The Business of Risk

By: Sam Vaknin, Ph.D.

Also published by United Press International (UPI)

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Risk transfer is the gist of modern economies. Citizens pay taxes to ever expanding governments in return for a variety of "safety nets" and state-sponsored insurance schemes. Taxes can, therefore, be safely described as insurance premiums paid by the citizenry. Firms extract from consumers a markup above their costs to compensate them for their business risks.

Profits can be easily cast as the premiums a firm charges for the risks it assumes on behalf of its customers - i.e., risk transfer charges. Depositors charge banks and lenders charge borrowers interest, partly to compensate for the hazards of lending - such as the default risk. Shareholders expect above "normal" - that is, risk-free - returns on their investments in stocks. These are supposed to offset trading liquidity, issuer insolvency, and market volatility risks.

In his recent book, "When all Else Fails: Government as the Ultimate Risk Manager", David Moss, an associate professor at Harvard Business School, argues that the all-pervasiveness of modern governments is an outcome of their unique ability to reallocate and manage risk.

He analyzes hundreds of examples - from bankruptcy law to income security, from flood mitigation to national defense, and from consumer protection to deposit insurance. The limited liability company shifted risk from shareholders to creditors. Product liability laws shifted risk from consumers to producers.

And, we may add, over-generous pension plans shift risk from current generations to future ones. Export and credit insurance schemes - such as the recently established African Trade Insurance Agency or the more veteran American OPIC (Overseas Private Investment Corporation), the British ECGD, and the French COFACE - shift political risk from buyers, project companies, and suppliers to governments.

Risk transfer is the traditional business of insurers. But governments are in direct competition not only with insurance companies - but also with the capital markets. Futures, forwards, and options contracts are, in effect, straightforward insurance policies.

They cover specific and narrowly defined risks: price fluctuations - of currencies, interest rates, commodities, standardized goods, metals, and so on. "Transformer" companies - collaborating with insurance firms - specialize in converting derivative contracts (mainly credit default swaps) into insurance policies. This is all part of the famous Keynes-Hicks hypothesis.

As Holbrook Working proved in his seminal work, hedges fulfill other functions as well - but even he admitted that speculators assume risks by buying the contracts. Many financial players emphasize the risk reducing role of derivatives. Banks, for instance, lend more - and more easily - against hedged merchandise.

Hedging and insurance used to be disparate activities which required specialized skills. Derivatives do not provide perfect insurance due to non-eliminable residual risks (e.g., the "basis risk" in futures contracts, or the definition of a default in a credit derivative). But as banks and insurance companies merged into what is termed, in French, "bancassurance", or, in German, "Allfinanz" - so did their hedging and insurance operations.

In his paper "Risk Transfer between Banks, Insurance Companies, and Capital Markets", David Rule of the Bank of England flatly states:

"At least as important for the efficiency and robustness of the international financial system are linkages through the growing markets for risk transfer. Banks are shedding risks to insurance companies, amongst others; and life insurance companies are using capital markets and banks to hedge some of the significant market risks arising from their portfolios of retail savings products ... These interactions (are) effected primarily through securitizations and derivatives. In principle, firms can use risk transfer markets to disperse risks, making them less vulnerable to particular regional, sectoral, or market shocks. Greater inter-dependence, however, raises challenges for market participants and the authorities: in tracking the distribution of risks in the economy, managing associated counterparty exposures, and ensuring that regulatory, accounting, and tax differences do not distort behavior in undesirable ways."

If the powers of government are indeed commensurate with the scope of its risk transfer and reallocation services - why should it encourage its competitors? The greater the variety of insurance a state offers - the more it can tax and the more perks it can lavish on its bureaucrats. Why would it forgo such benefits? Isn't it more rational to expect it to stifle the derivatives markets and to restrict the role and the product line of insurance companies?

This would be true only if we assume that the private sector is both able and willing to insure all risks - and thus to fully substitute for the state.

Yet, this is patently untrue. Insurance companies cover mostly "pure risks" - loss yielding situations and events. The financial markets cover mostly "speculative risks" - transactions that can yield either losses or profits. Both rely on the "law of large numbers" - that in a sufficiently large population, every event has a finite and knowable probability. None of them can or will insure tiny, exceptional populations against unquantifiable risks. It is this market failure which gave rise to state involvement in the business of risk to start with.

Consider the September 11 terrorist attacks with their mammoth damage to property and unprecedented death toll.  According to "The Economist", in the wake of the atrocity, insurance companies slashed their coverage to $50 million per airline per event. EU governments had to step in and provide unlimited insurance for a month. The total damage, now pegged at $60 billion - constitutes one quarter of the capitalization of the entire global reinsurance market.

Congress went even further, providing coverage for 180 days and a refund of all war and terrorist liabilities above $100 million per airline. The Americans later extended the coverage until mid-May. The Europeans followed suit. Despite this public display of commitment to the air transport industry, by January this year, no re-insurer agreed to underwrite terror and war risks. The market ground to a screeching halt. AIG was the only one to offer, last March, to hesitantly re-enter the market. Allianz followed suit in Europe, but on condition that EU governments act as insurers of last resort.

Even avowed paragons of the free market - such as Warren Buffet and Kenneth Arrow - called on the Federal government to step in. Some observers noted the "state guarantee funds" - which guarantee full settlement of policyholders' claims on insolvent insurance companies in the various states. Crop failures and floods are already insured by federal programs.

Other countries - such as Britain and France - have, for many years, had arrangements to augment funds from insurance premiums in case of an unusual catastrophe, natural or man made. In Israel, South Africa, and Spain, terrorism and war damages are indemnified by the state or insurance consortia it runs. Similar schemes are afoot in Germany.

But terrorism and war are, gratefully, still rarities. Even before September 11, insurance companies were in the throes of a frantic effort to reassert themselves in the face of stiff competition offered by the capital markets as well as by financial intermediaries - such as banks and brokerage houses.

They have invaded the latter's turf by insuring hundreds of billions of dollars in pools of credit instruments, loans, corporate debt, and bonds - quality-graded by third party rating agencies. Insurance companies have thus become backdoor lenders through specially-spun "monoline" subsidiaries.

Moreover, most collateralized debt obligations - the predominant financial vehicle used to transfer risks from banks to insurance firms - are "synthetic" and represent not real loans but a crosscut of the issuing bank's assets. Insurance companies have already refused to pay up on specific Enron-related credit derivatives - claiming not to have insured against a particular insurance events. The insurance pertained to global pools linked and overall default rates - they protested.

This excursion of the insurance industry into the financial market was long in the making. Though treated very differently by accountants - financial folk see little distinction between an insurance policy and equity capital. Both are used to offset business risks.

To recoup losses incurred due to arson, or embezzlement, or accident - the firm can resort either to its equity capital (if it is uninsured) or to its insurance. Insurance, therefore, serves to leverage the firm's equity. By paying a premium, the firm increases its pool of equity.

The funds yielded by an insurance policy, though, are encumbered and contingent. It takes an insurance event to "release" them. Equity capital is usually made immediately and unconditionally available for any business purpose. Insurance companies are moving resolutely to erase this distinction between on and off balance sheet types of capital. They want to transform "contingent equity" to "real equity".

They do this by insuring "total business risks" - including business failures or a disappointing bottom line. Swiss Re has been issuing such policies in the last 3 years. Other insurers - such as Zurich - move into project financing. They guarantee a loan and then finance it based on their own insurance policy as a collateral.

Paradoxically, as financial markets move away from "portfolio insurance" (a form of self-hedging) following the 1987 crash on Wall Street - leading insurers and their clients are increasingly contemplating "self-insurance" through captives and other subterfuges.

The blurring of erstwhile boundaries between insurance and capital is most evident in Alternative Risk Transfer (ART) financing. It is a hybrid between creative financial engineering and medieval mutual or ad hoc insurance. It often involves "captives" - insurance or reinsurance firms owned by their insured clients and located in tax friendly climes such as Bermuda, the Cayman Islands, Barbados, Ireland, and in the USA: Vermont, Colorado, and Hawaii.

Companies - from manufacturers to insurance agents - are willing to retain more risk than ever before. ART constitutes less than one tenth the global insurance market according to "The Economist" - but almost one third of certain categories, such as the US property and casualty market, according to an August 2000 article written by Albert Beer of America Re. ART is also common in the public and not for profit sectors. counts the advantages of self-insurance:

"The alternative to trading dollars with commercial insurers in the working layers of risk, direct access to the reinsurance markets, coverage tailored to your specific needs, accumulation of investment income to help reduce net loss costs, improved cash flow, incentive for loss control, greater control over claims, underwriting and retention funding flexibility, and reduced cost of operation."

Captives come in many forms: single parent - i.e., owned by one company to whose customized insurance needs the captive caters, multiple parent - also known as group, homogeneous, or joint venture, heterogeneous captive - owned by firms from different industries, and segregated cell captives - in which the assets and liabilities of each "cell" are legally insulated. There are even captives for hire, known as "rent a captive".

The more reluctant the classical insurance companies are to provide coverage - and the higher their rates - the greater the allure of ART. According to "The Economist", the number of captives established in Bermuda alone doubled to 108 last year reaching a total of more than 4000. Felix Kloman of Risk Management Reports estimated that $21 billion in total annual premiums were paid to captives in 1999.

The Air Transport Association and Marsh, an insurer, are in the process of establishing Equitime, a captive, backed by the US government as an insurer of last resort. With an initial capital of $300 million, it will offer up to $1.5 billion per airline for passenger and third party war and terror risks.

Some insurance companies - and corporations, such as Disney - have been issuing high yielding CAT (catastrophe) bonds since 1994. These lose their value - partly or wholly - in the event of a disaster. The money raised underwrites a reinsurance or a primary insurance contract.

According to an article published by Kathryn Westover of Strategic Risk Solutions in "Financing Risk and Reinsurance", most CATs are issued by captive Special Purpose Vehicles (SPV's) registered in offshore havens. This did not contribute to the bonds' transparency - or popularity.

An additional twist comes in the form of Catastrophe Equity Put Options which oblige their holder to purchase the equity of the insured at a pre-determined price. Other derivatives offer exposure to insurance risks. Options bought by SPV's oblige investors to compensate the issuer - an insurance or reinsurance company - if damages exceed the strike price. Weather derivatives have taken off during the recent volatility in gas and electricity prices in the USA.

The bullish outlook of some re-insurers notwithstanding, the market is tiny - less than $1 billion annually - and illiquid. A CATs risk index is published by and option contracts are traded on the Chicago Board of Trade (CBOT). Options were also traded, between 1997 and 1999, on the Bermuda Commodities Exchange (BCE).

Risk transfer, risk trading and the refinancing of risk are at the forefront of current economic thought. An equally important issue involves "risk smoothing". Risks, by nature, are "punctuated" - stochastic and catastrophic. Finite insurance involves long term, fixed premium, contracts between a primary insurer and his re-insurer. The contract also stipulates the maximum claim within the life of the arrangement. Thus, both parties know what to expect and - a usually well known or anticipated - risk is smoothed.

Yet, as the number of exotic assets increases, as financial services converge, as the number of players climbs, as the sophistication of everyone involved grows - the very concept of risk is under attack. Value-at-Risk (VAR) computer models - used mainly by banks and hedge funds in "dynamic hedging" - merely compute correlations between predicted volatilities of the components of an investment portfolio.

Non-financial companies, spurred on by legislation, emulate this approach by constructing "risk portfolios" and keenly embarking on "enterprise risk management (ERM)", replete with corporate risk officers. Corporate risk models measure the effect that simultaneous losses from different, unrelated, events would have on the well-being of the firm.

Some risks and losses offset each others and are aptly termed "natural hedges". Enron pioneered the use of such computer applications in the late 1990's - to little gain it would seem. There is no reason why insurance companies wouldn't insure such risk portfolios - rather than one risk at a time. "Multi-line" or "multi-trigger" policies are a first step in this direction.

But, as Frank Knight noted in his seminal "Risk, Uncertainty, and Profit", volatility is wrongly - and widely - identified with risk. Conversely, diversification and bundling have been as erroneously - and as widely - regarded as the ultimate risk neutralizers. His work was published in 1921.

Guided by VAR models, a change in volatility allows a bank or a hedge fund to increase or decrease assets with the same risk level and thus exacerbate the overall hazard of a portfolio. The collapse of the star-studded Long Term Capital Management (LTCM) hedge fund in 1998 is partly attributable to this misconception.

In the Risk annual congress in Boston in 2000, Myron Scholes of Black-Scholes fame and LTCM infamy, publicly recanted, admitting that, as quoted by Dwight Cass in the May 2002 issue of Risk Magazine: "It is impossible to fully account for risk in a fluid, chaotic world full of hidden feedback mechanisms." Jeff Skilling of Enron publicly begged to disagree with him.

In April 2002, in the Paris congress, Douglas Breeden, dean of Duke University's Fuqua School of Business, warned that - to quote from the same issue of Risk Magazine:

" 'Estimation risk' plagues even the best-designed risk management system. Firms must estimate risk and return parameters such as means, betas, durations, volatilities and convexities, and the estimates are subject to error. Breeden illustrated his point by showing how different dealers publish significantly different prepayment forecasts and option-adjusted spreads on mortgage-backed securities ... (the solutions are) more capital per asset and less leverage."

Yet, the Basle committee of bank supervisors has based the new capital regime for banks and investment firms, known as Basle 2, on the banks' internal measures of risk and credit scoring. Computerized VAR models will, in all likelihood, become an official part of the quantitative pillar of Basle 2 within 5-10 years.

Moreover, Basle 2 demands extra equity capital against operational risks such as rogue trading or bomb attacks. There is no hint of the role insurance companies can play ("contingent equity"). There is no trace of the discipline which financial markets can impose on lax or dysfunctional banks - through their publicly traded unsecured, subordinated debt.

Basle 2 is so complex, archaic, and inadequate that it is bound to frustrate its main aspiration: to avert banking crises. It is here that we close the circle. Governments often act as reluctant lenders of last resort and provide generous safety nets in the event of a bank collapse.

Ultimately, the state is the mother of all insurers, the master policy, the supreme underwriter. When markets fail, insurance firm recoil, and financial instruments disappoint - the government is called in to pick up the pieces, restore trust and order and, hopefully, retreat more gracefully than it was forced to enter.

The state would, therefore, do well to regulate all financial instruments: deposits, derivatives, contracts, loans, mortgages, and all other deeds that are exchanged or traded, whether publicly (in an exchange) or privately. Trading in a new financial instrument should be allowed only after it was submitted for review to the appropriate regulatory authority; a specific risk model was constructed; and reserve requirements were established and applied to all the players in the financial services industry, whether they are banks or other types of intermediaries.

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