• Growing regulatory acceptance as parametric solutions prove their value. (Issues of insurable interest have posed problems. Currently in testing in “sandbox” regulatory environments in a few countries including South Africa, where it has traditionally been viewed as non-compliant.)
• Addresses previously uninsurable risks for corporates and governments, filling protection gaps. Good application for captive insurers (I’ll cover this more in a later post)
• Complements reinsurance by covering areas traditional policies often exclude
• Primarily used for commercial lines, but personal applications are emerging
• Significant applications for transferring country-level risk for governments and certain NGOs
• Basis risk remains a consideration, but can be mitigated somewhat through careful structuring

Exciting developments include parametric ETFs, allowing investors to participate in this innovative market. We’re also seeing creative applications using new data sources, like phone signals to assess footfall.

I can get theoretically excited about smart-contracts for parametric insurance, but in practice this quickly feels like unnecessary complexity with limited current benefit.

Parametric insurance can compete with reinsurance, but it’s often best used in combination, or as a tool for reinsurers to spread risk

As always, professional advice is crucial when exploring these solutions.

Insurers, unlikely retirement funds, have to hold risk-based capital against the risks inherent in their investments. This makes it more difficult to underestimate the risks and services as a deterrent to large allocations.

Infrastructure assets can play a part in linked funds for life insurers, where the investment risk is passed straight back to the policyholders and no market risk capital is held by the insurer.

Under this policy construction, the risks can be similar to a defined benefit retirement fund. These include the practical challenges of pricing and valuation, and conduct and fairness issues of managing investment and divestment prices, liquidity with large withdrawals and transparency of pricing.

These liquidity constraints also make this a poor investment for non-life insurers or smaller life insurers, especially where they primarily write risk business.

Where are alternative assets used in insurance?

The three areas where infrastructure assets have a meaningful place to play in insurance are:

1. As a part of a portfolio of assets for long-dated, predictable and illiquid annuity liabilities.

2. Part of a with-profits portfolio, whether this is accumulation phase or with profit annuities in payment.

3. Part of large, well-capitalised insurer’s shareholder portfolio, subject to risk appetite constraints.

How are infrastructure assets treated for insurers for regulatory purposes

In 2014, EIOPA started to consider whether the Solvency II regulations would discourage insurers to invest in infrastructure assets. It was carefully phrased as “removing disincentives† but the line between that and deliberate incentives for insurers to invest in infrastructure assets is invisible.

Right towards the end of the development of South Africa’s Solvency Assessment and Management (SAM) regulatory overhaul, Task Groups of the SAM project were asked whether any adjustments were recommended.

Technical Provisions adjustments for infrastructure assets

The answer from the Technical Provisions Task Group was “no†. Technical Provisions were intended to be market consistent and, with possible exceptions for illiquidity premium / matching adjustments (already a part of the regulations) returns on assets should not, in general, affect the measurement of liabilities.

The illiquidity premium is still very much relevant. Up to 50bps can be added to the risk-free yield curve for discounting life annuity cash flows, provided the backing assets are a good cash flow match and are managed separately from the rest of the portfolio. The illiquidity premium is calculated as 50% of the spread achieved on the matching assets.

In South Africa, most of the available corporate paper available to generate spreads has a term of five years or less. This greatly reduces the effective average spread that can be applied. Longer-term (20 or 40 year) infrastructure debt-based investments are very welcome in this scenario.

This allowance is not specific to infrastructure assets, but is important as part of the overall capital assessment of infrastructure assets.

It’s worth mentioning that the European Solvency II “matching adjustment† is far more generous. I regularly experience actuaries or consultants from the UK talking up great plans for assets in a SAM environment, assuming that the rules are the same in South Africa as they are across Europe.

(The volatility adjustment in theory also has a place in this discussion, but that’s a bigger topic and typically a smaller impact in any case.)

Solvency Capital Requirement (SCR) adjustment for infrastructure assets

The Capital Requirements Task Group followed the European lead and allowed reductions in the equity shock and spread shock that would be applied to qualifying, high quality, infrastructure investments.

• 33% shock for equity (which is 77% of the “SA equity† shock, or about 70% of “Other Equities† shock, which I’d argue would be the most typical classification in the absence of an infrastructure asset class)
• Symmetric adjustment = 77% of SA equity
• 70% of spread shock for debt
• 65% illiquidity premium shock

The 65% shock to the illiquidity premium is not specific to infrastructure. It’s also complete irrational and greatly reduces the benefit of the very limited illiquidity premium in the first place.

• The stated risk here is a narrowing of the illiquidity premium, but this could only be realized through an increase in the relevant asset prices, matched with an increase in liabilities with no net impact. Since the shock is defined as “A 65% fall in the value of the illiquidity premium used in the valuation of technical Provisions† there is no offset for the asset of this calculation.
• The actual risk, if there were one, would be an increase in illiquidity premiums in the market, resulting in a decrease in asset values, only partially offset by a decrease in liability values due to the 50bps cap.) 

Impact of SCR relief

The impact of lower SCR on after cost-of-capital investment returns needs to be calculated for the specific portfolio and how it interacts with other risks within the business. One might expect a 1% to 2% increase in penalized returns.

Qualifying criteria

To qualify as an “infrastructure asset† and benefit from the lower capital charges, a fairly lengthy set of criteria must be met. For insurers already intended to invest in only high quality (and therefore lower return) infrastructure assets, these criteria may overlap with existing due diligence and investment analysis processes.

Non risk-based criteria

Risk-based criteria

The Infrastructure project entity can meet its financial obligations under sustained stresses that are relevant to the risk of the project.

• Must be externally rated (in theory it doesn’t have to be, but in practice it really should be and questions would be asked by the Prudential Authority if it weren’t.)
• The off-taker must be either the South African government, or there must be a large number of, ideally independent, diversified customers.

• The Infrastructure assets and Infrastructure project entity are governed by a contractual framework that provides debt providers and equity investors with a high degree of protection
• For bond investments, significant additional covenants are required
• The cash flows that the Infrastructure project entity generates for debt providers and equity investors are predictable. This must be demonstrated through one of the following:
  • Availability based revenues
  • Rate of return regulation covering revenues
  • Take or pay contract
  • Output or usage and price imply low risk

Should insurers invest in infrastructure?

It’s unhelpful to say “it depends†, but of course it does. However, with appropriate due diligence and consideration of the financial and capital implications, life insurers with large with profits or annuity books can benefit shareholders and policyholders, as well as potentially the country as a whole, by investing judiciously in infrastructure assets.

The risk is that they are outbid by retirement funds with less risk sensitivity to the investments.

The paper isn’t paygated so check it out – it’s only 6 pages so definitely accessible. Don’t worry about the couple of typos in the paper, bizarre as it may be to find them in a paper that presumably was reviewed, the ideas are still good.

The key idea is that prediction markets usually focus on binary events. Will Person Y win the election? Will China invade Taiwan? These outcomes are relatively easy to predict and circumvent important challenges of extreme outcomes and Taleb’s Black Swans.

A quote from the paper, itself quoting Taleb’s book, Fooled By Randomness, sums up the problem of trying to live in. Binary world when the real world has a wide range of outcomes.

In Fooled by Randomness, the narrator is asked “do you predict that the market is going up or down?† “Up†, he said, with confidence. Then the questioner got angry when he discovered that the narrator was short the market, i.e., would benefit from the market going down. The trader had a difficulty conveying the idea that someone could hold the belief that the market had a higher probability of going up, but that, should it go down, it would go down a lot. So the rational response was to be short.

The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.

Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.

But what should Greek insurers do in the meantime?

Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.

The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).

All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.

He was saying that he doesn’t see the point in investing in debt instruments.  He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.

Well, he’s wrong.

Risk and asset-liability matching

Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities.  Naively consdering expected return only and not asset-liability risks  gives naive results.

Credit risk premia more than compensate for default experience over time

It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.

The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent.  The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.

I’m going to hunt round for some references here so you’re not just trusting my word.

Illiquidity premia = higher returns for some

Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss.  You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.

The jargon that Lewis uses is generally explained and shouldn’t prevent non finance geeks from understanding the role of subprime lenders, mortgage originators and, of course, the Wall Street banks that fed the frenzy with CDSs, synthetic CDOs and bonuses for all.

The story places a few characters at the centre of the story. I wasn’t convinced that these guys were all skill and no luck, but they certainly seemed to have a clearer idea of what was going on in the murky, muddy waters of securitisations of that era than many of the supposed experts.

Overall, it’s won’t be the smash hit that Liar’s Poker is, but it’s entertaining reading all the time. The links to Gutfreund are tenuous and smell a little of name-dropping. If Lewis wanted to remind the reader of his role in toppling the ex CEO of Salomon Brothers he succeeded. If he wanted to somehow project the glory onto the new book, he failed.

The Big Short at Amazon.co.uk

The Big Short at Kalahari.net

Check out Book Finder for prices from several stores (new and used) in your currency including delivery costs to your location.

Parking on the top floor does have a cost. It takes longer to drive up all the ramps and does, perhaps, on average take longer than parking on the most convenient floor every time. This extra time is a premium I pay to reduce the potential for really bad outcomes and thus optimising the parking problem. For example:

• I avoid the situation of attempting to park on a lower floor (trusting the untrustworthy electronic vehicle counter) and, after driving around for a while trying to find parking, having to give up and try a different floor. This much longer time, even if it only happens rarely, is a much worse outcome than 30 seconds on every flight. It can easily be the difference between making and missing a flight.
• I don’t have to worry about remembering where I parked my car. I don’t know that I am more forgetful than the average traveller, but travelling almost every week makes each trip blur into the next. I don’t waste headspace on trying to remember where I parked my car, and I don’t worry about forgetting. I have the peace of mind from having purchased a time of insurance against the risk of forgetting where I parked.

I get no value out of successfully memorising my car location, but gain from removing this risk and this worry from my routine.

If your company has a foreign currency exposure due to imported input components, this is a risk and a worry over which you have no control. Your energies are better expended elsewhere, on the operational and sales issues that you can effectively change. Get rid of these risks and get on with your real business.

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.

Many people with a little mathematical, statistical or economic backgrounds view gambling as foolish because on average, those playing against “the house” will lose. Playing the game has a negative “expected value” since on average more money is spent than is one. (Casions regularly pay out approximately 97% of the money they take in, safe in the knowledge that most of the money they pay out will be return straight to the casino. The casino has several bites at your wallet. Playing ten times over reduces the effective payout to below 75%.)

A negative expected value is not sufficient to make it irrational to play the game. Insurance has a negative expected value for the insured but for the reasons mentioned above it is rational to use an appropriate amount of insurance.

The step that comes closer to making gambling irrational is that the gambler is paying to take on risk. Insurance is all about paying a premium to reduce risk. If humans are naturally risk-averse, how can it be rational to pay a premium to take on risk?

This brings into sharper focus the problems around the generalisation that humans are risk averse. I’ll try to explain how it can be rational to gamble under some parameters as an example of how risk-seeking behaviour (paying to take on risk) can be rational.

Entering the national lottery twice a year (you and your spouse’s birthday, for example) will cost around R7 per year. If you start this when you get married, using very rough numbers, it will almost certainly cost you less than R500 over your entire life. That R500 is not going to change your life in any meaningful way, but it does provide the chance of a completely life-changing event. You could pay off your house and cars, stop working, travel the world, donate to your favourite charities and provide for your children’s health and education. You now have upside exposure to that very unlikely, buy very desirable outcome.

Provided you don’t live your life expecting to win the Big One, and provided you don’t buy a hundred tickets every month to improve your chances at the expense of food on the table for your family, this can be an entirely sensible decision.

Other tails

Gold miners can’t control the gold price. In order to plan operations and capital investment, they should be hedging gold production at some level. The downside tail of very low gold prices is an unbearable risk that limits the ability of the organisation to be an efficient gold miner.

Gold exploration companies, on the other hand, are geared to the upside tail. Expenses are relatively fixed, and the chance of success isn’t great, but the payoff is they literally strike gold is fantastic.

Entrepreneurs are putting themselves out into the risky world, hoping to catch a wild ride up a huge positive tail.

Management diversifying a business because all their personal interests are too tightly focused in a single company, in a single industry, in single part of the value chain are hoping to avoid nasty tail events (or trying to diversify away from a dying business, or simply empire building rather than returning cash to shareholders, but that’s several separate posts altogether).

The lesson

The distribution of what can happen is important. Forget about the MBA mean and standard deviation mirage. Those measures conceal more information than they provide. Understood the most likely events and the extremes, understand how they affect your business and understand how the perception of these issues affects the decisions of those around you.

My original post was to temper the irrational optimism around the currency peg, rather than to say there is bad news around the corner. However, I still feel Moody’s may be slightly optimistic, upgrading a small country’s bonds when the extent of the global recession is not clear.

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?