how to regulate capital adequacy and "too big to fail" and only one (Robert Hunter) made a serious, if sketchy, effort to answer the question

From Naked Capitalism:

"Insurance Experts Tongue-Tied on Ideas for Capital Adequacy, Too Big to Fail Rules

The Capital Markets, Insurance, and Government Sponsored Enterprises subcommittee of the House Financial Services committee held hearings on how the Federal government should oversee insurance, a timely question since we've discovered the Federal government is backstopping a state regulated activity.

What is noteworthy about this session is that five experts were asked to opine on how to regulate capital adequacy and "too big to fail" and only one (Robert Hunter) made a serious, if sketchy, effort to answer the question. I can understand not having a simple answer to a complicated question (there are a lot of different products in insurance) but the flat-footedness is not encouraging.

The experts were:

Mr. Baird Webel, Specialist in Financial Economics, Congressional Research Service;
Ms. Patricia Guinn, Managing Director, Global Risk and Financial Services Business, Towers Perrin;
Mr. J. Robert Hunter, Director of Insurance, Consumer Federation of America;
Mr. Martin F. Grace, James S. Kemper Professor, Department of Risk Management and Insurance, Georgia State University; and
Mr. Scott Harrington, Alan B. Miller Professor, Wharton School, University of Pennsylvania."

Me:

Don said...

It might help to know exactly what people mean by Systemic Risk. I see the current problem as Debt-Deflation. Consequently, I can propose various solutions to try and keep that from occurring again. For example, I like Narrow/Limited Banking. I can also see that as long as we have a Lender Of Last Resort, we cannot rule out Moral Hazard. No real government would tell people "Good luck" facing Debt-Deflation, especially if you have a LOLR. That's basically what it means to have a LOLR.

I guess I'm arguing that a Systemic Risk Regulator will be mainly window dressing, although it probably would do some good, assuming that people don't rely on its blessing as the word of God. Good luck.

Don the libertarian Democrat

protecting insurers -- who are among the big holders of bank debt -- is one of the reasons that we've protected bank bondholders

TO BE NOTED: From Clusterstock:

"Treasury Will Expand TARP To Bail Out Insurers (HIG, LNC, PRU)

Joe Weisenthal|Apr. 7, 2009, 9:41 PM|

Print

Tags: Wall Street, Treasury, Bailout, TARP, Financial Services, Insurance, Financial Crisis, Tim Geithner

HIG Apr 7 2009, 07:38 PM EDT

8.45	Change	% Change
	-0.96	-10.20%

LNC Apr 7 2009, 07:41 PM EDT

6.89	Change	% Change
	+0.51	+7.99%

PRU Apr 7 2009, 06:41 PM EDT

22.10	Change	% Change
	-0.71	-3.11%

Life insurance companies are facing many of the same solvency challenges as banks, and have been trying desperately to get under the TARP. Some, like Hartford Insurance (HIG), have announced acquisitions of thrifts banks in hopes of garnering eligibility.

In fact, Hartford has been nursing its potential acquisition to the tune of $20 million in loans while it finds out whether the move will make it eligible.

Well it looks like they're in luck.

WSJ says the move to allow insurer participation will be announced in the next few days:

How much money would be available to the insurers remains unclear. The Treasury says it has about $130 billion remaining in TARP funds. Life insurers that are bank holding companies have been eligible for TARP for some time, but the Treasury had not yet given the green-light to approve their applications.

Several have applied, including Prudential Financial Inc. (PRU), Hartford Financial Services Group Inc. (HIG) and Lincoln National (LNC) Corp. No decisions have been made yet about which applications will be approved, these people said.

Bear in mind that protecting insurers -- who are among the big holders of bank debt -- is one of the reasons that we've protected bank bondholders so far. Obviously, that alone isn't enough.

Just $130 billion left though. Might take some creativity to stretch it out, since the prospects of getting more from Congress are daunting."

FT Alphaville has been unable to locate the upside to investing in the insurance industry.

From Free Exchange:

"SELL: Insurers Posted by Sam Jones on Feb 13 16:18.

This is a reader appeal.

FT Alphaville has been unable to locate the upside to investing in the insurance industry. Surely its somewhere… after all, the insurance sector has fared relatively well of late.

We have, we might add, been very able to find plenty of reasons not to invest. Or rather, sell. Urgently.

We noted the other week, for example, what bad fixed income investors many US life insurance companies were.

And in light of HBOS catastrophic writeoff against its corporate loan book barely an hour ago, we feel that insurers’ position is even more untenable.
UK insurers are, afterall, hugely exposed to corporates — be it through equities or bonds.

To boot, it’s probably quite reasonable to think of insurers as highly leveraged companies - certainly in effect, if not in actuality. In the UK, because of particularly stringent regulatory requirements, for example (specifically, the strict requirements placed on safeguarding policyholders’ collateral), it should only take a relatively small decline in insurers’ large books to potentially wipeout shareholder equity. Because of minimum capitalisation requirements, the equity very much functions as a first loss tranche - and very much carries a nasty cliff risk.

The wrinkle is that insurers do not mark their books to market: in other words, the market declines in bond prices that we have seen of late, are not in themselves a matter for concern at the insurers. The rationale is that as long term investors, insurers do not need to worry about market risk (the bond, of course, redeemed at par) but rather, have only credit risk to worry about - the actual default of their bonds.

This is revealing. It explains why, in spite of unprecedented market turbulence, insurers’ massive investment portfolios are holding up. They are only significantly affected by defaults.

This has the FSA worried. Because the defaults are coming. And the default cycle is broadly assumed to be severe enough to cause significant damage to the insurers.

Damage in the sense that it could wipe them out.

We reproduce the below table from Deutsche Bank, which we feel is potentially explosive.

The table shows the percentages of insurer holdings as against the insurers’ UK legal solvency requirements (100 per cent = the legal solvency requirement)

As should be evident, Legal and General and Prudential are not in pleasant positions. Before we even consider the corporate bonds, just look at those structured holdings.

Put bluntly, defaults in those structured product portfolios could easily render L&G and Prudential insolvent.

And even if the defaults don’t occur , the FSA’s new conservatism will surely render capital raising inevitable to protect against eventualities.

What’s more, the above figures only detail trouble for the insurers at the shareholder level. The insurers hold hundreds of billions of corporate bond and equity assets at a policyholder level - ringfenced in a seperate non-profit part of the business. Stress testing may well reveal much steeper default provisioning requirements at the policyholder level, which would require even greater capital levels than insurers have currently.

In short, there are a host of capital threats to the UK insurance industry.

This entry was posted by Sam Jones on Friday, February 13th, 2009 at 16:18 and is filed under Capital markets. Tagged with aviva, friends provident, L&G, legal and general, prudential, standard life."

Me:

Don the libertarian Democrat Feb 13 19:01

The upside is that there are a lot of people like you who don't see an upside. So, I'm going to assume that prices are going to be driven too low by stories like this one, and I'll cash in if you're wrong.

I wouldn't do this, but it is a possible upside, especially if the government somehow steps in. Instead of their fundamentals, I'd be looking at their lobbying efforts if I were interested in this kind of investing/speculating.

And then, eventually, when there's a big insurable disaster, we'll all be shocked -- shocked!

From Felix Salmon:

"Why We Need Federal Insurance Regulation Now

Rolfe Winkler has a great post on Allstate's finances today, which underscores two things: the urgency of massive regulatory overhaul in the financial sector, and the necessity of including insurance companies under the unified financial-services regulatory umbrella.

Unless and until that happens, companies like Allstate will go regulator-shopping (the state of Illinois seems pretty well-disposed towards them) and bad insurance will drive out good. And then, eventually, when there's a big insurable disaster, we'll all be shocked -- shocked! -- that Allstate isn't able to use deferred tax assets, and other "capital" of dubious real-world worth, to pay out on its policies."

Me:

I hate to tell you this, but until they blow up, nothing will be done. And, even then, it will take forever to do anything, which will turn out to be ineffective.

I saw the same story in the Post, but my thought was "What's the point of commenting?". The lengths to which we are are willing to go to avoid nationalization of a few banks, which I have been for since September, is a confirmation of my worst fears. Allstate is laughing at all of us.

Before I move on to being laughed at for hoping that insurance gets a good going over, I'd like to keep up the pressure on the banks, who are proving again and again that they'll have the last laugh, and a jolly good one it will be too. I'm sure that they'll find it quite exhilarating.

By DonthelibertarianDemocrat Posted: Feb 09 2009 12:28pm ET

"Rather, the spectacular, outrage, and irrational blame have been the big winners lately"

The great Derivative Dribble on Credit Default Swaps:

"Systemic Speculation

Pundits from all corners have been chiming in on the debate over derivatives. And much like the discourse that has dominated the rest of human history, reason, temperance, and facts play no role in the debate. Rather, the spectacular, outrage, and irrational blame have been the big winners lately. As a consequence, credit default swaps have been singled out as particularly dangerous to the financial system. Why credit default swaps have been targeted as opposed to other derivatives is not entirely clear to me, although I do have some theories. In this article I debunk many of the common myths about credit default swaps that are circulating in the popular press. For an explanation of how credit default swaps work, see this article."

Please read the whole post. Here was my comment:

“To call the latter gambling is to call all of investing gambling. For there is no difference between the latter and buying stock, buying bonds, investing in the college education of your children, etc.”

Wow. Another great post. You got right to my question.

Investing involves looking at a business, say, and getting a return for how the business does.When you buy a stock or a bond, you are either purchasing part of the company or loaning it money, but your analysis is based upon and tied to how the business does.

If you bet on sports, say, you have knowledge of the game which you use to determine your wager, but you are betting on an event. You’re not investing in the teams. Now, your knowledge might well lead to predicting which teams are good or bad, but you are still betting on a particular outcome.

CDS’s seem more akin to sports wagering than investment as I’ve just defined them. Both involve money and risk, but they seem to have different qualities and objectives.

I have always thought that investors, as opposed to traders, say, were seen to be different types of creatures. Traders do look more like gamblers than investors.So clearly stocks, bonds, all financial products can involve investment that looks more like gambling.

To the extent that CDS’s were more or less insurance, they seemed to make sense. I’m kind of proud of myself that your post help me get to my question on the same day that article on gambling came out.

http://don-thelibertariandemocrat.blogspot.com/2008/10/it-is-commonly-said-that-derivatives.html

My point was not what the WSJ was saying. I agree that such CDS’s can make sense and even be useful as you describe them, but my fear was that they were being marketed as safe investments, and the risks were not well understood by some of the buyers.

However, until you said this:

“But why should someone profit from ABC’s failure? Because if B’s belief in ABC’s impending failure is shared by others, their collective selfish desire to profit will push the price of protection on ABC’s bonds up, which will signal to the market-at-large that the CDS market believes that there will be an event of default on ABC issued debt. That is, a market full of people who specialize in recognizing financial disasters will inadvertently share their expertise with the world.”

I did not clearly understand the benefits. I had thought that the benefit was hedging your bet or positions by buying a CDS for one direction of movement, and some other form of financial asset for the opposite movement. In other words, it was a way of seeming to minimize risk, but that was really more risky than it seemed.

I hope I have explained my confusion, and thanks again for the explanation. Please don’t post this if it makes no sense. I’m hoping it does, but I’m not sure.

Here's the response:

"Hi Don,

I’m glad I can help you better understand things. These are complicated issues and it’s not always clear who’s right. One of strange things about a lot of human behavior is that selfish actions can have effects that are beneficial for everyone. I’m not saying this is always the case, but it is quite common. So, look past the greed and ask what is the effect of the greed."

So, in the end, I don't fault the investments themselves. I would tend to stay with what I termed investments, but that has to do more with my level of understanding and competence.

After reading Derivative Dribble, I find that these investments should have been able to be clearly explainable and better managed. I'm wondering how much of the problem is fraud and negligence on the part of the sellers of these products, and wishful thinking on the part of the buyers. But I subscribe to what I call the Human Agency explanation of this crisis. What were the factors used in deciding to take such poor risks and make such poor judgments. I'm not crediting complexity as much as others, nor mechanistic explanations of the movement or flow of financial instruments. I suppose that this is a philosophical difference as well.