Sunday, July 29, 2012

Insurance IV

Thanks for bearing with.

I've attempted to place into conversation a couple of concepts about insurance, found in Insurance, Insurance II, and Insurance III. Regulatory costs are those costs forced upon insurance companies by regulatory agencies. There are two types of regulatory costs; internally generated costs and externally generated costs. In Insurance II, I bring up the model of insurance that to many serves as the pure model of insurance; Lloyd's of London. LL was the paradigm of insurance to many of us for years. It was a market place of investors who would decide whether or not to accept the risks posed by your activities, originally maritine, but later, for any associated economic activity. If you listen to reports about economic activity, what you may hear from time to time is the expression, "to short" your investment. Insurance companies attempt to compete for your business based upon shorting positions. They "buy" the cost of replacement of an entire vessel--in the case of maritine insurance--at a level lower than the actual cost of the vessel, in order to create a lower cost of coverage. Basically, this drives down insurance costs, as investors are willing to take greater risks against downside, in order to gain the premium to insure the vessels at question.

How is it that brilliant men, smart investors, great business men are willing to short their own positions, in order to gain the cost of insurance coverage?


What is the difference between an insurance company and a bank?

Absolutely none.

How do banks make money? Fractional reserves.

When the downturn in 2008 occurred, what is it that had occurred with the banks, versus what had occurred with insurance companies, such as AIG? Books will, and have, been written. For me the bottom line is, AIG took risks that it shouldn't have taken. There were investors and economists that warned the entire housing industry, from banks, to mortgage companies, to insurance companies, that the promises of federally guaranteed loans were going to find themselves under water.

The point is, we knew that the policies of the federal government were leading us to a place where the promises we had made to our citizenry were no longer affordable, and yet, we lacked the courage to tell those who voted for our politicians, that the breadboard was bare. A Mother Hubbard redux.

So, to repeat, how do banks make money? Fractional reserves.

In my take on reality, the most important question that needs to be asked about current government law, policies and planning, is what effect are those exogenous variable going to have on insurance companies, and why is it  that the most brilliant economists are hired by insurance companies?  Small shifts in exogenous variables can impute huge increases in profitability by the companies engaged in economic activity within the markets described by those variables. 

Let's re-state that. If you are a large insurance company, you are going to be receiving millions, hundreds of millions, and yes, billions of dollars in the simple quest to cover against loss. You give me a percentage of the value of your possessions, and I'm willing (as an insurer) to cover you against accidental loss for the full price or cost of those possessions, for a fraction of the value of those possessions. You pay me a fraction, I'll make you whole.

This is insurance.

And the dumber you are, the more risk you assume.

The richer you are, the more assets you have, the lower your costs of insurance are going to be. You may end up paying more for insurance than someone with a lower income, but the more you pay, the better protected you are going to be. And as a percentage of income, you can afford comparatively cheaper insurance. Billionaires pay proportionately less for coverage than you and I.

Can you figure out why?

Moving on.

Banks make money due to fractional reserve banking. Banks do not need to hold in their vaults, the entire value of the deposits held, as a liability of the bank. For those with basic bookkeeping, assets equal liabilities plus equity. Would you expect your Savings and Loan to have all the cash deposited in your local S & L standing in your S & L' s vault? Of course not. If you've been induced to deposit your cash in an S & L, part of the marketing of an S & L is in the argument that S & L's typically are lending sources for you and your neighbors; small loans for auto and appliances, large loans for homes. S & L's had for years an advantage for this type of lending, not seen since the passage of the deregulatory bill in 1983.  Changes in tax laws, changes in regulation have all contributed to the decline of S & L's. But the reality of small banks, S & L's, credit unions still exist. None of these depository institutions maintain on hand an hundred percent of their depository obligations. If you deposit an hundred dollars into any financial institution, only a fraction of that deposit will be held, on hand.

Remember "It's a Wonderful Life"?

Jimmy Stewart finding out that he couldn't meet the payment demands of his correspondent bank?

Remember, this scene took place before the FDIC was established.

But think about it. "It's a Wonderful Life" wouldn't have been a picture without one crucial scene; the theft of payment.

And then the movie goes on. The "rich" guy is corrupt. Unquestionably. Just as are so many of us. Including Jon Corzine. The bundler who lost millions, and still hasn't been indicted by the Obama Justice Department. MF Global is one of the most egregious examples of "Potter" in recent history. But...nothing.

Insurance companies hired on early in the debate over public health care. Obamacare. Why?

Because, insurance companies hold fractional reserves against their possible liabilities, just as do banks.  But most of us never look at our insurance companies as having the same fiduciary responsibilities as we do the banks we deal with. And that's not an intelligent  position to take.

Of course insurance companies have the same responsibilities and liabilities as banks. But you never hear our President railing against the insurance companies.

Why is that?

Because of ObamaCare.

ObamaCare is the biggest shift in assets, from personal to corporate, than has ever occurred before in the history of the world.

Remember, that banks don't hold your deposits in a vault. They only hold a fraction of their liabilities in their vaults, and have determined that there is only a percentage of what they owe, that will ever be demanded, on any particular date. Bank runs are dangerous, since a bank run would mean that all depositors would be asking for all their cash at a single point in time. (No wonder poor George argued against the bank run in the video above!)

Insurance companies, however, are a little bit different. Not being a bank, the beneficiaries of an insurance company are different from other holders of equity. We're all aware of our FDIC insurance. What insurance do you have against the payments paid for an insurance policy, in the event of your insurance policy holder's failure? What is the limit of the liability of such a failure?

I think I have given you a lot to think about. You own some insurance, whether it's only automobile, or homeowner' s insurance. If you own a company, or invest, there are other types of insurance available. Imagine, you own a portfolio of mortgages. Can you find insurance against loss for that portfolio of mortgages?

Would you be surprised to find out, that you can insure yourself against loss against a portfolio of mortgages that you own? And, wouldn't you expect that someone would be willing to insure you against loss for that type of portfolio?


MAX Redline said...

Loved Jimmy Stewart. He did some timeless stuff.

Jardinero1 said...

Say what you will about fractional reserve lending and I may agree with you. But, it's a gross simplification to equate insurance companies with banks. In a bank there is an explicit agreement that you may have your money back on demand. In insurance, the consumer receives only a promise to receive a percent of their loss if they experience a loss at all. The business of re-insurance which is where AIG got into trouble is altogether different than garden variety property and casualty firms which deal, mostly, in the business of many small losses. Re-insurers only pay when the insurers losses exceed thus and such amount, usually after a catastrophe. I will grant that re-insurance has changed the model by which P&C operates, for the worse, by allowing ordinary P&C companies to maintain lower reserves against losses and charge lower premiums than they should.