insurance


Arguably, the one of the few good things in the bill is coverage of preexisting conditions. The rest looks like rancid sausage. The biggest problem is there is not a single thing in the bill guaranteed to lower health care costs. We have to take it on faith that the plan will save money.

Insurance cannot include pre-existing conditions. A system of insurance requires that premiums be collected from a pool of low-risk people so that funds are available in case a high-risk event befalls a particular person.

Risk, must be a prerequisite of insurance. Risk being defined as an unknown future event that carries an actuarial probability of occurring. This is a legitimate use of statistics, based upon distributions that are controlled through nature, viz. mortality tables.

By allowing pre-existing conditions, the future is known. There is no risk, thus, insurance is a totally inappropriate solution to the problem. Also created is an inbuilt bias that would guarantee failure. That is the skew imposed by the withdrawal of currently healthy insurable risks. By paying the fine, you can opt out, only to opt back in, when you are no longer a risk, but a known event.

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The US want more of their citizens covered by Medical insurance, various ploys have been thought up to defray the costs from the lower incomes.

One of the fundamental problems is that a diagnosis is just so expensive, and it’s totally unnecessary. As a clinician, I start with a thorough medical history, which will mandate any clinical testing required. At this point a diagnosis is made. Further investigations, which are your myriad blood tests, MRI scans, CT scans, etc are not required to make a diagnosis, only to try and confirm a diagnosis.

In the US, doctors run every test imaginable, and they are very expensive, needlessly, and primarily to escape any medical lawsuits. The quality of their diagnosis does not improve, in fact I’d guess it actually falls off.

It is the cost of paying for these myriad tests that push medical insurance premiums so high. Lose the tests, unless required to confirm an existing diagnosis, and your medical insurance costs will drop significantly.

By Jon Markman
Nearly seven decades ago, the eight months between Germany’s invasion of Poland in 1939 and its invasion of France in 1940 was known as the “phony war” — a period of escalating anxiety, denial, appeasement, danger and death, but nothing like the murderous global train wreck soon to follow.

Likewise, we may come to look at the period between July 2007 and January 2008 as a sort of phony war in the worldwide credit crisis, because although the market has fallen 15% since summer, there have been no defaults of key bonds or asset-backed securities. The curious lack of real blowups has led even seasoned observers to believe that fears were exaggerated and that chaos will be averted.

In reality, however, the skirmishes we’ve seen so far might be little more than a prelude to a deeper, harsher, longer decline than most yet perceive possible. And in a very postmodern twist, it is beginning to look like unexpected consequences of an investment instrument designed to mitigate risk could turn out to be the nuclear option that bombs the globe into the financial equivalent of World War III.

Banks left exposed
That instrument is the credit default swap, or CDS. It was developed as a way for bondholders to buy insurance against the possibility that companies might fail to pay their debts, and later it morphed into a way for big traders to actively bet on the likelihood of the default of bonds and other credit instruments. But what is only now becoming clear is that major U.S. and European banks and hedge funds bought up to $20 trillion worth of that insurance to offset their exposure to mortgage-related securities they owned. And those banks and hedge funds are discovering the sellers of the swaps may not pay up.

This leaves already deeply troubled banks virtually naked at just the moment they most need protection, as the pace of credit defaults is likely to accelerate this year so long as the Federal Reserve remains behind the curve in cutting interest rates. It’s as if the banks already have pneumonia, and they’re now being marched into a snowstorm wearing little more than bathrobes.

The problem surfaced to an important degree in a footnote to the news last week that Merrill Lynch (MER, news, msgs) would take an $11.5 billion write-down of bad debts for the fourth quarter. Of that amount, $3.1 billion was a write-down of credit default swaps that Merrill had purchased from bond insurer ACA Capital to hedge the risk of owning a lot of collateralized debt obligations, or CDOs, which are leveraged bundles of asset-backed securities. (In a typical CDS transaction, a debt holder or speculator agrees to pays 1.5% or more per year for $10 million worth of insurance on a specific slice of a debt security.)

This means that not only is Merrill unprotected against a default in the CDOs, but it has lost all the money it has paid for that insurance. It’s as if you had paid $200,000 in premiums over the years in a $1 million life insurance policy for your spouse, and when a death occurs not only does the insurer tell you it’s broke and can’t pay — but your premiums are down the drain, too.

Don’t count on insurers
Several other major banks and brokers, such as the Canadian Imperial Bank of Commerce (CM, news, msgs) and Lehman Bros. (LEH, news, msgs), have been stiffed by ACA to the tune of billions, and all have let the insurer seek more capital before forcing it into bankruptcy. So the case gives us just a taste of what may come. Consider that ACA was no fly-by-night outfit. It was AAA-rated and met all standard benchmarks for safety. Yet those benchmarks now look ridiculous, as the company was allowed to provide $60 billion worth of guarantees on a capital base of just $500 million.

Can you imagine, as a citizen, if you were allowed to collect fees on $60 million worth of loan guarantees because you owned a house worth $500,000? It’s nuts.

Specialty bond insurers such as ACA and troubled Ambac Financial Group (ABK, news, msgs) at least are well-known companies subject to modest scrutiny. But because we are coming out of a long period in which debt defaults have been unusually low, hundreds of little-known hedge funds, pension funds and insurers worldwide were lulled by a false sense of complacency into the practice of selling CDSs — and their ability to pay up in the event of widespread defaults amid a long, hard recession is not just in doubt but completely unlikely.

In other words, if you think it’s hard to get your insurance company to pay off in the event of a car accident, just wait until you hear the screaming from CDS holders in the next couple of years. Here are a few ways insurance sellers will try to jump off the hook, according to derivatives expert Satyajit Das, who spoke to me this week from Pune, India:

Documentation difficulties. Ever go into a store to try to return a piece of merchandise and forget your receipt? Or have you had clerks point out that the return period expired two weeks ago, or that the fine print says the warranty is not good if the package been opened or if the item was bought on a Tuesday, or that they’re sorry, but Bob, the guy who wrote the receipt, doesn’t work there anymore, and current management can’t honor it? Das says CDS sellers’ attorneys have innumerable ways of claiming your contract does not apply. The big problem is that the standard CDS contact is a trading instrument that is standardized for simplicity and may not match the risk in the way its owner expects, even if the owner is a sophisticated investor like Merrill. It cannot be tested except by a real default, and by then it may be too late.

Weakness in the instrument. If you bought a CDS contract on the bonds of a company that has been bought by another firm, the new owners may not be obligated to pay up. This is particularly true if the original “reference obligor,” as they say in the business, is based in one country and the new owner is based in another. Foreign courts might not enforce contracts. Ownership change can also change the credit risk of a derivative in unforeseen ways, preventing you from even having a seat at the table to protect your interests.

Credit event definition. CDS contracts rely on a trigger to go into effect — typically a sharp downgrade, failure to make a payment or bankruptcy. But CDS buyers may not be protected against all defaults in all currencies, particularly if a bondholder restructures rather than enter bankruptcy. CDS holders may thus have trouble proving a default has taken place. Additionally, CDS sellers may be in such dire straits that forcing them into bankruptcy may exacerbate losses.

Settlement and collateral problems. The CDS holder must deliver a defaulted bond or loan, but today CDS sales are six to 10 times larger than all bonds outstanding due to the way they were resold and leveraged. In the case of car-parts maker Delphi (DPHIQ, news, msgs), protection buyers received an average of just $3.6 million per $10 million CDS contract, meaning they were not fully hedged and had no further legal recourse to recover.

Counterparty risk. This is when you realize that CDS contracts don’t eliminate credit risk — they only transfer it. Instead of just worrying if a bond will pay off, now you have to worry about the health of the insurer. Transference of risk was the main reason to buy CDSs, but in an era of extreme leverage, the example of ACA Capital shows that no counterparty is safe, especially as many banks and funds have “daisy-chained” their risks together.

In September, Das told us he believed the unwinding of the great post-millennial credit bubble had barely begun. Now he thinks that the game is finally in the first inning, with much more pain and heartache to come. He points out that all of the new capital raised by UBS AG (UBS, news, msgs), Citigroup (C, news, msgs) and Merrill Lynch has only made up for the losses they have acknowledged so far in the fourth quarter of last year, and that if they continue to need to write off their credit default swaps and loans as customers sink under the weight of recession and default on loans, they will be taking equally large deductions against earnings in every quarter of this year and into 2009.

With at least $1.5 trillion in off-balance-sheet debt coming onto their books and tens of billions of dollars in CDS contracts potentially up in smoke, Das figures the banks will need $200 billion in new capital to shore up reserves at the same time they suffer $100 billion in real loan losses. If they need $300 billion — and so far the sovereign wealth funds have, with some reluctance, put up only around $25 billion — you start to see the potential size of the problem that lies ahead.

“The hole is bigger than they or their investors expected,” Das said. “And they’re still digging.”

In short, though it appears the Federal Reserve has answered its wake-up call with an interest-rate cut of unprecedented size, I continue to recommend that you treat financial stocks with skepticism. Their Maginot Line has been breached, and reinforcements are bogged down.

A while back in this post https://leduc998.wordpress.com/2008/09/23/its-an-insurance-problem/#comments I postulated that at it’s heart, the credit contraction has proven so intractable due to the systematic fear of a systemic failure. The Banks, Corporations, and now the average depositor have no confidence that their Bank, financial institution will be deemed worth saving, thus all confidence is slipping away, with the consequences observed to date.

If the problem is one of confidence in survival, then insurance can be provided by the “government” as the insurer of last resort. The government is already implicitly insuring via guarantees in any case, by making the insurance explicit and formalising the guarantee of the system, the government will gain leverage on the capital it puts into the system.

This is important as the notional value of CDS [which are currently at the heart] is huge, some estimated $63 Trillion. Thus the leverage the government gains by using capital sparingly gains more bang for the buck.

Already we see moves away from TARP to the idea of recapitalizations via Preferred Stock investments. However, Preferred Stock values due to the CDS values involved could evaporate overnight, necessitating a further bailout [or further failures, which currently would be a mistake]

The government is in effect insuring “tail risk” which in essence is the trigger to a systemic failure. The value of tail risk is currently unknown, which is why the Banks are now hoarding as much capital as possible. While the exact figure is unknown currently, it is bound to be large.

The government by only using resources where required, saves capital from banks that eventually survive on their own capital.

The government should offer to sell credit insurance on portfolios of assets that were rated AAA as of July 2008. This limited set of assets are targeted in order to focus in on the problem of systemic risk. If the assets already have limited insurance from a private issuer, the government should offer a top-up policy that covers everything beyond what the private issuer has already promised.

These are of course the sliced and diced tranches of AAA rated MBS that were in reality no such thing, and on which Banks, Hedge Funds etc have increased their bets via huge leverage in the black box of OTC derivatives via CDS on failures in these rather toxic assets.

The Treasury could implement this approach immediately under existing provisions of the buyout bill. Section 102 explicitly allows the Treasury to sell credit insurance, and to segregate premiums received in a special Troubled Assets Insurance Financing Fund.

In summary, the freezing of credit in the inter-bank market, the commercial paper market, the LBO market and Corporations draining previously agreed credit lines have at their heart the same fear, that someone who they extend credit to, on any timeframe, might, due to their unknown third party exposures, cease to exist overnight. Government insurance against this tail risk, would start to ease this lack of confidence.

The insurer has suffered $18 billion of losses in the last three quarters tied to guarantees it wrote on mortgage-linked derivatives. It ended June with $1.05 trillion of assets. Its failure would likely be larger than that of Lehman, which said it ended August with about $600 billion of assets.

What exactly were they paying their underwriting staff for? Insurance companies are supposed to understand risk, risk management. Did it not occur to them that financial instruments have inherently different characteristics to say chance involved in fire damage? One [fire] has a statistically normal distribution, financial assets based on insurance products, which AIG were selling, carry massive left sided tail risks, with zero compensating right side tail rewards.

With all the downgrades coming yesterday and today, any capital raising will be pretty much a miracle if it gets done. The leverage, again requires estimates of $70 Billion being required. In this current market…two hopes, Bob and none.

This credit cycle is claiming some really big “names.”

I shall use the debacle at Lloyds to highlight some similarities and differences within the Credit Default Swaps [CDS] market.

Lloyds was [is] concerned historically with marine insurance. The pertinent fact regarding marine insurance, at least in earlier times, was the all-or-nothing principal. The ship either made it to port, and the premium received could be booked as profit, or, there was total loss, and you paid out.

Lloyds organized on the basis of syndicates, backed by “Names” who pledged their assets to the paying of claims, proportionately to their share of premium written [for them] by the underwriter, who sitting in the “box” accepted or rejected business brought by brokers.

At some point, the model started to change. No longer did Lloyds specialise, they started to diversify into other lines of business. This in of itself, probably would not have been a critical error, save, that they started taking long-tailed business, that carried unlimited loss. In essence, writing long-tailed business, with uncapped [potential] losses is exactly the same as selling Call Options, the reward is limited to the premium received, but the losses are in theory infinite.

The answer to this problem resides [in theory] within the concept of “Reinsurance” and “Retrocession” where, I as the principal underwriter, limit my [potential] losses by purchasing Reinsurance [stoploss] with a portion of my received premium. The underwriter who accepts this risk, may, offset his risk by purchasing Retrocession [re-reinsurance]

There is no limit to how many times this can be done in theory. In practical terms, the initial premium payment is soon used up.

To cut a long story short, Lloyds, would reinsure risks written, within Lloyds of London, often with the same “Names” in a different “Syndicate” thus, rather than diversifying the risk, they concentrated the risk, compounded by shoddy underwriting, compounded by shoddy reserving, eventually, asbestosis claims killed them, being a long tailed risk, for which they assumed unlimited liability, for which adequate premiums were not charged, adequate reserves were not taken, being paid out as profits, thus bankrupting thousands of Lloyds names in the process.

Which brings us to CDS contracts.

CDS contracts are in essence insurance contracts that insure against the loss on Mortgage Backed Securities [amongst other financial instruments] paying out under terms of the contract.

These contracts are not standardised, thus, are open to all manner of challenges and interpretations, already holders have been caught out.

In a similar way, lets say a Hedge Fund wants to earn premium income, so they sell a CDS contract, but want to limit their risk, buying an offsetting CDS with part of their premium, they have in insurance terms, purchased Reinsurance.

Unfortunately, due to the lack of standardization in the contracts, they may not be covered, and this has already proven to be the case, a Hedge Fund believing their exposure to stand at $100K had to pay out $10M

Here is where we come to two major problems within the CDS market;
*Concentration
*Under-reserving
*Excessive leverage [monumentally]

The insurance industry, learnt, one would hope from the Lloyds example, that risks via reinsurance and retrocession really must be diversified, otherwise, you find in the event of claims, they overwhelm the ability to pay, thus triggering a systemic meltdown.

Have the Banks learnt this lesson? One would have to say probably not. They have proven once again that they are without doubt some of the greediest and most stupid people in business, but we’ll come back to this.

Under-reserving on the other hand, cannot be fully laid at their door. Money [profits] taken as reserves are tax deductible, thus, only minimum reserves are allowed to be taken. Therefore, should the bank engage in providing risky loans, they cannot adequately reserve against them, placing at risk their capital structures.

Of course, now the losses have been mounting, capital has become a critical issue, with many banks becoming insolvent, necessitating the Fed bailouts, interest cuts, Treasury swaps, etc.

With the CDS market at a notional $63T, and exposure estimated at say $3T, obviously should these fall payable, solvency for any bank simply evaporates.

This seemingly is the argument against the banks currently, and it has merit, which is why the Fed is willing to remove from the market any MBS, CDO, that has linked to it CDS exposure.

The MBS assets, are finite, not unlimited exposure, they probably could be termed “long tail” as the MBS may well have a potential 30yr lifespan, but for the Fed, this is not really a problem. That the risk is finite…viz cannot exceed 100% of value, the risk is quantifiable. Of course, ultimate losses will not run to 100%, the assets will have recoverable value.

By removing the “trigger” from the market and not allowing prices to enter the market, the CDS timebomb should be safely defused. In addition, CDS contracts have generally a 5yr lifespan, again, there is a limit to the risk exposure expressed in time.

Risk in MBS is also intimately tied to liquidity. The inability to close out positions quickly was what in part created the requirement for CDS cover. That the illiquidity of the underlying only magnified the movements in the derivatives, possibly was unplanned, as the standardisation of contracts seems to have initially caused problems, this however should be easily resolved now that it has been identified, but we shall see.

In conclusion, while CDS is certainly a bit of an unknown quantity, and the numbers involved are simply silly, it would seem that the magnitude of the problem has been significantly reduced by the Fed, who have deep enough pockets to absorb the underlying to maturity, thus eliminating the trigger on the derivative portion of the market. Unlike an unlimited long tail exposure, the risk is finite, quantifiable, and thus manageable. This being the case, the crisis will pass in time.

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