#insurable risk

[insurancepedia]

Five Basic Principles of Insurance

INSURANCE-PEDIA.COM | Insurance principles are the basis or basis of any problems arising in insurance contracts. According Soemitra (2010: 262), there are five principles of insurance as follows:

1. Insurable Risk Insurable interest is the interest of the participant / insured with the insured object / party insured. If the insured suffers a loss or disaster on the object / party insured then the…

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[midwest-musings]

MY FRIEND MIKE

I have a friend named Mike who I have always considered to be the world's third smartest man. A number of years ago we were in the midst of a lavish party being hosed by a sorvereign debt trader of our acquaintance (he used to work for me). Sovereign debt in those days consisted of old bank loans from the eighties, most of which had been restructured under various agreements and which were trading at various discounts with spreads thru which one could drive a truck. At some point in the evening my friend Mike wandered up to our host who was engaged in explaining the intricacies of the business to a knock-out reporter from Reuters to whom I had introduced him and said: "Let me get this straight. You guys make a great deal of money selling debt that nobody else wants to each other." Our host was aghast, the knock-out retreated in horror and I dissolved in gales of laughter. Mike, to this day, has the ability to reduce the seemingly complex to the mundane. We proceeded to get very, very drunk and left knowing that we had won one for the average man. At the time of The Great Collapse, credit default swaps (CDSs) totaled in some estimations $40 trillion. They were surrounded by mystery but after all is said, they are insurance policies written by one party to cover the obligations of another to someone who doesn't like the credit but yet owns it. Now if you were to ask my friend Mike about this stuff he would probably say why the hell would you want to get into a business where you are guaranteeing the investment of professional lenders when they are supposed to know the credit to whom they lend? He would also question why one would do this with the same credit again and again and again. Told you Mike was a smart guy. Now insurance is a pretty straightforward business: there is a single asset at risk that has a certain value, such as a house. If you are going to collect on a policy you have to have the insurable risk...i.e. you own the house. You can't go out and buy 100 policies on the same house because in the insurance business the minute a risk is insured a record is created that is available to the public so everybody knows what has occurred. It's impossible to game the system. Not so with CDSs. Anybody could write a policy and you could have a claim even without an insurable interest. Or. to put it another way, you could speculate on both ends. You could also sell the damn things or create your own on the very same credit, and this is precisely what happened. There was a very large market in the trading of CDSs with quoted and recognized spreads that were adjusted as the perception of the underlying credit changed but also changed as a result of the perceived change in the credit of the underwriter. All sorts of risk could be written; senior debt, sub-debt, mezzanine etc. It is a complex business, totally driven by market perception and subject to the brutalities of the market. I wasn't always such. The business of guaranteeing debt goes back centuries but for our purposes, one can say that it was the municipal bond market that marked the emergence of the idea of credit enhancement. Like all other debt instrument, the cost to a municipal issuer is dependent upon its credit rating supplied by well-known rating agencies. A triple-A rating gets the best deal and the cost rises to every issuer further down the rating scale. But what if a low-rated issuer could somehow enhance its debt rating? Well, that would mean a lower cost of issuance and as long as the cost of that enhancement was lower that the premium which would be paid without it, it was a win-win. An important point: The risk of default with a municipality was practically nil: it never happened because governments HAVE THE POWER TO TAX on various levels. Given this fact, firms were only too happy to substitute their credit for a fee to help out the issuers and the investors were more than happy to trade a lower yield for a better credit risk (in actuality, the yield was always a bit higher for an enhanced deal that for a primary issuer of the same credit standing) and in addition, there are many investors who are unable to invest in any credit below a certain credit rating by charter, so this was a boon to all. It was a nice, safe business that made everyone happy. So what went wrong? Tune in tomorrow and try to think like my friend Mike. It's simple, really.