Reinsurance: The Ultimate Derivative

Some housekeeping before I begin this evening. Here’s my progress on the blog:

  • RSS as far as I can test has no problems.  If you have problems with my feed, please e-mail me any details.  Before you do, try dropping my feed, and re-adding it through Feedburner.
  • My logo was anti-aliased for me by BriG.  Looks a lot cleaner.  Thanks ever so much, BriG!
  • The comment error problem is gone, and I suspect also the same one that I have when I post.  It was a bug in one of my WP plugins that was not 2.3.1 compliant.
  • My descriptive permalinks are still lost, though.

I still need to fix my left margins as well, and make my top banner clickable.  Still, that’s progress.

On to tonight’s first topic: my view on derivatives differs from that of other commentators because I am an actuary (as well as an economist and financial analyst).  In the late 1980s, the life insurance industry went through a problem called mirror reserving.  Mirror reserving said that the company reducing risk through reinsurance could not take a greater reserve credit than the reinsurer posted.

That’s not true with derivatives today.  There is no requirement that both parties on the opposite sides of an agreement hold the same value on the contract.  From my own financial reporting experience (15 years worth), I have seen that managements tend to take favorable views of squishy accounting figures.  The one that is short is very likely to have a lower value for the price of the derivative than the one who is long.

But can you dig this?  The life insurance industry is in this area more advanced than Wall Street, and we beat them there by 20 years minimum.  😀  Given the way that life insurers are viewed as rubes, as compared to the investment banks, this is rich indeed.

Now, as for one comment submitted yesterday: yes, counterparty risk is big, and I have written about it before, I just can’t remember where.  I would argue that the investment banks  have sold default on the counterparties with which they can do so.  That said, it is difficult to monitor true exposures with counterparties; one investment bank may not have the whole relationship.

Also, many exposures are hard to hedge because there are no natural counterparties that want the exposure.  When no party naturally wants  an exposure, either a speculator must be paid to bear the risk, or the investment bank bears it internally.

The speculators are rarely well-capitalized, and the risks that the investment banks retain are in my estimation correlated to confidence.  When there is panic, those risks will suffer.  Were that not so, there would be counterparties willing to take those risks on today to hedge their own exposures.

So, is counterparty risk a problem?  Yes, but so is deadweight loss from differential pricing.