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The Risk with Reinsurers

March 17, 2011 | About:
The idea of reinsurance is a very good one based upon the basic principles of diversification. With regular insurance, a specific insurance sales company does not think that they are going to have claims against their company; they know they will. The whole idea of charging premiums, however, is so that if (when) an incident occurs, the insurance company should be able to offset the costs of that incident with all of the other accounts and still make enough to produce a profit.

However, insurance companies do not always like having to take all these risks. So enter the reinsurance companies. By selling off some of the very risk that they took on in exchange for insurance premiums, the insurance companies are able to diversify some of the risk and the debt (in case of accident or disaster) to a completely different company. So, if a natural disaster comes in and affects a whole city (which could affect a large percentage insurance company’s clients), how could the company afford to pay the claims by themselves?

While that idea is a very novel one (insurance companies seeking out insurance), it’s actually very hard to calculate how this specific market can be efficient. In order for the reinsurance program to run an efficient business, they too must calculate the specific level of compensation that they must charge in the form of premiums, or else they will also be in trouble when a large problem occurs and multiple claims spring up.

The way that the reinsurer works is a double edged sword. Yes, they buy only a small portion of the risk and claims (or a percentage) from insurance companies, but what if they do not diversify enough? What if an asteroid hits a city and kills one million people or a massive earth-quake in Japan causes a nuclear meltdown?

If a minor incident (or no incident) occurs, the company pays out a very large sum to the individual(s) making the claim, and nothing had happened. If, however, a major event such as a natural disaster occurs like the events currently unfolding in Japan, how does a reinsurance company calculate that value? The damage itself will be countless, it will almost be impossible to sort through who lost what, what items were damaged by what events, the business interruption losses, etc.

How does a reinsurance company plan for this event? The news is constantly being updated, however, as of this writing some estimates are that the claims alone are already anticipated to be at an (estimated) $50 billion. That number will most likely continue to grow.

When you also account for long term planning, the reinsurers themselves did not foresee a catastrophe on the scale that occurred in Japan. There is no way the reinsurers can account for “Black Swan” events, because by definition black swan events are impossible to predict. While everyone is NOW debating the safety of nuclear plants, the next black swan could be entirely different in nature, such as a massive asteroid wiping out a country.

As an example, only a few weeks ago the headline news was all about the unprecedented and unexpected uprising in Libya. Then a 9.0 magnitude earth-quake struck off the coast of Japan, and the topic of conversation completely changed.

Some specific estimates are currently coming in, but it will be very difficult to tell the total damages and effects of the disasters for quite some time. The estimates have suggested anywhere from tens to hundreds of billions of dollars in damage, but then again, at this point who knows? Part of the problem in calculating the damage is that the Japanese government itself has created a structure where the individuals can either claim 5%, 50%, or 100% for their losses. Under those terms, the total property and casualty losses would be estimate at around $16.5 billion, with the Japanese government being hit with around $52 billion. The reinsurers would suffer the rest of the insurance damage.

Another aspect to consider is that, for one reason or another, many of the Japanese people do not participate in the insurance market themselves. According to The LA Times approximately only 10% only of all Japanese homes are fully insured. The paper also states how powerful the damage itself can be, as with the 1995 Kobe earthquake; while over $100 billion in economic losses occurred only $3 billion were insurance losses. So, while the damage itself could be countless, there is still a lot left to occur before we see the final damage number.

A reinsurance company at this point has many questions to face. It is unclear if these reinsurers will have made a profit in Japan when all of the damage and claims are actually calculated.

It is also unclear as to how you can properly plan ahead for an event such as this; one of the very events that reinsurers are supposed to be in business for. After all it is impossible to account for black swans in any potential risk model. Reinsurance companies can be making billions of dollars one year, and then a black swan occurs, which wipes out all the profit they ever made. This was similar to the case with AIG, which was selling CDSs on CDOs to insure against possible default. In 2007, Joe Cassano, an executive in the Financial Products division of AIG stated, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions”. In 2008, AIG reported a loss of nearly $100 billion, wiping out all the profit the company had earned since the early 1990s.

VaR and similar risk measurements are merely a symptom of the inability of humans’ to predict the future. Investors must be keen of this fact when investing in insurance companies.

Disclosure: None

http://www.valuewalk.com/

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


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Comments

rnagarajan
Rnagarajan - 3 years ago
Since 9/11/01, most reinsurance companies are far more cognizant of outliers than before. Even Warren Buffett admitted that he failed to properly price risks for events such as 9/11 to say nothing of a nuclear detonation in a major city. This has changed, at least at Berkshire, and I believe that policy exclusions protect against uncapped losses on policies.

What we need to keep in mind is the following: In the event of a truly horrific even such as nuclear war impacting multiple cities or countries, there is nowhere to hide, period. While a reinsurance company may cap risks in such a scenario, the value of all common stocks and all businesses would be decimated through a destruction of real wealth. There would be no place to hide in such a doomsday scenario.

I don't know of any way to invest without accepting the fact that if the world truly goes to hell in a handbasket through an event like nuclear war that there will be no escaping the consequences. If you think about it this is intuitively obvious as the entire world would experience a dramatic loss in real wealth and productive capacity which will be reflect in all financial assets. I would argue that even gold would have diminished utility in an apocalyptic scenario - and could potentially put holders at risk of physical harm.

My view is that one must plan for risk as best as possible but cannot go through life conditioned on planning for the totally unthinkable - it's not a way to live.
rgosalia
Rgosalia - 3 years ago
Jacob,

My comments are not pertaining the main topic of your article. But, a side comment about Joe Cassano's famous words from AIG's 2007 conference call.

I spent many months in the last 2 years looking at the entire AIG blowup by reading every conceivable government report on it. I just wanted to throw some light on the details of the blow-up in the AIGFP group.

If you look at the performance of the underlying CDOs that AIGFP CDS contracts insured, now held in New York Fed's Maiden III SIV, there have indeed been very few realized loses. So, in technicality, Joe Cassano's words are often misquoted in my opinion.

The real reason for the blow-up is the following in my opinion. Firstly, collateral calls were trigerred by the reduction in the "fair-value" of the underlying CDOs. If the parties disagreed with the fair value, then the contracts had a dispute-resolution process, one of them being "dealer poll." During Joe's time, they had disagreements with several large counterparties, they used all available defenses to get steep reductions in the called-in amounts.

However, then came the bomb. AIG was downgraded by the rating agencies due to underlying collateral pressures and problems in the securities lending business. This caused yet another round of collateral calls, draining liquidity from the parent.

Joe Cassano's biggest mistake was not an error of fundamental analysis - that the CDS will not have any realized loses - but an undue reliance on AIG's ratings and not hedging the book in 2005 when they stopped writing CDS business. He forgot Keynes lesson that the market can stay irrational longer than you can stay liquid.

However, if the govt. instead of effectively nationalizing AIG, had provided the liquidity support, it would have moved its ratings up to AAA and stopped the liquidity drain. Over time, AIGFPs contracts would have recovered similar to how Maiden Lane III is recovering its investment in the underlying CDOs. Instead the govt chose to nationalize AIG and bailout the counterparties 100c on the dollar - Goldman et al without any negotiations. For an interesting detailed account on this topic, I recommend reading SIGTARP report on this bailout at sigtarp's website.

I can talk about this topic for hours, but I don't mean to take over the thread on your great article.

Just thought I'll put my 2c in on AIG and the frequently misunderstood words of Joe Cassano.

-Rishi

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