Black Swans, the Sub-prime Crisis and Systemic Risk

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Presentation to NY actuarial meeting giving my insurance underwriting perspective on the financial crisis, the CDS market, and solutions we should consider.

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Black Swans, the Sub-prime Crisis and Systemic Risk

  1. 1. Actuarial Society of Greater New York “Black Swans”, the “Sub-prime Crisis” and Systemic Risk: One underwriter’s Perspective James W. Macdonald, ARM JW Macdonald Associates, LLC November 10, 2008 Page 1
  2. 2. Presentation Overview • How did we get here? • Who is to blame? • What have we learned? Page 2
  3. 3. How did we get here? Financial Risk Policies: Not new to insurance… • Surety Bonds (predate industrial revolution) • Municipal Bond Insurance (1971 – Present) • Credit Insurance • Title Insurance • Warranty Insurance • Other expense related covers (e.g., products recall insurance) Page 3
  4. 4. Financial Risk Insurance: Underwriting Challenges • “Business Risk” – “Insurable Interest”? • Moral Hazard / Adverse Selection • “Transaction Value” – Is a Zero Loss Ratio assumption Valid? • Collateral - Liquid, fungible? • Recourse - Unlimited? • Pricing – Credible, equitable? • Coverage: Non-standardized, complicated - understood? Page 4
  5. 5. Financial risk Insurance Products Accelerated growth in soft markets Domestic P&C Market Cycle -Growth in Net Written Premium: 1970 - 1984 1980-90: S&L Crisis 1973: MBIA 1983: WPPS! 1980-1984: New generation of financial 1971 AMBAC insurance products 1975: NYC Financial Crisis Source: Insurance Information Institute
  6. 6. WPPS and S&L Crisis Resulted in full limits losses to D&O and E&O Insurers • WPPS Bond Default (1983) • $2.25 billion municipal (revenue) bond default • Largest municipal default in USA history • In litigation almost ten years • Losses included D&O of 30 municipalities with “take-or-pay” obligations, A&E, Accountants, Lawyers • S&L Crisis (1980-1990) • Over 2,400 savings and loan association failures • Estimated losses of $560 billion - $320 B paid by US Government • Major D&O losses sustained by F&D, MGIC and others Page 6
  7. 7. Early Eighties Soft Market (1980-1984): New Financial Insurance Products “to the rescue”? • MGM Grand Fire Retroactive Liability Insurance • Residual Value Insurance • Limited Partnership Surety Bonds • Homeowner’s Warranty Insurance Company (first RRG) • Systems Performance insurance • “Career Guard” Insurance • NYIE: Baseball Strike Insurance • Excess SIPC Insurance Page 7
  8. 8. MGM Grand Fire Retroactive Liability Insurance • In early 1981, thirty insurers agreed to multi-layered placement of $120 M limits insured for • Approximate $40 M premium • Arguably the first, high profile “finite” deal • Resulted in detailed industry debate over risk elements to permit “insurability” (including payout timing, and investment income) • Fronting insurer went into liquidation in March 1995 • Several years later, MGM settled out-of-court for $87.5 million, shortly after jury selection. Page 8
  9. 9. Residual Value Insurance • Typically characterized, like municipal bond insurance, as low-risk credit enhancements to otherwise solid transactions, • Normally related to asset-based financing, with sale / leasebacks; • Recourse to insurer / guarantors was normally limited to taking ownership of underlying assets; • Assets varied widely – included trains, planes, buildings, and even movies. • Extremely complicated multi-party contracts with numerous possible events of default. Page 9
  10. 10. Financial Insurance 1986 -2007: Key developments… Domestic P&C Market Cycle -Growth in Net Written Premium: 1986 -2007 25% 1986: Federal Tax Reform Act 20% 1989: New York Article 69 – requires FGIs to be “mono-line” 15% 10% 1992: FASB 113 1995-2000: Extensive use of finite reinsurance 5% 0% 19995-1998: PLSRA enacted, D&O insurers -5% 1988: Centre Re give full allocation, entity coverage 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Current $ Real $ 2000: Reliance offers Earnings Insurance Source: A.M. Best, Insurance Information Institute
  11. 11. Limited Partnership Surety Bonds: Another “Black Swan” event? • Guaranteed General Partners full payment of scheduled 5 year investments by high net worth individuals. No collateral but full recourse was required; • Partnerships highly leveraged with gross deductions permitted by early eighties tax code; • Tax reforms were expected but almost everyone thought the risk to existing deals was zero • 1986 Tax Reform Act eliminated gross deductibility; no “grandfathering”; • Wealthy investors defied expectations: refused to make future payments; • Huge initial losses paid by Surety insurers were eventually recouped. Page 11
  12. 12. 2000-2008 “Black Swans” (Extreme Events), Market Softening, and the “Panic of 2007” Domestic P&C Market Cycle -Growth in Net Written Premium: 2000 -2007 2003: Hurricane Spitzer – Mutual Fund Timing Scandal 2004: Hurricane Eliot – Bid- 15% 9/11/01 Attacks Rigging, Finite Reinsurance 10% Katrina, Wilma, Rita: New Capital 5% Flows to P&C 0% 2001-2005: Fed Funds Rate 1%, negative real cost of capital to banks -5% 2000 2001 2002 2003 2004 2005 2006 01-02: Corporate Scandals, SOX “Panic of 2007” Current $ Real $ Sources: Insurance Information Institute, Fortune Magazine (10/08)
  13. 13. Presentation Overview • How did we get here? • Who is to blame? Page 13
  14. 14. Who is to blame? “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” Joseph J. Cassano, a former A.I.G. executive, August 2007 Page 14
  15. 15. Who is to blame? • “Perfect Storm” (Everyone, ergo: No One?) • Greed (i.e., human nature?) • Late nineties legislative pressure on GSEs? • “NINJA” and “Alt A”loans – What possible justification? • Ideological faith in deregulation? • “Market Conduct” Regulatory Failures (e.g., Is any cost to consumers - be it premiums or mortgages - too cheap?) Page 15
  16. 16. Who is to blame? • Unprecedented Gross Leverage • No Originator Risk-Taking (“Fronting”/ “Pass the Trash”) • Synthetic Financial Instruments? • Financial rating agencies? • Flawed mathematical models (i.e., empirical data suggested “all Swans are White”)? • CPA auditor failures • Fed Funds Rate, 2001-2005, too low, too long. • Post-Enron, Mark-to-Market Accounting • GLB, Sarbox: Bring back Glass Steagle? Page 16
  17. 17. Presentation Overview • How did we get here? • Who is to blame? • What have we learned? Page 17
  18. 18. What have we learned? • Financial insurance product growth is pervasive in soft market cycles. • Regulatory response has been consistently slow, generally ineffective. • Paradigm shift is occurring: Need alternatives to reliance on private sector self-regulation, e.g., NAIC is currently discussing forming new financial rating agency. Page 18
  19. 19. Financial & Insurance Underwriting: Back to the Future?…Many lessons learned • “Business Risk” – “Insurable Interest”? • Moral Hazard / Adverse Selection • “Transaction Value” – Is a “Zero Loss Ratio” assumption Valid? • Collateral- Liquid, fungible? • Recourse - Limited? • Pricing – Credible, equitable? • Coverage: Non-standardized, complicated - understood? Page 19
  20. 20. Financial & Insurance Underwriting: Some positive examples under discussion… • Real Estate / Recourse: Require the lender to have full recourse in the event of default, not just rights to given real property (similar to surety bonds – limits moral hazard). • Originator: Require some financial risk retention – “skin in the game” – recalls “fronting” and “MGA” legislation in response to insurer insolvencies, e.g. Failed Promises – 1990 Dingell report. Page 20
  21. 21. Financial & Insurance Underwriting: Some positive examples under discussion… • Require some underlying “insurable interest” in short selling or CDS transactions – classic difference between “insurance” and “gambling”. • Introduce new modeling approaches such as terrorism risk “deterministic” scenarios to better anticipate tomorrows “Black Swan” events, e.g. Nassim Taleb’s “counterfactual reasoning”. Page 21
  22. 22. Bibliography • Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Crash, Public Affairs, March 2008 • Bruner & Carr, The Panic of 1907: Lesson’s Learned from the Market’s Perfect Storm, Wiley & Sons, 2007 • Gary Gorton, The Subprime Panic, NBER Working Paper 14398, Available at: http://www.nber.org/tmp/1063-w14398.pdf • Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Random House 2007 • Subcommittee on Oversight & Investigations, Failed Promises: Insurance Company Insolvencies, February 1990, US Government printing Office Page 22
  23. 23. Q&A Contact Information Jim Macdonald is an independent consultant based in Philadelphia. Macdonald has 35 years of experience as an insurer, reinsurer, and consultant with market-leading companies such as AIG, ACE-INA, C.N.A., Munich Re, Conning & Company, Navigant Consulting, and General Re . His consulting services include expert witness services in arbitrations and litigations, as well as strategic assessment services for investment bankers and the public sector. Macdonald is also a Senior Fellow with the RAND Corporation. This presentation does not express or imply any opinion on the subject by RAND and offers solely the personal opinions of the author. Phone: 215-925-2188 Email: jwmacdonald@msn.com Web: http://www.jwmacdonald.net Page 23

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