Reinsurance.
What is it?
When an insurance companies reinsures its liabilities, the initial insurer transfers the risk of the insurance to another company referred to as the reinsurer. The reinsurer rather than the insurance company that originally provided the policy then provides the financial guarantee on the insurance policy. (Via Capital Markets: Institutions and Instruments by Fabozzi and Modigliani)
Think about it:
If I am an insurance broker getting paid to originate policies and then sell them to someone else, what incentive do I have to perform extensive due diligence? How much does that end-party (the reinsurer) really know about the policy they hold?
Subprime Connection:
Just as in mortgage origination, the end-holder of the liability has little knowledge of the person underlying the asset they hold. Also, the originator of the liability looks to churn out as many policies as possible, regardless of the underlying risk.
Differences:
For one, there are a wide variety of reinsurance types, many of them including strategies that do not purchase the entire liability from the policy writer, but only the risk above and beyond a pre-determined value. Also, reinsurers take on a wide
variety of liabilities, rather than JUST home loans.
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4 comments:
That's an interesting idea you bring up. As I'm sure you know, several of the reinsurers, particularly the financial guarantee types (notably MBIA, Ambac and the now defunct ACA) had problem last year and early this year. Bill Ackman of Pershing Square Capital in particular has been down on them for quite a while. It seems to me that all that bearishness been priced into their equity at this point. The ones in trouble from their financial guarantee businesses raised new capital. (Interesting presentation & other documents from him on this very topic here: http://pershingsquare.valueinvestingcongress.com/)
My question to you is: where do you see this going forward? Do you think there are going to be insurers failing? What reinsurance sectors/business you think this is going to hit? I'd be interested in talking to you about this and hearing your opinion.
(Anecdotal evidence of their survival: MBIA's office is near where I live and last time I drove to the airport they had a brand new entrance sign up. Seems they have enough money for frills like that.)
Right now with the current market conditions insurance could fail in any sector. If the insurance companies cannot come up with the money to pay off their liabilites then obviously this is a major issue, but I don't really see that happening because governments across the globe are willing to step in to avoid this. Although if the "trust" problem is fixed the problem isn't as looming as it is now. My understanding of insurance is that both parties agree at some equilibrium where they would be satisfied in both states of the world. (house burns down vs. nothing happens). Insurance companies may transfer this to the reinsurers but they know that the reinsurers are not going to execpt bad terms so in this way they have an incentive to make sure that the contracts they get in the first place are of high quality. This puts a heavier proportion of the burden on the reinsurers to due their due diligence. Obviously as ardent pointed out the models these companies were using did not work so well.
The next subprime bubble could very well be college student loans many of them insured by the government.
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