Twenty Third Floor
Technical Business Advantage

Insurance and gambling have much in common. They both involve uncertainty and money and the rational consumer will, on average, lose money through the interaction. Both business models involve leveraging the tail of probability distributions (one nasty and one nice).

The tail of a distribution includes the very bad and very good possible outcomes, that typically have a very low frequency of occurring. Having your house burn down is a very bad outcome, but fortunately happens very infrequently. Winning the lottery is very good, but unfortunately in this case is also very unlikely for any particular individual.

Managing the nasty tail

A rational person who wants to avoid the unlikely but catastrophic risk of  losing their house to fire will be prepared to pay more than just the average cost of the loss of the house in order to avoid the risk. Typically, we humans are risk averse (a wild generalisation given the research into utility and decision making that has led to behavioural finance and behavioural economics, but probably good enough for now). Insurance provides:

• genuine decrease in risk and indemnification of losses against the loss event happening
• peace of mind even if no loss is ever experienced, which has real value in terms of clearing the mind to think about other more important and more controllable personal and business matters
• reduction in the amount of capital / liquid assets individuals and businesses need to keep against unforeseen events. This capital can be better used and invested elsewhere

Contrary to the popular view, insurance has value even if you never claim.

Gearing to the nice tail

Gambling can be dangerous and addictive. It can also be entirely rational to gamble within certain parameters. (more…)

CEIOPS issued additional guidance around the standard formula for calculating capital requirements in respect of operational risk late last year.

Why was a new OpRisk formula needed?

The original formula for OpRisk proposed in QIS4 was widely condemned. Complaints included being too simplistic, being insensitive to risk (and basely primarily on business size) and the impossibility of calibrating to 99.5% in a meaningful way. CEIOPS accepts most of this criticism, but counters by reminding stakeholders that the aim of the standard formula is partly about being simple.

A more serious problem is that in comparison against companies’ own internal models, the standard formula produced results lower than companies’ own assessment. Median internal model requirements for OpRisk were 133% of the standard formula and 13 out of 16 countries reported higher requirements under their insurers’ internal models.

One of the aims of the standard formula is to be slightly conservative to provide an incentive for insurers to develop their internal models. Clearly this objective is not being achieved. (more…)

A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.

Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.

The question:

What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?

My brief answer (this is a huge topic!):

There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product

Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).

Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives. (more…)

The South African Reserve Bank today lowered the REPO rate by a further 50 basis points, down to the level last seen in 2005 and the lowest the REPO and BA Rate have been in nearly 3 decades. Surveys leading up to the announcement and analysis of market interest rates suggests that the expectation was for rates to be held constant. Was this a purely populist decision, or does Tito Mboweni see more economic trouble ahead that other, more optimistic South Africans believe?

To date, the South African economy has been relatively less affected by the global financial crisis. Unemployment in Spain is up to 18% – within spitting distance of our own extravagant unemployment rates. Several large economies have been making eyes at 10% annual declines in GDP – often used as an informal definition of a depression (compared with a recession typically defined as two consecutive quarters of decline in real GDP). Property prices have been declining between 5% and 10% (depending on who you ask) and even after allowing for our higher inflation and thus greater real decreases, we compare very favourable to the drops of 20% to 50% in some parts of some countries. (more…)

In my previous post I discussed some of the risks to various currencies.

Now what happens if your local currency is pegged to the US Dollar as it is in Lebanon? Speaking to Lebanese bankers and insurers there seems to be a devout belief  that the peg is rock solid.  This is surprising given the history of the Lebanese Pound (LBP) over the last 30 years. Decades of civil war and hyperinflation decimate a currency.

photo credit: austinevan

Now if you offer insurance policies denominated in USD or LBP, accepting premiums and paying benefit in currencies assumed always to be pegged at a fixed  rate you might want to consider what assets you have backing those policies. USD policies backed with assets in LBP (and LBP policies backed with USD assets) are a massive currency risk. The probability of a break in the peg may be small, but the result could be catastrophic.

Unfortunately, it is arguably worse. Even if the USD policies are backed with USD deposits and bonds at Lebanese banks, how will the banks fare if the currency is devalued? How about if the USD does plummet on the back of inflation concerns in the US economy and the LBP is forced to be revalued upwards? Unless the banks are managing this currency risk themselves and are appropriate matched the contagion of currency problems will flow through banks and straight to insurance companies.

Now is not the time to assume that artificial links will remain no matter what happens to the global economy. This is a massive currency risk.

Currencies aren’t what they used to be. The US Dollar can no longer be viewed as a safe bet as Obama and Bernanke spend their way out of a crisis partly fueled by too much spending. Inflation will come, it’s just a matter of time. Warren Buffet thinks so too. The current relative strength of the USD is a short-term reaction to the money flowing back into the US. It won’t last.

photo credit: plenty.r.

The Swiss are acting in the market to weaken the Swiss Franc to protect the economy. Given the problems Swiss banks have been having as a result of the credit crisis and pressure on banking secrecy rules out the franc.

The South African Rand? South Africa has a huge current account deficit, significant political risk, serious government spending and a decline in exports and production in our base metals economy.

The Pound Sterling is teetering on the back of a meltdown of the financial system – long the heart of the London and UK economy. I hear Ireland is in horrible shape too.

Some are suggesting the Norwegian Krone. It’s one of the world’s top ten traded currencies, which provides liquidity. Significant oil wealth has been accumulated and diversified in a “pension fund for the country”. However, currencies can be driven for extended multi-year period purely based on fashion. I don’t know that I want to risk being in a currency that simply goes out of favour.

The Japanese Yen has to deal with the worst economic declines in nearly 40 years. The Chinese Yuan is subject to state manipulation, usually pushing to keep it low to sustain an export-driven economy. Not sure I like my eggs  fried in that basket either.

The argument typically turns to Gold. The shiny metal that has been a store of value for several hundred years. Only problem is that gold arguably has less intrinsic value than steel or wheat or oil. The price is driven by demand – demand that is driven by assumed future demand. Flows into Gold ETFs have been strong, and significantly responsible for the current prices. Getting in now at around $900 per ounce might not be smart if everyone else is already in and looking for a time to sell.

So, where’s the safe?

The Fed joins Bank of England and Bank of Japan in repurchasing government bonds.

photo credit: amber.kennedy

This actions (quantitative easing) increases the prices of bonds (more demand, diminishing supply) pushing down long-term yields.

Great if you own bonds, not so great if you are an insurer with imperfectly matched long-term liabilities. Given how difficult it is to find assets of sufficiently long term to back long-dated annuities, many insurers may find themselves with assets of shorter duration than liabiltiies. More losses for insurers could follow.

Insurers have started using swaps to match their annuity portfolios, or to simply increase the duration of their assets such that the sensitivity of assets and liabilities to overall changes in the level of the yield curve has a limited effect. This solves part of the problem. When short term interest rates are affected  by desperate monetary policy and longer term yields are set by a perfect storm of future inflationary expectations, recession fears and now central bank intervention in the markets, matching key durations is a minimum requirement not to have large swings in surplus assets.

And this doesn’t even consinder the impact on Guaranteed Annuity Options and Variable Annuities in the US. More fun.

Skyrocketing home prices were ignored by the retired masses. With limited income and huge equity stored in their primary houses, thousands of retired home-ownders in the US and UK dipped into the equity in their houses.

photo credit: TheTruthAbout…

Banks facilitated this through the creation of home equity release products or “reverse mortgages”. The bank lends money to the home-owner against the property as security. However, since the income of the “borrower” is limited, no interest payments are required. Instead, on death, the house is sold and the proceeds go first to repay the accumulated loan to the bank. The emotional trauma of having to sell one’s home is limited, no interest payments are required and the bank has another channel to route excess liquidity.

Bad selling practices and high effective interest rates gave these products a bad name. Sometimes the correct move, if difficult, is to downsize rather than rapidly erode the equity in a house. This tempered sales of the home equity release products that might otherwise have caused more headaches for banks given the current, twinned crises of credit and property. (more…)