Are insurers giving up their primary job – taking risk?

I read an article which says ‘Chartis No Longer Writing Excess Workers’ Comp as Stand-Alone Product’.

Chartis is one of the biggest writers of the excess worker’s compensation and has now stopped writing these insurance policies. The reason being – adverse development in 2010 and 2009 of $825 and $925 million, hurt them.

The problem with this business is that the risks are larger and extreme – meaning longer and fatter tails. Also, this business is highly sensitive to changes in assumptions in:

1) Medical inflation or worker longevity (injured worker)

2) changes in legal, judiciary, social environment.

3) cost of additional treatment

4) Territorial experience differences

Firms like Chartis started products like these because they saw a profit opportunity and a need in the market. If they pull out sighting profitability issues, then how would the need be answered? Perhaps firms need to start getting into the business of managing their own risks? Maybe here’s an opportunity for a w venture – niche risk management firm?

Full-link to article : http://www.insurancejournal.com/news/east/2012/03/02/237914.htm

Chartis: ‘Insurance in Russia still ‘push’ product’

http://rt.com/business/news/russia-insurance-chartis-adamantiadis-007/

Chartis is a global property-casualty and general insurance organization serving more than 70 million clients around the world. The Company has been operating in the Russian market since 1994 and is focused on property and casualty insurance for corporate and individual clients. The article below is an interview with Christos Adamantiadis, the general manager of Chartis Russia, recorded in January 2012. It highlights the differences of the Russian insurance market place and opportunities the country presents. The general manager believes that insurance in Russia needs “evolutionary growth”, because few Russians choose the security of insurance, and it hasn’t yet become a part of their everyday thinking. Furthermore, he says that Russians don’t yet understand both the mechanism and the purpose of insurance. The most striking thing to him is the very low penetration of Life and Pension insurance, which could be linked to generally low savings rates. The low penetration rates in Russia, and the economic pick-up after the 2008 crisis make Russia one of the best market segments for Chartis to be in. The manager mentions that, based on the 2011 data,  the US, Europe and Japan were static or, in some cases, even degrading in 2011, whereas the rest of the world was growing at reasonably healthy rates. Within the latter group, Russia ~15% growth clearly stands out.

His outlook for Chartis Russia in 2012 is bright: “I see four main developments, which will largely define the direction of the market in 2012. First, the growth in new Auto sales. Auto insurance being a key determinant of the market dynamics. Second, the traction of the new law on the Liability of High Hazard industries – which I see as a very positive development for the corporate insurance market as well as for citizens’ rights, in Russia. Third, the speed with which Bancassurance grows. Bancassurance being a relatively new but very dynamic distribution channel.

There were several comments to the original article, and I found that one of them was very represntative of the typical Russian view on insurance; so here it is: “insurance in my country is one of those things that suck you out of money. Car 1 is compulsory, 1 is if only one wants it. If you ever try to “insure” something those money making companies always try very hard to say that it was the case you werent insured for. There were instances when certain people insured themselves and then cut off their most “costly” finger so they got a lot money after they were insured with numerous companies and so on”

In other words, scam-scam-scam; we don’t trust the establishment.

 

Low Yields Force Insurance Companies to Get Creative

As we will be in a session with Mr. Peter Hancock of Chartis Insurance, I thought I would focus on a topic that has affected all investors, but insurance companies in particular. Doug Dachille was on CNBC earlier this year talking about how record low yields on fixed income securities make the asset class highly unattractive. This is particularly true for savings and loan banks and insurance companies who have limited options for compensating for lost revenue due to low investment yields.

Insurance companies must take great care to preserve their portfolios of liquid assets while at the same time meeting customer claims and operating the business day-to-day. A team from Earnst & Young did a study on the impact to portfolio yields of the 25 largest insurers in the U.S. Their results showed that portfolio yields could drop by 20-80 basis points in the current interest rate environment. That seems like a very small number, but multiply that by hundreds of millions or billions of dollars and you are taking about multi-million dollar decreases in investment revenue and meaningful declines in profitability.

The report describes measures insurance comapnies are using to compensate for lost investment yield. In most cases, increases in operating risk seems to be inevitable. Whether it is taking on longer dated fixed income investment, allocating money to riskier assets, entering into higher risk areas of insurance or even paying claims with premiums without investing the income first, all pose extra risks to insurers that were avoidable when yield levels were higher.

The rate of bank defaults has decreased over the last 18 months, which is a re-assuring sign of sustained economic recovery in the U.S.. Insurance companies, however, are feeling the squeeze more and more with each passing month of low yields and lack of higher yielding, low-risk investments. With luck and good management, insurers may be able to weather the drought of historically moderate yielding investments. There is now a higher likelihood that more insurance companies may be forced to sell assets, reduce service, raise extra capital at low valuations or seek financial support or bailouts from outside investors if they are not able to remain solvent in the current yield environment. Hopefully none of us will find ourselves without coverage due to an insurer shutting its doors as a result of the current market yield environment.

Earnst & Young Paper Link:

http://www.ey.com/Publication/vwLUAssets/Low_interest_rates_effects_on_the_insurance-industry/$FILE/The%20impact%20of%20prolonged%20low%20interest%20rates%20on%20the%20insurance%20industry.pdf

John Corron

Refinancing Home Loans without Documentation is Politically Sagacious

On a CNBC interview, Doug Dachille, CEO of First Principles Capital Management, LLC, which is a registered Investment Advisor based in New York city[1] and managing $7 billion in fixed income[2], made some interesting recommendations. His recommendations were very compelling and it was obvious that his hypothesis of how to transmit the intent of the Federal Reserve’s (the Fed) policy initiative of benefiting home owners, was rooted in insights of grass root reality.

According to him, the Fed started buying MBS (Mortgage Backed Securities) and invested 1.25 Trillion dollars so as to provide liquidity and reduction in Home Loan rates. All that this policy achieved was growth in Value of MBS thereby enriching the investor rather than lowering the loan rates and payment obligations of home owners. This was mainly because very insignificant percent of first time home mortgages were being created as there was very little new production of houses and most mortgages were not being refinanced to lower interest rates as the riskiness of the asset was still high given that value of the debt continued to be more than the value of the property. Refinance, as we know, had worked well when the value of houses was rising.

In short, refinance of home loans to lower interest rates was not happening. Therefore the benefits of lower interest rates were not being transmitted to the home loan borrowers. The windfall gain of lower rates which had raised the value of MBS has only enriched the investors who captured all the gains. The mortgage provider was also doing the right thing in the sense that he has to deal with multiple risks that arise from various sources and unless he has documentation to establish credit worthiness of the home loan borrower, he would not lower rates or refinance.

Dachilles’s recommendation for transmission of benefit of the Fed policy to the intended beneficiary was rather controversial, yet sensible. He suggested that the required documentation, which is a basis for refinancing their loans at lower rates for those who have been paying their loans consistently for last 18 months, even if they are unemployed, be done away with. The fact that such borrowers have demonstrated responsibility towards payment is proof enough to pass the benefit to them and allow unhindered transmission of policy. This would increase their credit-worthiness as with lower payment obligations, their disposable income would increase, which would back their responsibility to pay. The recommendation was apparently controversial as absence of verification of income and asset as a precursor to giving loans was the basis of Housing crises of 2007. However, the logic of the recommendation appears compelling given that lion’s share of the borrowers were paying the loans consistently, establishing their responsibility.  Interestingly, this may have been politically very sagacious as the benefits would have gone to a very large section of society. The recommendations were made in August of 2010!

Fed had started buying $1.25 Trillion mortgage bonds in January of 2009. Since then, the value of Housing estate in US, which represents 15 percent of economy, has fallen by 4.1 percent. While the Fed has helped lower the mortgage rates to all time low, yet, the home loan borrowing in 2012 is expected to set a record of being the lowest in 15 years. Credit-worthy borrowers continue to be locked out due to bureaucratic documentation.[3]

Is anybody listening!

 

Posted By

Saachi Pande

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[1] http://www.fpcmllc.com/

[2] http://www.youtube.com/watch?v=yQhiWiwodtg

[3] http://www.bloomberg.com/news/2012-01-11/bernanke-doubling-down-on-housing-bet-asks-government-to-help-mortgages.html

[4] http://www.bloomberg.com/news/2012-01-11/bernanke-doubling-down-on-housing-bet-asks-government-to-help-mortgages.html

Blame futures, not Europe

Source: http://www.cnbc.com/id/47145423?__source=yahoo|headline|quote|text|&par=yahoo

According to Mad Money’s Jim Cramer, the news that the stock market has seen sharp losses recently is not because of instability in Europe. Granted there has been some unsettlement in Europe because the Netherlands is unhappy that other countries in the Euro Zone are not keeping their budgets under control, Cramer states that blaming Europe is just wrong in this case. Cramer thinks that futures are to blame for the large down swings in the market.

” The market didn’t always trade this way, though. Prior to 1983, stock futures didn’t exist. Many companies resisted the creation of stock futures, too, because they feared stocks would be controlled by the futures rather than the performance of the company. As it turned out, that’s exactly what happened, but Cramer said nobody cared because investors saw S&P futures as a great way to hedge.  Instead of dumping all stocks on fears of an economic slowdown, investors could now sell a future and hold onto their stocks.”*

Cramer cites Ross Stores as an example to make his argument. Ross Stores is a US based discount retailer that has no business operations in Europe at all, however, its stock price has declined recently. The cause? It is on S&P 500, and sophisticaed investors are selling futures of stock on the S&P 500. The problem according to Cramer is that stock price now-a-days is not related directly to the performance of the company, but instead is a hostage to the large hedge funds that trade in options and futures that only care about turning in quick profits instead of the financial health of the system as a whole.

Option traders use sophisticated heuristics, never the Black Scholes model – Nicholas Nassem Taleb

When I first read this statement – it seemed outrageous. But coming from Nicholas Taleb (author of the Black Swan and a well-known option trader himself) and Haug (author of several option pricing papers), made me read through. While I am yet to decipher the entire paper, a brief abstract is as follows:

The paper says that the Black-Scholes model was a mere ‘argument’. The foundations of option hedging and pricing were already far more firmly laid down before Black, Scholes and Merton. Infact, options were actively trading at least already in the 1600 as described by Joseph De La Vega –implying some form of technë, a heuristic method to price them and deal with their exposure. What Black, Scholes and Merton did, was mere “marketing” of the ‘dynamic hedging’ concept. The Black-Scholes-Merton’s claim to fame is removing the necessity of a risk-based drift from the underlying security –to make the trade “risk-neutral”. But one does not need dynamic hedging for that: simple put call parity can suffice.

Second, the paper says trader’s do not ‘use’ the model to price options. He says that for traders, producing an option ‘price’ when none has knowledge about probability distributions, is not ‘valuation’. Such prices could change based on their beliefs, based on a trader’s inventory, etc.

Link to the paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1012075&https://www.google.com/

Thinking of Project Investments as Real Options

Investments decisions relating to new projects such as R&D, Advertising campaigns, additional capacities in existing plants or creating new plants, are some of the toughest decisions that corporate executives have to make. They are tough not because they require committing sizeable shareholder funds into projects that will take time to generate returns but because markets and environments never stand still and often move unpredictably thereby impacting the value of these investments.

The world of Finance has given us wonderful option pricing theories epitomized by Black Scholes Option Pricing Model (BOSPM). The same theories when applied to real assets are called Real Options. In building analogy between BOSPM and Investment decisions based on Real Options, Prof Timothy A Luehrman of HBS, in his very interesting article (1998)[1] draws analogy of call options and the five fundamental variable that are basis of Options’ valuation, as also determinants of value of options for real assets (being created through capital investments) of the type referred above. Refer the table below[2]

Table 1

TREATING PROJECT INVESTMENTS AS CALL OPTIONS
FINANCIAL OPTION VARIABLE	REAL OPTION ANALOGY
STOCK PRICE	PROJECT NPV
EXERCISE PRICE	INVESTMENTS IN THE PROJECT
TIME TO EXPIRATION	LENGTH OF TIME THE DECISION MAY BE DEFERRED
RISK FREE RETURN	TIME VALUE OF MONEY
VARIANCE IN RETURNS OF STOCKS	RISKINESS OF PROJECT ASSETS

Then leveraging the “Real Option Analogy” variables (Table 1) he creates another very powerful analogy between a gardener who tends to his crop of tomatoes and a CEO who tends to portfolio of possible investments.[3] His analogy goes like this:

• A gardener who walks into his garden of tomatoes in August of an year would notice that there are tomatoes that are ripe, these need to be picked and there are those that have over-ripened, these need to be plucked and disposed. These are like investment decisions that cannot be deferred any more. The former are analogous to investments being NPV positive and the latter being NPV negative. There is nothing to be gained by deferring the investments.
• In between these extreme cases are tomatoes that are reasonably ripe and could be left on the vine only if there was little possibility of the squirrel getting to them. These are like investments which are NPV positive but a little deferment of the investment would be a little beneficial, however if there is fear of competitor’s pre-emption, the investments may be made. Here the deferment has a favourable option value.
• Then there are tomatoes that are not ripe enough to be edible. These cannot be picked even if a squirrel did get to them, moreover the season is still not over and if left on the vine, they would certainly gain and become worthy. These are investments that show promise but the option exercise (investment commitment) may be deferred as there is still gain to be made by remaining flexible for a while more.
• Etc.

With gratitude to theories and their creators!

Posted By

Saachi Pande

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[1] Luehrman, Timothy A., “Investment Opportunities as Real Options: Getting Started on Numbers” HBR, July-August, 1998

[2] Luehrman, Timothy A., “Investment Opportunities as Real Options: Getting Started on Numbers”, HBR, July-August, 1998

[3] Luehrman, Timothy A., “Strategy as a portfolio of Real Options”, HBR, Sept-Oct 1998

Options could be safer than stocks

source: http://finance.yahoo.com/news/options-safer-stocks-162540682.html

While option pricing is dependent on the actual price of stocks, trading in options could potentially provide a less risky adventure than trading in stocks, according to the article. The article sites apple’s stock crash on March 20th as a prime example to stock market volatility. While protection against nose diving stocks is available to stop-loss and trailing loss trades, there can still be a significant loss to the investor since order can be filled at lower than desired prices, especially during flash crashes.

The article discusses the Bull call , and the Iron butterfly options. Both those strategies work to reduce losses, but can also cap gains. So in essence, trading in options can be used to reduce the volatility of gains and losses. Here is an example fro investopedia regarding hedging using Bull Calls:

Let’s assume that a stock is trading at $18 and an investor has purchased one call option with a strike price of $20 and sold one call option with a strike price of $25. If the price of the stock jumps up to $35, the investor must provide 100 shares to the buyer of the short call at $25. This is where the purchased call option allows the trader to buy the shares at $20 and sell them for $25, rather than buying the shares at the market price of $35 and selling them for a loss.

To set up an iron butterfly, the options trader buys a lower strike out-of-the-money put, sells a middle strike at-the-money put, sells a middle strike at-the-money call and buys another higher strike out-of-the-money call. This results in a net credit to put on the trade, hence it is a credit spread*.

When employing those strategies in trading options, no hedge is necessary, since you are already hedged when employing those tactics. The price of such hedging is the cap on maximum profits.

While options trading require a higher degree of investor sophistication, the  long term benefits of trading in options could be worthwhile for the investor to acquire said knowledge.

 

 

 

*http://en.wikipedia.org/wiki/Iron_butterfly_%28options_strategy%29

Black-Sholes – Dangerous in the Wrong Hands

We have all heard many explanations of the causes of the financial crisis of 2008. Ian Stewart, writing an article for The Observer, is the first person I have seen who put some of the blame on the Black-Sholes options pricing equation. Be forewarned, Stewart is a mathemetician so I’m sure he’s got an affinity for equations. Fortunately for his readers, there are no numbers in the article, just a pretty straightforward examination of the role of Black-Sholes in the last market crisis.

Stewart credits Black-Sholes for revolutionizing global finance with their options pricing equation. The blame he places is on those who used the Black-Sholes equation in complex financial models that were not imbedded in a world of imperfect market participants and market influences. Assumptions were made to address some of the shortcomings of the Black-Sholes equation, which turned out to be castles built on sand. Many models failed miserably when their simple assumptions about market co-movement and price behavior  proved much too aggressive and optimistic (variation which Black-Sholes assumes is normally distributed).

Like atomic energy and bioscience, Black-Sholes and financial innovation can be used for the betterment of humanity if only abuse and misuse of these technologies could be contained or limited. Until responsibility and accountability becomes a cornerstone of innovation, the dangers of abusing or misunderstanding the power of innovations will always lead to mania that brings down large swaths of society as credit derivatives did in 2008.

So while Black-Sholes has been a major gear in the global financial machine for decades, Stewart re-confirms that it’s power and shortcomings are misunderstood by many. In the wrong hands even with good intentions, using Black-Sholes and its assumptions blindly in future financial innovations can be a very dangerous and costly experiment. An experiment that we should all warily keep in mind as we are constantly enticed to invest our wealth and assets in more customized and easy-to-use financial instruments.

Stewart Article Link:

http://www.guardian.co.uk/science/2012/feb/12/black-scholes-equation-credit-crunch

J. Corron

Skew – A Critical Piece of Financial Information

http://online.barrons.com/article/SB50001424053111903835404577347822859797612.html?mod=BOL_options_home

A lot of investors look at the Chicago Board Options Exchange Volatility Index (VIX), to get a quick gauge of how fearful or complacent investors have become. And the widely-watched VIX, currently trading at a relatively sanguine 20, isn’t signaling the fear that it was last fall when it was in the high 40s. But few sophisticated investors dive deeper into the market and look at skew, which is often a bit at odds with the VIX.

Skew measures if the options market is pricing an advance or decline in associated stocks, exchanges traded funds and indexes. It measures the difference between the implied volatility of out-of-the-money puts and calls.

When investors are afraid a security will decline, they tend to buy puts that would increase in value if the security falls say 5% in one or three months. Conversely, when they think a security will rise, they tend to buy bullish calls. The buying action is reflected in implied volatility of puts and calls. Implied volatility is like a mathematical measure of demand. When lots of investors buy something at the same time, implied volatility tends to increase because it indicates investor expectations about something that will happen in the future. Thus skew is a canary in the investor’s coal mine.

High put skew, which is what now defines the Standard & Poor’s 500 Index, demonstrates that investors are buying puts to prepare for a stock market decline. A contrarian approach will be to use high skew as a foundation for bullish stock adventures.  By selling puts on blue-chip stocks that pay reliable dividends, investors can take advantage of the fear premium in the options market. Whenever put skew is high in an index, it tends to drift into the stocks that comprise the index.  Of course, the danger to selling puts, especially when skew is high, is if the stock market sharply corrects, and anyone who sold puts is stuck buying them even if the market price is higher than the put strike price. If you can live with that risk, and it is a real risk, the options market will pay you a princely sum.

Posted by Alla Wagner