s comment that captives are a

“cost-effective way of addressing overly conservative reserving requirements… Alternative means of financing such reserves have drawbacks. Using equity could reduce returns to levels below those required by investors”

does not read well. When a regulated firm is focussed on ‘the returns required by investors’ rather than a safe level of capital for its risks, one might reasonably infer the wrong attitude to capitalisation. If nothing else, Lawsky’s crusade against shadow insurance should provide good spectator sport.

Shadow insurance June 14, 2013 at 7:29 pm

Matt Levine at Dealbreaker points us to a ‘big angry report‘ (his words) on captive reinsurance, by Benjamin Lawsky and his New York State Department of Financial Services. Matt’s certainly right that Ben has a bone to pick, given the ‘at least $48B’ of ‘shadow’ transactions apparently done. But when you look a little more closely, the shadow lifts a little. You see, these trades are only possible because US insurance regulation is, well, easily arbitraged. It’s the same with any regulatory arb – you can’t arb regulations that always treat the same risk the same way. US insurance regulation doesn’t, so you can wave your magic wand and turn primary risk into qualifying reinsurance, and *poof some of the capital has gone. The fact that as Lawsky points out, the reinsurer might well be owned and guaranteed by the insurer’s parent is a rather large hole in the regulatory framework.

I’ll be gone from DEM for a little while, hopefully sunning myself. Have fun while I’m away, gentle reader.

Just deserts only in Utopia February 12, 2013 at 10:48 pm

One of the key messages of this blog in its early years was ‘actuaries have escaped a big dollop of blame for our financial mess that is rightfully theirs’, the argument being in very short form that without their utterly unjustified assumptions about investment growth and life expectancy we would not have nearly as big a pensions crisis as we do.

I’m currently watching the last episode of Utopia. (Spoilers.) One of the things that this series posits is a cabal trying to return Earth to a much smaller population. Apart from making me cheer for the baddies (I’m a child of the Limits to Growth generation), it also made me wonder what the consequences of another bad actuarial design decision – current pensions funded by increasing numbers of workers – will be. We have already seen the beginning of this crisis in muniland, and it is going to get rather worse. The baddies in Utopia are meeting increasingly ugly ends: while I wouldn’t wish any of them on the average actuary, I do rather think that some measure of accountability for their past deeds would not be entirely unwarranted. That’s just Utopian, right?

Three links August 8, 2012 at 9:21 am

I’m a little busy trying to finish something, so here are three terse items from my ‘read, and want to blog about’ list for the week so far:

  • A truly shocking article on The Big Picture about the effective tax rates of the most profitable US companies. I really don’t think this state of affairs can continue: people will not tolerate it.
  • An insightful letter by John Hutton in the FT about the EU proposal to extend Solvency II type regulation to pensions schemes. The key point:

    The immediate impact … would be a significant but arbitrary increase in pension scheme liabilities. If these proposals go ahead, funded pension schemes will undoubtedly have to adopt higher funding levels and shorter periods over which they have to make up any deficits… If schemes are forced to adopt ultra-cautious funding models, they will need to disinvest from equities, which would be highly damaging for European financial markets… None of this will offer meaningful protection to fund members – on the contrary, it will undermine the very existence of the remaining defined benefit schemes.

  • A typically over-stated Felix Salmon column that nevertheless makes one good point. He discusses the rise of collateralized funding arrangements such as repo and the decline of the interbank market. This is a bad thing:

    If we’re talking about the banking system, here, we’re talking about a world in which banks simply cease to trust each other at all, and the answer to all interbank credit [extension] questions is “no”. The only way for banks to lend to each other is to either go through some central counterparty, hub-and-spoke style, or else to retreat to the world of repo, where banking prowess counts for nothing and all that matters is collateral quality.

    Clearly a fundamental job of banks is to lend, including to each other: to make credit judgements and to put money on the line based on those. We need to find a way to restore bank confidence in each other (not least because smaller amounts of unsecured debt in a bank’s capital structure gives less of a cushion protecting depositors in resolution).

Accounting for credit risk before the crisis – a case of a gateway drug? April 20, 2012 at 8:48 pm

(Crossposted from FT Alphaville.)

“The question is,” said Alice, “whether you can make words mean so many different things.”

In a recent Alphaville post, I made the claim that if the monolines had been required to mark the credit risk that they had taken to market, they would not have played such a prominent role in the financial crisis. Here I want to provide some support for that claim.

There will be several threads to this narrative. We begin with credit spreads.

What’s in a credit spread?

A credit spread is the compensation the taker of credit risk receives for risk. It is well-known that this includes more than just compensation for default risk. Citi research, for instance, produced this illustration recently, showing the default and non-default components of generic BBB credit spreads over time:

Components of the credit spread

They use the term ‘risk premium’ for the non-default component: in reality this component is a mix of compensation for liquidity risk, funding risk, and other factors.

Notice how this non-default component varies over time. What this means is that a holder of credit risk who is marking to market suffers some P&L volatility that is unrelated to default risk (as well as some that is).

The consequences of marking credit to market

If you have to mark a credit risk position to market, then:

  • You have to fund losses caused by credit spread volatility;
  • You have to support the risk of credit spread volatility with some equity; and
  • The risk of the position includes the risk of movements in the non-default component in the credit spread.

A non-mark-to-market holder of the same risk does not have these issues. Depending on their precise accounting standard they may have earnings volatility resulting from changes in perceptions of default, but they won’t have volatility resulting from non-default factors, and thus they don’t need as much equity to support the same position. The need for less equity means that a non-MTM credit risk taker will require a lower return than one who has to mark-to-market.

The history of historic cost

Long ago, the existence of multiple ways of accounting for financial instruments made sense. There were liquid (or at least semi-liquid) securities, and these were marked; there were totally illiquid loans, and these were accounted for based on historic cost (with a reserve being taken if the loan was judged to be impaired). Banks had a buy-and-hold strategy in the loan book, so recognising P&L on an historic cost basis made sense, while marking to market was natural for the flow-based trading book. Insurance companies had approaches* that were similar to historic cost: essentially they recognised premiums as they were paid, and reserved for claims that had been incurred but not yet presented.

Over the 1990s, these boundaries became blurred. Credit default swaps and securitisation liquidified banking book credit risk, and some institutions adopted originate-to-distribute strategies, while others were able to take credit risk in unfunded form by writing credit protection.

This meant that an arbitrage became available whereby the same risk could be taken by both mark-to-market players (by buying a trading book security) and non-MTM players (by writing credit protection which did not have to be marked or making a loan).

So how exactly did you take unfunded credit risk without having to mark it?

Several methods were developed to allow insurance companies to take unfunded credit risk without having to mark it to market.

  • In the transformer approach, the insurance company would write a contract of insurance to a SPV which then wrote a CDS. Provided that neither the insurer nor the CDS buyer consolidated the SPV, this provided a compound contract that at one end looked like and was accounted for as insurance, and at the other end looked like and was accounted for as a credit default swap.
  • In the wrap approach, the insurance company provided a financial guarantee contract on a bond. If the guarantor was AAA-rated (which the large monolines were pre-crisis), this essentially split the bond into a funding component provided by the buyer of the wrapped bond and a risk component, provided by the insurer.

Insurance companies took credit risk in other ways, too, of course, including some mark-to-market ones; we will come back to this shortly.

Why was taking credit risk in unfunded non-MTM form attractive to some insurers?

The insurance business model is, roughly: take risk by writing insurance, receive premiums, invest the premiums, and pay claims when presented. It works well when the value of invested premiums is larger than that of the presented claims. Given this model, some insurers found credit risk attractive: due to the non-default components of the credit spread, it seemed as if they could get paid more to take credit risk than defaults would cost them, and the structuring technology described above allowed them to do this without having to worry about intermediate earnings volatility caused by having to mark to market. The only question in this business model was ‘do you expect ultimate default losses to bigger or smaller than the value of invested premiums?’

Insurance risk models vary significantly from firm to firm, but what they share is a desire to estimate the capital required to support the risk of unexpectedly large claims. In other words, they assumed that the key risk was the risk of bigger-than-expected claims; something that is perfectly reasonable given the insurance accounting model.

Credit risk taking, then, was potentially attractive to insurers for three reasons:

  • It could be made to look like a business model they were familiar with (take premiums, invest them, pay claims);
  • It could be accounted for as insurance; and
  • The capital required to support some forms of credit risk taking, such as writing protection on asset backed securities, was rather small according to their models.

Was insurance accounting a gateway drug?

It is certainly not that case that most credit risk taken by insurers pre-crisis was non-MTM. AIG, for instance, used fair value accounting on most of the contracts it wrote. However I believe that the availability of the non-MTM model in the early 2000s acted as a kind of ‘gateway drug’, getting some insurers into credit risk taking. Without it, the capital required to support credit risk taking would have been higher, and thus the business would have seemed less attractive. Moreover, the earnings volatility potentially created by having to mark to market** would have at least have given pause for thought at a much earlier stage.

To be fair to insurance accounting standards setters, it is hard to see what they could have done differently. Financial guarantee accounting makes some kind of sense where the guarantor is writing a wrap on an entire municipal bond, and there are no reasonable proxies available. The transformer structure, where a transaction is accounted for as insurance at one end and marked to market as CDS at the other, is less defensible. Arguably, though, the transformer SPV is a major part of the issue, and the rules governing when such things are consolidated have been tightened up (as have the details of financial guarantee accounting). One does wonder, though, what the relevant supervisors had in mind given their evident comfort with the types of practice described here.

Conservation of P&L volatility

Many laws in physics say that in any interaction, some property such as momentum or charge is conserved: the total amount of it in the system remains the same. In a certain sense, moving credit risk from an MTM to a non-MTM player violates conservation of risk. A non-MTM party sees less risk in the deal than an MTM party as the volatility of the non-default-related component of the spread has disappeared. Early 2000s structures such as the one we have described facilitated this, and thus allowed the non-default component of the spread to be monetized.

The introduction of CVA made this situation somewhat better. Non-MTM parties do not get the full benefit of their accounting if they have to post collateral based on the mark of the position – at very least they have to fund the collateral, and that is a drain on their liquidity. So many of monoline trades were done without collateral agreements. This in turn meant that once CVA charges were imposed, some of the volatility of the non-default component of the credit spread reappeared as CVA volatility. This risk hadn’t disappeared after all. Perhaps that is the real lesson: if your trade seems to make risk disappear, there’s something wrong with it.

*Obviously a one sentence account glosses over many complexities and jurisdictional differences.

**Of course, being able to use a model to mark means that much of this volatility can be avoided, at least while the asset credit protection has been written on is not obviously impaired.

Pensions and the deficit September 27, 2010 at 1:28 pm

I didn’t catch this, but Jonathan Hopkin did. Julie Finch has the original suggestion in the Observer. Hopkin comments on her article

high earners in Britain receive enormous tax relief on their private pensions, estimated by Richard Murphy to be worth £38 billion per year, about a quarter of the deficit. [Julie] suggests that ‘we should maintain the subsidy, but only if the recipients divert at least a proportion of their funds into infrastructure investments and local authority bonds’.

Sounds good to me. In fact, why stop at that? The subsidy could be tied to the purchase of Treasury bonds at rates close to the rate of inflation. After all, the deficit is at least in part the consequence of saving the value of private investments through state intervention. Financing government borrowing at a reasonable rate seems a fair contribution from those who have benefited so much. This would remove fears of a spike in bond prices, allowing us to plan for an orderly reduction of the deficit over a longer period of time.

Absolutely. This would also have the side effect of reducing asset price bubbles and the inevitable clamour when pensioners lose money on (highly risky) equity investments. How about a requirement to invest a minimum of half of your pension in long-dated linkers?

The future of public debt February 24, 2010 at 12:39 am

A recent paper by Cecchetti et al. The Future of Public Debt has been widely noticed: see for instance here for Ritholtz or here for the Econgrapher. The paper is certainly thought provoking. In particular, it points out that the time bomb of ageing populations is not confined to Japan:

The current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending. Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts. Added to population ageing is the problem posed by rising health care costs.

Aging Populations

An ageing population who have been promised a lot combined with slower growth and hence less tax income gives a problem. A big problem in some countries, as these promises are simply unaffordable:

Projected interest on debt

What can we conclude? The authors are clear:

fiscal problems facing industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis on fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population

Clearly first world governments are not going to let interest service payments get to 10% of GDP without a struggle. That means some of (perhaps all of) reduced pensions and health care, lower public spending, and increased taxation. Reducing the real value of liabilities makes sense too, so expect somewhat higher inflation eventually – but not for a while. Intergenerational wealth transfer is going to become a key political issue in the developed economies, too. There are interesting times ahead…

Credit derivatives and insurance October 27, 2009 at 6:27 am

The standard argument that credit derivatives are not insurance runs in brief:

  • They require no insurable interest;

  • They require no proof of loss; and in particular
  • The payout is independent of the counterparty

All of this is standard, and goes back to an opinion of Robin Potts. Now, with ill-advised US action to regulate some credit derivatives activity as if it were insurance deferred, there is a new and more comprehensive account of the issues from M. Todd Henderson.

Henderson does a reasonable job, although the case seems a little over-argued to me. In particular, credit derivatives product companies (CDPCs) are much like insurers in financial substance – as was the Financial Products Group of AIG. So arguing from the perspective of the need to regulate insurers not applying to companies engaging in CDS may involve ground that is not firm. Where Henderson is good, though, is pointing out where risk shifting and pooling contracts in other spheres do not constitute insurance. For instance, if I set up a company to sell naked puts to commodities producers, and invest the premium, then I am acting as a pooling and risk shifting enterprise, but not an insurance company. The paper is worth a read if you have an interest in these matters even if it does seem to me a little propagandist.

Update. It is worth pointing out that the ‘insurance’ vs. ‘not insurance’ question is about more than regulation. It also affects accounting – insurers have their own accounting framework which is rather like accrual – and taxation. Given that much of the need to regulate CDS relates to counterparty credit risk, it seems that a much more cost effective fix to the vulnerabilities revealed by AIG is simply to do what we are doing anyway – set up a central clearing and market data reporting entity. Add in a reclassification of financial insurance as a derivative, enforce fair value requirements, and prudent capital requirements, and you would have a reasonably robust regulatory framework without the need to get insurance regulators involved.

Monoline Death Watch August 11, 2009 at 7:42 pm

Felix Salmon discusses some recent JPM research on MBIA:

in a note issued this morning they said that MBIA’s tangible book value is actually negative, to the tune of about -$40 per share.

OK, the full article has some caveats. But the mere fact that a reputable investment bank (if that is not an oxymoron) can suggest that MBIA is insolvent should raise some warning signs about the extended historical fiction that is insurance accounting.

Monoline death watch, day 1000 May 14, 2009 at 6:39 am

(The fate of the monolines was sealed by the risk they wrote in 2005-2007, so day 1000 is if anything conservative – it takes insurers a long time to die thanks to their accounting and the pay as you go nature of the claims against them.)

In a move so predictable it hardly raises a yawn, Bank of America, Citigroup, JPMorgan and 15 other large financial institutions filed suit on Wednesday against MBIA, claiming the bond insurer reduced its ability to pay policyholders by splitting its business in two.

It is difficult to think of how a monoline could split without generating lawsuits. If x of capital and y of investments support z of risk, and you split z into to pieces, how do you divide x and y? There is not widely agreed answer, so someone is going to think that the credit quality of the piece they end up with a claim against is lower that it should be – and they will sue. Moreover since there are clearly diversification benefits between risks, even if the split is entirely fair, the capital needed for the two pieces is larger than that for the original whole.

The lesson? Agree collateral upfront, based on your marks.

Finite reinsurance: a strange and sometimes manipulative thing April 5, 2009 at 8:08 am

Thanks to AIG, the weird and wonderful world of finite reinsurance has come under broader scrutiny recently. (You may recall that a finite reinsurance policy between AIG and Gen Re was the method used to inflate AIG’s earnings in the case that came to the courts in 2008.)

Now, thanks to the Big Picture, further amusing documents have achieved more general publication. I don’t agree with much of the thrust of the post – which frankly contains altogether too much credit derivatives related hysteria. But the extra light on finite reinsurance is welcome.

When is finite reinsurance a valid business tool, and when does it verge on fraud? This is difficult to answer because finite reinsurance is a very sophisticated tool that can be used in myriad ways. But let me illustrate a good and a bad situation.

Good finite reinsurance. Suppose a company has a liability with a known size but uncertain timing. Asbestos-related claims are a commonly cited example: the firms knows it will have to pay workers for past exposure to asbestos, and it can estimate the size of those claims reasonably well, but it does not know when the claims will be presented as the sickness has a long and uncertain gestation period. The uncertainy thus created weighs on the share price, even though the company has every intention of paying and the resources to do so. Therefore it purchases a finite reinsurance policy whereby it pays a premium equal to (roughly) the present value of the expected claims to a large, well capitalised reinsurer. The reinsurer takes two risks: one small (that the claims will be larger than expected: this is unlikely as typically the risks insured under finite schemes have rather little uncertainty in claims); and one larger (that the claims will be presented earlier than expected, and hence the invested premium will not have grown sufficiently for them to make a profit). From this we see that finite schemes are often about transferring timing or investment risk rather than the risk of uncertainty in claims.

Bad finite reinsurance. Consider the effect of the scheme above though. Before the reinsurance, the firm had a known hit to earnings in the future but with uncertain timing. Afterwards, it has a stream of expenses – the premium payment or payments on the policy – but no uncertainty. Earnings have been smoothed. Clearly we can extend that effect more broadly via policies which pay out money in the future for an appearance of risk reduction today (buying surplus for an insurer, i.e. flattering their capital position) but where all of the risk comes back in later years, or via policies which move current profits into later years, smoothing earnings. Accounting rules do not permit you to arbitrarily reserve whatever amount of current earnings you like against some future risk, especially a very unlikely and hard to quantify one, but finite reinsurance policies achieve the same effect.

Finite reinsurance can therefore be used, quasi-legally, to manipulate earnings for many companies. It can also be used to manipulate insurance companies’ capital position. If ever there was an area of finance crying out for better regulation, I’d say it was insurance.

AIG – Where did the money go? March 16, 2009 at 6:51 pm

AIG FP related uses

(HT The Big Picture.)

What is interesting about this is the GIAs. I _think_ that these are GICs, i.e. guarantees of minimum investment returns, sometimes on variable balances. Obviously as rates have fallen, GICs have become more valuable to the holder and riskier to the writer. Insurers have conspicuously underpriced the implied puts in GICs for years, and now it seems that for AIG these have come home to roost.

Actuaries and other scams January 29, 2009 at 6:38 am

I think that someone tried to scam me yesterday. I had gone out for a pint of milk, around 8 in the evening, when a man came up to me. At first glance he seemed well dressed – although the suit wasn’t hand-made and the tie wasn’t silk – and he had a sob story. His wallet had been stolen. He had no money. Could I lend him a tenner to get the train home? Sadly he rather ruined the spiel by clutching a mobile phone, with which he could have presumably have called a friend or work-mate. And the script was rather similar to one I have heard several times before. But what completely ruined it for me was that he claimed to be an actuary. He even showed me his business card, presumably in an attempt to establish his credentials as a trustworthy person. Now, dear reader, if you know what I think of actuaries, you will know that this back-fired.

What happened next? Well, I didn’t steal his mobile. Although I was tempted. But he didn’t get the cash. So the lesson, scam artists of E1, is when you are trying a con, pick a profession that your interlocutor doesn’t think is fundamentally mis-guided.

MTM December 19, 2008 at 1:31 pm

MTM means for course `mark to me’. It appears that AIG has determined the most reliable source of fair values for some transactions is — itself. Think of a number. Wow, the number I just thought of was … the number I was thinking of. I must be right.

I exaggerate of course. Let Bloomberg take up the story:

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe…
[These swaps] are different because they didn’t insure against losses… they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps.

[AIG has] unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial-products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis [AIG risk officer] said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

There is more to trouble an AIG investor, European bank regulators, the SEC, the FED, and AIG’s auditors in this, if it’s true, than you can shake a stick. Here are a few of the issues.

Firstly you would have thought that the Gen Re case had taught AIG that doing transaction purely for regulatory manipulation without risk transfer is a bad idea.

Secondly, what do European bank regulators think of this? (I’ll leave Basel 2 being described as an accounting standard as a signal that this new item may not be entirely reliable. And while we are asking questions, where exactly in Europe hasn’t Basel 2 been implemented yet? And what is a default swap that does not transfer losses, and how exactly does it qualify for capital relief?)

Thirdly, if both the transaction and AIG’s accounting for it are correctly described, why on earth do their auditors, PWC I think, let them get away with this? Hasn’t AIG had enough auditing issues at AIG FP already?

Fourthly does the FED really want an almost 80% state owned company doing this kind of transaction? And accounting for it this way?

The humbling of the actuaries, part 357,121 December 6, 2008 at 10:03 am

Bloomberg has a nice article on one of my favourite pieces of actuarial insanity, guaranteed annuity contracts. The basic story is that life insurance companies wrote long-dated equity index and basket puts in size and didn’t price them properly, because their actuaries didn’t understand derivatives. With the recent market falls, they are beginning to see just quite how stupid an idea this was.

It’s ending in tears. In September, the insurance raters A.M. Best and Fitch moved the life-insurance industry into its negative-outlook column. In October, Moody’s, and Standard & Poor’s did the same. A.M. Best has downgraded 30 life and annuity companies so far this year.

Of course, because all of this is in an insurance wrapper, there is no requirement to mark to market, so investors cannot see the size of the problem.

In the meantime, the industry is proposing to handle its problems the good, old-fashioned, American way: by putting lipstick on its books.

As the value of GMWB [guaranteed minimum withdrawal benefit] annuities tumbles, the carriers are required to raise the reserves they hold against these products, as a way of assuring that consumers will be paid. Raising reserves, however, could starve their working capital at a time when they’re also writing down toxic mortgage assets. The companies say they’re already holding plenty of reserves, so they’re asking the states, which regulate the industry, to loosen the rules.

Astonishingly, some of the state regulators seem sympathetic:

The National Association of Insurance Commissioners will discuss the proposed changes this month. Iowa insurance Commissioner Susan Voss calls some of the reserves “redundant” and suggests that NAIC will go along.

Short now, short in size. It is a very cheap way to get protection on an extended period of low equity markets.

Accounting for Warren November 27, 2008 at 2:39 pm

How should we view Warren Buffett’s short put position? The FT has some comment which clarifies both Buffett’s thinking and the conflict between insurance and capital markets views of risk. It is useful background to my earlier post about this position.

First the facts. Berkshire has sold long dated out of the money (forward) puts on major indices and received premium upfront. These puts are getting closer to the money as the indices concerned fall, giving rise to mark to market losses.

John Gapper’s FT article points out that Buffett is usually thought of as a great investor – and he really is one – but what is less commonly discussed is where the money came from for that investment. The answer is that it is often from writing insurance. That is, Berkshire is a classic insurance company: it writes insurance, receives premiums, and invests them in the attempt to produce a bigger pot of money than is needed to meet claims. It has been highly successful at this.

The two different communities, insurers and derivatives folk, look at risk in entirely different ways. An actuary would ask how like a risk is to be manifest and what it will cost the insurer if it is based on history. A derivatives trader would ask what the market price of the risk is. Thus insurers and investment banks made great trading partners as the insurer will often take risk for far less than the bank thinks it is worth. This is one of the reasons AIG wrote so many default swaps: they thought that they were being well paid for them.

Another point is that for classical insurance risks like catastrophe, auto or terrorism, the accounting for the risk is on the basis of received claims. You don’t take a mark to market hit on the hurricane book if the weather gets worse in the North Atlantic: you only have to provision for the loss when claims are both likely and can be estimated. This is very close to accrual accounting in banks loan books.

Derivatives, though, are different. Here Warren has to mark to market, so Berkshire suffers earnings volatility regardless of whether the puts really will pay out or not, a fact that anyway won’t be known for many years. Why are investors spooked by a mark to market write-down on a derivative with eleven years left to run when they are perfectly unphased by the warming Atlantic, something that could – if it generates more hurricanes like Katrina – devastate Berkshire’s cat book? Investors seem overwhelmed by the risk that they are being forced to look at, yet indifferent to the ones the accounting glosses over. Interesting, isn’t it?

AIG and default correlation mis-estimation November 15, 2008 at 11:50 am

Felix Salmon has a nice piece on AIG FP’s strategy and why it went so badly wrong.

When AIG wrote protection on CDOs and the like, it got insurance premiums in return, and considered those premiums to essentially be free money, since (according to AIG’s own models, and those of the ratings agencies) the chances of those CDOs defaulting were essentially zero.

…AIG’s biggest mistake was in failing to realize that this business couldn’t scale in the way that most insurance does scale. Most insurance does scale: if you insure a house against fire, for instance, it’s easy to lose much more money than was paid in insurance premiums. But if you insure houses across the country against fire, you’d need a nationwide conflagration in order to lose lots of money.

… The reason AIG’s models said the CDOs couldn’t suffer any losses was that house prices don’t fall in all areas of the country simultaneously. Since AIG was only insuring the last-loss CDO tranches, investors with lower-rated tranches took the risk that prices in Florida, or Arizona, or California might fall. AIG would only lose money if prices fell in all those states at once — which is, of course, exactly what happened.

In other words, AIG’s models assumed default correlation would be low, and that there was a good measure of diversification benefit between the different CDOs it had written protection on. In reality once house prices turned down there was very little diversification, default correlations leaped up, and the mark to market on many of AIG’s contracts turned against them, necessitating the collateral postings that brought the insurer into the welcoming arms of the FED.