Saturday, May 9, 2009


The insurance business has always been viewed with some suspicion by the law, governments and the moral arbiters of society. This is because there are obvious dangers in insulating people from the consequences of their actions, or even providing financial incentives to do the wrong thing. Insurance contracts have always been subject to the thorough scrutiny of law courts, and certain types of insurance arrangements have long been illegal.

Perhaps the best-known example is the “Slayer’s Bounty” doctrine of the Common Law, which provides that a killer cannot benefit financially from his actions. A husband who murders his wife thus will not inherit her wealth, and will not be permitted to collect proceeds of a life insurance policy naming him as beneficiary. For similar reasons, you are not allowed to take out a life insurance policy on another person without that person’s knowledge and consent. Other dangers arising out of insurance contracts are more subtle, giving rise to complex arguments about “moral hazard,” the creation of disincentives for responsible behavior.

Over the centuries of our jurisprudence, we have determined that insurance is appropriate if it protects us against random catastrophic events (“acts of God”) for which the holder of the policy cannot be held responsible. A certain number of ships are going to be caught in horrendous storms, a certain number of people are going to be hit by lightening, a certain number of buildings are going to burn down---all these are legitimate subjects of insurance. Even here, there may be some element of human responsibility, of course, and then there will be arguments about whether the insurance company will have to pay on the policy. If you intentionally burn down your house, you can’t collect. But what if you were merely negligent in keeping that bucket of oily rags in the garage? Well, that might be something for a court to decide. We might view the danger of oily rags as something a reasonable person might overlook, but only if we do not encourage carelessness in the process. This is where public policy and the courts become involved in a private insurance contract. It is important to everyone that people take fire prevention seriously, so insurance that might reduce the financial burden of negligent behavior becomes a matter of public interest.

There are many risks where society insists that the risk-taker not be permitted to reduce his exposure through insurance. Suppose John Doe opens a shoe store, for example. John knows the shoe business, he is sufficiently capitalized, he has studied the local traffic patterns and competition, he knows what his expenses are likely to be, and he rationally projects his business will make $100,000 profit its first year. Based upon his projections and all the homework he has done, John goes to his insurance agent and tries to buy an insurance policy guaranteeing him a $100,000 profit in the event fate should intervene in some fashion and limit his success.

Spend a minute thinking about this, and you begin to see the problems. John may well have all the tools in place to succeed in the shoe business, but what is his motivation to do so? Without such an insurance policy, with his savings and his dreams and his livelihood on the line, he might well make his $100,000 profit. But with such a policy, how long will it be before John begins to wonder why he is working 16-hour days and haggling with suppliers and chasing shoplifters and sweeping the backroom and smiling at rude customers and shoveling snow off the sidewalk? What’s the point? He’s getting his $100,000 at the end of the year whether he succeeds or not.

There was a time, and it wasn’t that long ago, when the insurance business was run by crusty old guys who smoked cigars in downtown office buildings and called their secretaries “Hon.” (Think Edward G. Robinson in Double Indemnity.) Back then, before insurance became just one piece of a globalized “Financial Services” industry with tens of thousands of computer-generated investment products that even financially-sophisticated people struggle to understand, the very idea that John Doe was seeking such an insurance policy would have produced only laughter. Now, I’m not so sure.

When someone opens a shoe business, what is the fundamental risk he is undertaking? It’s that he won’t make any money at it. Maybe he doesn’t manage employees well, maybe he doesn’t schmooze well with other businessmen, maybe customers just don’t like him---there are a thousand reasons he may fail, and the crusty old guys in the downtown office buildings wouldn’t insure against any of them. They would insure against fire and flood and slips on the sidewalk and theft and hurricanes---random disasters that could devastate John’s business but which he can’t really plan for---but they wouldn’t insure against the fundamental risk he is undertaking, that John himself is not up to the job.

The crusty old guys would have realized instinctively that such a thing is antithetical to the very idea of insurance. In addition, they may have assumed that such insurance was illegal. This brings us to the public policy argument.

You and I, and society in general, want a shoe store that provides us with the latest styles at competitive prices in a situation where the people selling us shoes care what we want. They don’t care about us “as people,” of course; they just want to get us to exchange our money for their shoes. But that’s fine. That’s all I want from them. I’m not looking for a marriage partner. I want them to care enough about my shoe needs that they are willing to go to the trouble to find out what I want and offer it to me at a price I’m willing to pay. It takes real effort to do that, but shoe-sellers are motivated to do it by prospect of making money. The desire to accommodate us is what makes shopping a relatively pleasant experience for most people. It’s why most of us would rather go shopping for shoes than visit the Department of Motor Vehicles, where the desire to please us is conspicuous by its absence.

And how does the shoe-seller find out what I really want? It’s not necessarily going to be what I say I want, or what I think I should want, or what some politician feels would be best for me. Throughout human history, only one method has been found: the pricing system, because of the information it conveys. If I am willing to take money out of my pocket and exchange it for a pair of shoes, it means that the shoes are worth more to me than the money is, and this is critical information for the shoe-seller. And since he’s charging me more than the shoes are worth to him (ensuring a profit), he’s happy too. The pricing system, and the lure of profit, is what makes the whole system work, and where it is absent, there is no mechanism to identify what consumers really want, and thus no way for producers to provide it. There are many reasons for the fall of the Soviet Union, but this is certainly one of them.

There’s another reason we don’t (or didn’t used to) allow insurance for the risk that a capitalist will fail. At any given moment, there is a finite amount of capital in the world, and it hurts all of us when some of it just sits around doing nothing. If John Doe can get insurance for his projected $100,000 profit, his shoe store may sit there indefinitely, performing no real function in society. Not only will customers be displeased with it, but John’s capital will be locked into a venture that is producing no wealth and no growth. John gets his $100,000, of course, but if he were truly successful, he might open another store, or he might sponsor a little league team, or he might give some of his money to charity. We, as a society, want John Doe to succeed. And if he doesn’t succeed, we want him to fail. We want somebody else to get John’s storefront and put a tire store in it, or a Starbucks---some place where we can happily exchange our money for a product or service we desire.

Failure is arguable better for John Doe, too. If he shuts down and salvages whatever money he can from his failure, he may learn from his mistakes and come back with a successful business in the future.

This is why the crusty old insurance guys would never insure against the fundamental risk of an enterprise. They would insure against a ship sinking in a storm, but not against the possibility that the cargo could not be sold for a profit. They wouldn’t insure against someone failing a bar exam. They wouldn’t insure a casino against losses at the baccarat table. It’s bad for everyone to insure people against their own failure. Human nature being what it is, insurance like that only makes failure more likely.

All of which brings us to AIG, which used to be run by a quintessential crusty old insurance guy named Hank Greenberg until he was forced out in a moral crusade waged by famed moral-crusader Eliot Spitzer. It was only after Greenberg’s departure that the more modern (and less crusty) financial geniuses who took over AIG figured out a way to lose a bazillion dollars.

The selling and reselling (and re-reselling) of sub-prime mortgages featured two mechanisms designed to insulate the investor from any knowledge of underlying facts relating to any specific mortgage or any specific borrower. The first was “bundling,” where thousands of such mortgages would be joined in a single package for investment purposes. This was supposed to provide a measure of safety for financial firms that bought the bundles. Buying one mortgage is always a risk because it might go into default, but if you buy thousands, and your data and assumptions are correct, the default percentage is quite predictable. Theoretically.

The second mechanism was “securitization,” which is where derivatives were created. Instead of buying a share of all the mortgages, you would buy a slice (a “tranche”) of each mortgage. For example, you might buy a security representing the income to be generated only in the seventh year of thousands of 30-year mortgages.

Some of our largest financial institutions were major participants in the market for these derivatives. However, the two mechanisms of bundling and securitization meant it was extremely difficult for a buyer of these securities to determine the real value of any of the underlying mortgages. Performing any sort of due diligence on such a security would mean personally investigating thousands of individual borrowers and then attempting to determine a value for the particular slice of that person’s mortgage you were buying (along with thousands of other slices). Instead, the institutions that bought them relied on the assumptions of those marketing the securities.

What happened next was inevitable. Since there was a large appetite in the markets for these mortgage instruments, and it was next to impossible to independently verify their value, unscrupulous mortgage brokers and real estate agents began to arrange mortgages for people who did not qualify for them, even under the lowered standards of the sub-prime mortgage market. In addition to outright fraud, there was simply no incentive to investigate whether a borrower who said he made $40,000 a year actually made $40,000 a year. If a mortgage could be written, it was written, and immediately re-sold to the derivatives market where it would disappear in a sea of other mortgages. It worked as long as real estate values were increasing at unsustainable levels, but when that bubble burst, defaults and foreclosures sky-rocketed.

In the derivatives market, AIG’s slice of all these questionable mortgages was the risk of default. AIG is, after all, an insurance company, so they sold insurance against default and foreclosure, collecting premiums in the process. For those marketing these derivatives, AIG’s role was a godsend, since it enabled all the other slices of the mortgages to be sold “risk-free.”

What’s wrong with this picture? Well, I would say the risk of default is the fundamental risk a lender faces when writing a mortgage. What AIG did here was the equivalent of insuring Joe Doe against the possibility he wouldn’t make money in the shoe business, and thereby encouraging Joe Doe not to make money in the shoe business. And this is just not something an insurance company run by crusty old insurance guys would ever have done. You want to write a mortgage? Fine. In days gone by, AIG would insure every risk related to that mortgage except the risk that you used poor judgment in extending the funds in the first place. Their decision to change that policy is the reason for their downfall.

But, of course, they never really saw it coming, and that is because many financial instruments today are created by computer programs and are so complex that even professionals cannot properly evaluate them. More importantly, issues of moral hazard and other basic tenets of the insurance business get lost in the confusion. Insuring against foreclosure for thousands of mortgages you know nothing about is simply a stupid thing to do, and you don’t need an MBA to figure that out. It’s a matter of common sense. Unfortunately, the nature of these investments is so convoluted that common sense can gain no purchase.

The complexity of even the most basic sorts of investments is such that no human being can account for all the variables involved. We all know what wheat is and what it is used for and how it is grown, but no one knows what wheat will cost a year from now. The mechanics of a standard 30-year mortgage is also within our comprehension, but that doesn’t mean anyone on earth can tell you what interest rates will be in 2015. Nevertheless, if you spend your entire career studying wheat or mortgages, you can arrive at educated guesses that may enable you to make money in those complex worlds.

But the bundling and securitizing of investments that already challenge our understanding makes one wonder whether they are purposely designed to defy analysis (and create incentives for fraud). Whether purposeful or not, that is the effect. The complexity of modern financial instruments is an extremely dangerous design flaw in our markets, especially since the dangers are multiplied by the globalization of finance. Now, instead of destroying a single company, the proliferation of these financial instruments can bring down nations.

Copyright 2009 Michael Kubacki