Black Swans, the Sub-prime Crisis and Systemic Risk

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Information about Black Swans, the Sub-prime Crisis and Systemic Risk
Business & Mgmt

Published on November 16, 2008

Author: elvisvp



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

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

Presentation Overview • How did we get here? • Who is to blame? • What have we learned? Page 2

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

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

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

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

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

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

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

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

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

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)

Presentation Overview • How did we get here? • Who is to blame? Page 13

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

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

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

Presentation Overview • How did we get here? • Who is to blame? • What have we learned? Page 17

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

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

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

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

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: • 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

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: Web: Page 23

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