A bridge too far
The expansionist post war era has been characterized by the development of
the FIRE economy (finance, insurance and real estate), with a greater and
greater dependence on leveraged risk. A necessary consequence has been
increasingly sophisticated mechanisms for operating at financially rarified
levels far removed from any basis in real wealth. As the network of economic
and financial connections has broadened exponentially, and become increasingly
complex, greater attention had been paid to apportioning and diverting risk,
and to anticipating and avoiding losses through insurance.
Insurance is the equitable transfer of the risk of a loss, from one entity to
another in exchange for payment. It is a form of risk management primarily used
to hedge against the risk of a contingent, uncertain loss…The transaction
involves the insured assuming a guaranteed and known relatively small loss in
the form of payment to the insurer in exchange for the insurer's promise to
compensate (indemnify) the insured in the case of a financial (personal) loss.
The use of, and dependence on, insurance has spread throughout society in
developed countries, and has led to changes in the perception of risk. Rather
than addressing risk directly through prudent behaviour or due diligence, risk
management has become highly abstract. Being able to pay to officially offset
risk can lead to the perception that risk has somehow disappeared. The supposed
insulation, or buffer, adds to the comfort level of operating at high levels of
leverage, in the same way that driving a vehicle with many safety features can
lead to people driving more recklessly, because they feel more secure in taking
risks they feel they control, or have paid to minimize.
To pursue the driving analogy, if we are interested in controlling driver
behaviour for the benefit of all, perhaps instead of more car safety features,
we should consider installing a large spike in the middle of the steering
wheel, pointed directly at the driver's chest. Making risk apparent and
personal makes us pay attention to it and adapt our behaviour accordingly.
Faced with an obvious an immediate threat, we would drive in such a way as to
avoid the consequences. If everyone were driving slowly and cautiously, road
safety would improve significantly, although the frenetic pace at which our society
operates would have to slow down as well.
The point is that human beings appear to have an internal risk set point,
which will vary from person to person. When we perceive external factors to
have reduced the risk we face, we adjust our risk-taking behaviour upwards.
When we perceive external factors to be magnifying our risk, our actions become
much more risk averse. It is the combination of actual external risks and our
perception of them that determines where our collective risk set point lies at
any given time.
Unfortunately, spreading risk around on paper and in the virtual world does
not make it disappear, whatever our perception may tell us. Instead it makes
risk systemic. Expansion eras are typified by risk insulation and complacency,
while the contractions that follow are characterized by risk aversion. The
knock on consequences of risk perception skewed in one direction or the other
can be considerable, and are a major factor in creating self-fulfilling
prophecies, or spirals of positive feedback, first in one direction, then in
the other.
Insurance is a ubiquitous feature of life in modern societies, in the
ordinary lives of citizens and between large organizations and institutions. It
operates at all scales simultaneously. Insurance premiums paid for risk indemnification
are set based on a combination of the probability of an adverse event and the
cost of the consequences should it occur.
Complex risk models are used to quantify both factors, and risk may then be
shared among many parties, depending on how much capital is required to back a
given risk. Chains of reinsurance cover may be
necessary, which of course increases the impact of counter party risk. Coverage fails if the weakest link in the chain
cannot meet its obligations when called upon to do so. Counter party risk has
been growing substantially behind the scenes as systemic leverage has
increased.
Not all risks are insurable, as some are far too likely and others have
potentially catastrophic consequences too expensive to back. The nuclear
industry is a case in point. States must act as insurers of last resort for
risks on that scale, and even they may not be able to do much if those risks
are realized (witness Fukushima). A risk is privately insurable if an insurance
provider can make a profit while charging a premium that enough people can
afford to pay, so that a large enough pool of premium payments comes in to be
invested and generate income to cover potential payouts plus profits.
If circumstances change, and covering a specific risk is no longer
profitable (or not longer acceptably profitable from the point of view of the
insurer), insurers are going to have a problem. They could stop issuing
policies covering that risk, or they could limit payouts on policies, or both.
In recent years, insurance payouts have been considerable, at least partly due
to very costly natural disasters, but also increasingly due to fraud.
Certain risks are ceasing to be insurable, such as hurricane damage on the
Gulf coast, and insurers are deeming some aspects of their business to be
unacceptably profitable. Getting out of the business of issuing
cover means limiting premiums coming in, whereas merely tightening conditions
for payouts allows incoming premiums to be maintained while limiting
out-goings. Unless a risk is clearly uninsurable, this has to be a tempting option.
It is indeed becoming more difficult to extract payouts on existing
policies in many fields of insurance. Many people are continuing to pay
premiums, either because insurance is required, or on the expectation that
cover will be available if needed, but more and more often, when risks are
realized, payments are not forthcoming as expected.
Caveat emptor when it comes to purchasing insurance cover. Insurance
is not a substitute for personal risk management. Often it will be
sold in a manner seemingly designed to be confusing, so that people may fail to
fill in the form correctly, or may make understandable mistakes in doing so, or
may leave out a triviality that can later be used as a pretext to deny a claim.
It is instructive to look at a few cases.
Home Insurance:
Contents insurance may hinge on the insured having a detailed list of their possessions, complete with photos and receipts for their
purchase:
A couple whose belongings were stolen from their
downtown Vancouver condominium garage can't understand why TD Insurance denied
their claim — despite video surveillance evidence, police reports and witnesses
that all attest to the crime. "We're left in the hole," said Daniel
Parlee, a certified commercial transport mechanic. "My life savings of
tools are gone — and we are denied every single penny of our loss."
TD Insurance records indicate the claim was refused
because Daniel and wife, Sepide, couldn't prove they owned the tools and other
items they claim were stolen…Daniel said he had several thousand dollars worth
of specialized tools collected over a 20-year period in the back of his truck.
"I don't have any receipts, because the tools are so old. I don't keep
receipts for that long ago," he said….
The Insurance Bureau of Canada (IBC) said it's common
for claims to be denied when claimants have no documentation to prove they
owned what they lost. "You have to be able to bring yourself within the
contract to say that I had these specific items," said IBC spokesperson
Lindsay Olson.
"It's not enough to say 'I had 50 pieces of
tools'. You have to be able to say these are the specific items I had - and
here are the receipts or the instruction manuals for those, or here are the
photographs of them."Most people would
not be in a position to justify their claims in this way, and would not even be
able to rectify the situation of lack of receipts. Many may well be paying for
insurance cover that will not pay out when needed.
Weather damage to property is increasingly problematic for insurers,
particularly in areas prone to experiencing such damage. Exclusions and deductibles are increasing, and damage from
multiple causes may not be covered, even if one of those causes is:
After Hurricane Irene hit in August 2011, more insurers
tucked hefty wind and hurricane deductibles into their policies. They run 2
percent to 5 percent of the insured value of your home, says Charles Hahn, an
insurance agent in Little Falls, New Jersey, where "we're known for
flooding a lot."
Keep in mind that many insurers have
"anti-concurrent causation clauses" in policies now that say if you
have damage from multiple causes, say wind and flooding, where wind is covered
but flooding is not - they won't cover anything at all.
Some major classes of home risks may not be insurable at all, even if one has insurance for related issues. People
may not realize the exclusions that apply to their policies:
Amidst the power outages, gas shortages, mass transit
shutdowns and school closures left behind in Superstorm Sandy's wake, there's
one issue few people are talking about, and that's the cost that homeowners
will incur from mold damage. Aside from the health risks associated with mold
from flooding, mold removal is extremely costly and is not covered by most home
insurance policies, according to the San Francisco Chronicle.
The average homeowner could be forced to shell out
anywhere from $200 to $30,000 for mold removal. In a recent report on Sandy's
destruction obtained by Business Insider, Citi strategist Jeffrey Berenbaum
wrote, "mold damage could likely be the largest risk to properties that
remain flooded for weeks."
Travel Insurance:
The success of travel insurance claims can rest on minute details:
Complaints about seemingly arbitrary rejections cross
my desk at regular intervals. No surprise: Travel insurance is a $1.8
billion-a-year industry, according to the US Travel Insurance Association
(www.ustia.org), an industry trade group. And it has been growing steadily,
from $1.3 billion in 2006 to $1.6 billion two years later to the latest figure,
from 2010.
It's no shocker in another sense, too: The travel
insurance business is generally profitable, the occasional volcanic eruption or
tsunami notwithstanding, and critics say that the only way it stays that way is
by rejecting most claims, particularly the expensive ones.
The most trivial or irrelevant discrepancies in filling out the paperwork can be used to deny a claim:
When it comes to travel insurance claims, Hannah Yun
was about as sure as anyone that hers would be successful. She'd bought a
gold-plated "cancel for any reason" policy for a trip to South Korea.
When her boyfriend proposed and she decided to call off the trip to start
planning her wedding, she thought that collecting a check would be just a
formality. Travel Guard, the company she'd purchased the policy through, turned
down her claim on a technicality. Yun, a college student in Salt Lake City, had
originally told the company that her plane ticket had cost $1,090; she'd
actually paid $1,092.50.
Failure to board a flight to a destination where one knows in advance something bad is about to happen counts as grounds for forfeiting the cost of the
trip despite insurance, as it amounts to 'disinclination to travel' unless a
specific government travel warning has been issued:
It was meant to be the family holiday of a lifetime,
an expensive, but much anticipated, half-term five-night trip to see the sights
of New York with our two children, aged 18 and 14. But it turned into the
holiday from hell as we were virtually confined to our hotel, in a city in
lock-down, with all public transport systems, tourist attractions and virtually
all shops and restaurants, closed as Hurricane Sandy did its worst...
...What was really galling was that we knew before
leaving the UK that this was going to happen, yet could find no way of
cancelling and rescheduling without losing all our money – despite having paid
£90 for comprehensive travel insurance.
Where insurance companies have been found not to be liable to make payouts,
courts are sometimes looking for other parties to cover passenger losses, where
or not those parties were in any way responsible for the losses. For instance, airlines have been found liable for the costs of passengers stranded by the ash
cloud following the eruption of Eyjafjallajökull:
The volcanic eruption left millions of passengers
unable to return home because it was deemed too dangerous to fly through the
ash clouds. Today's ruling could leave airlines open to a raft of future
claims. The court recognized compensation claims could have 'substantial
negative economic consequences' for airlines, but said a high level of
protection must be afforded to passengers …. Mr O'Leary [of Ryanair] said the
court's decision made the airlines 'insurers of last resort' and said whoever
was responsible for cancellations should pay compensation.
He blamed the Government for closing British airspace
in 2010, even though 'there was clearly no ash cloud over the UK.' He said: 'We
now have a position that when the next time there's an ash cloud or the skies
are closed by Europe's governments, the travel insurance companies will walk
away and wash their hands and say it was an act of God and the airlines will
become the insurers of last resort.' 'Somebody who has paid us fifty quid to
travel to the Canaries, who may be stuck there for two weeks, two months, six
months, will now sue the airlines and you will have airlines going out of
business, and the ones who stay in business will be putting up the air fares to
recover these crazy claims.'
The fight over who must bear the consequences of realized risks is hotting
up. We can expect both the base cost of travel and the premiums for travel
insurance to rise. As people's ability to pay is going to be heavily
compromised over the next few years, travel will be very much less frequent
than today. Already, older people are increasingly priced out of travel, as the
insurance premium can be significantly higher than the cost of the trip. Travel for the elderly is becoming an uninsurable risk.
Medical Insurance:
Out of country emergency medical expenses can be extraordinarily high if uninsured risks materialize:
Australia’s foreign affairs minister is looking into
the case of a Sydney couple stuck with a million-dollar hospital bill after
their daughter was born in Vancouver last August. John Kan and Rachel Evans had
taken out travel insurance and extra cover for Ms. Evans’ pregnancy without
realizing the policy would not cover birth or the baby. They were about to
return to Australia after their B.C. vacation when Ms. Evans went into
premature labour at the airport.
Piper Kan stayed in the neo-natal ward of the B.C.
Women’s Hospital and Health Centre for three months and the bill ended up being
about $1-million. Australian media reports the couple negotiated a payment plan
with the hospital at about $300 a month, which would take 278 years to pay off.
In terms of medical coverage, 'pre-existing conditions' people did not know they had are an increasing barrier to claims, even where
the insured had been cleared to travel by a doctor:
Gojevic came down with what he thought was a bad cold
just days before heading to Las Vegas to celebrate his wife Arleatha’s birthday
in February. An X-ray suggested he might have pneumonia, so an emergency doctor
prescribed him a 10-day course of antibiotics. The doctor said he was good to
go on vacation….But the 53-year-old started having difficulty breathing on the
plane as the Las Vegas strip came into sight. He was administered oxygen on the
plane and was met on the jet runway by paramedics.
He was rushed to Desert Springs hospital in Las
Vegas….After the couple was flown home via B.C. Air Ambulance they received a
double whammy of horrible news: Mike was not suffering from pneumonia, but a
life-threatening lung disease called pulmonary fibrosis. He was put on the list
for a double lung transplant. Then One World Assist denied the travel insurance
claim, saying he was on the hook for $140,000 in medical expenses.
The company said he didn't qualify because he was
treated stateside for a "pre-existing condition.”….But Mike Gojevic argued
that it was the pulmonary fibrosis that was the health problem that kept him in
hospital, and he hadn’t been diagnosed with the serious lung condition at the time.
He had only been diagnosed with pneumonia -- a condition considered minor by
the insurance company.
Discrepancies between doctors' definitions of diagnosis and
treatment and those used by insurance companies can be a major obstacle to
making a claim:
A B.C. couple on a fixed income is facing a $50,000 US
hospital bill, despite buying travel health insurance for their last trip….Last
year, they bought full medical coverage as usual, through their broker, from
Prime Link Travel Medical Insurance. While in California, Anna had to go to
hospital with a blood clot in her leg.
The Friesens struggle to understand English, so said
they relied on broker Barrie Cartmell to fill out their application. He read
them several questions from the form, including: "In the last 36 months,
have you received treatment for kidney disorder (including stones)?" Anna
answered no. She's had weak kidneys for several years, but has not actively
been treated….Despite letters submitted since from doctors, insisting she is
not receiving any treatment for her kidney condition, the insurance claim
denial letter reads, "You do have a chronic kidney disease for which you
have undergone investigations which is considered treatment."…
The Friesens are now getting calls from a U.S.
collection agency and are afraid to go south for their usual trip…."I
don't even lift up the phone anymore. I see it's a number from outside, I don't
even lift up the phone anymore," said Anna. "Because [the collection
agent] told me last time I am supposed to pay him $5,000 a month."…
Bullock says the forms are ambiguous, and he thinks
that is intentional. "I've come to the conclusion that it's a deliberate
tactic," he said, citing several examples of what he calls
"trivial" denials. "A lady didn't disclose that she had an ear
infection four years ago. Another lady didn't disclose that she had hemorrhoids
during her pregnancy two years ago. A fellow didn't disclose that his brother
had a heart attack. He didn't know his brother had a heart attack. That didn't
matter. He didn't disclose it," said Bullock….He said seniors should
realize insurers can and will look at all medical records, so it's best to
disclose everything, even if it costs more for coverage. He said some medical
conditions trigger premium increases of 300%….
David Rivelis of Prime Link, the Friesens' insurance
agent, said even when a customer's doctor states they are not being treated for
a condition, the adjuster's interpretation can supersede that. "The
insurance company ultimately determines the term of the contract," said
Rivelis. "How the doctor defines something may be different from how it's
defined by an insurance company."
Coverage can be denied on the basis of pre-existing conditions documented
only in medical files the insured did not have access to, even if those
pre-existing conditions were unrelated to the problem that required treatment.
In Florida, Bill had chest pains and numbness in his
arm. He discovered he had suffered a heart attack and needed emergency surgery
to remove five blockages in his heart....Recovering back home, Bill was stunned
to receive a letter six months later, saying his travel health insurance claim
was denied and he owed $346,000 US in medical bills. Manulife says Bill should
have answered yes to this question about two conditions:
"In the last two (2) years, have you been
prescribed or received treatment for and/or been hospitalized (as an in-patient
or seen in the emergency department) and/or been prescribed or taken medication
for any of the following conditions: diverticular disorder or gastrointestinal
bleeding?"
Bill insists that he didn’t know what was spelled out
in his medical file or that he’d been diagnosed with those two conditions. He
thought all his symptoms were related to the colon cancer he’d had surgery for
19 months earlier. "Most importantly to me would be the question, 'What
does anything, what does anything related to this have to do with Bill’s
heart?'" Tracy said. "Absolutely nothing. Absolutely nothing."
Susan Eng of CARP, a Canadian advocacy group for
people over 50, says the system is set up for claims to be denied.
"Ordinary people are out thousands and thousands of dollars because they
did not get the protection they thought they had — only because they made a
mistake on the form that they could not possibly have done correctly," she
said.
Life Insurance:
Failure to disclose trivial health details and indulging normal behaviour can be used as a pretext to deny claims from
critical illness and death due to completely unrelated conditions:
Nic Hughes, 44, died in October after battling cancer
of the gall bladder leaving his wife Susannah Hancock, 44, and twin
eight-year-old son and daughter. But insurance company Friends Life have
refused to honour Mr Hughes’ critical illness policy saying he did not give
full disclosure of his health. The insurers say Mr Hughes should have told them
his GP suggested he cut down his alcohol intake - and that he experienced pins
and needles. But medical records show he drank just 10 to 20 units of alcohol a
week - below the NHS recommended weekly allowance of 21 units. Nic’s consultant
oncologist Dr Rubin Soomal, from The Ipswich Hospital, said neither alcohol,
nor pins and needles were linked to his death.
Pre-existing conditions can even be used to deny a life insurance claim for
a victim of murder:
The widow of a man killed last year when he was shot
in the back is suing the life insurance company that refuses to pay a claim
because the man had a "pre-existing condition," unrelated to the
cause of his death. According to the lawsuit filed by Stephanie McCraw, widow
of Curtis McCraw, who was gunned down by unknown assailants last April in
Knoxville, Tenn., Settlers Life Insurance denied her claim because her husband
had Hepatitis C.
(In this case it appears there were extenuating circumstances that probably
meant paying a claim would have been inappropriate, but nevertheless, the basis
for the official denial of the claim is clearly problematic.)
Car Accident Insurance:
Insurers may deny, or seek to reduce, a claim if they can place some, or all, of the responsibility for an accident
on to the victim:
An insurance giant is appealing against paying up to
£5million compensation to a schoolgirl left brain damaged in a car accident –
because she wasn’t wearing a high-visibility jacket at the time. Bethany
Probert was 13 when she was hit by a car while was walking home from riding
stables along a country lane on a December evening.
The schoolgirl, now 16, suffered a broken collarbone,
lung damage, and devastating head injuries which have caused permanent brain
damage. A High Court judge found the driver 100 per cent liable for the crash
but his insurers, Churchill, have appealed, claiming it was partly Bethany’s
fault….The test case will decide to what extent children can be held
responsible for their injuries in road accidents.
Outrageously, insurance companies may decide it is in their financial
interests to avoid a payout to relatives of a victim by defending an accused
perpetrator in an attempt to avoid liability:
Baltimore resident Kaitlynn Fisher, 24, was involved
in an automobile accident which stole her life on June 19, 2010. She was struck
at an intersection by Ronald Kevin Hope III, who ran a red light. Hope had
minimal insurance, but Fisher's policy had a special clause which called for
her insurer, Progressive Insurance, to cover the difference if and when she was
involved in an accident with someone who was under insured. Rather than pay
Fisher's $100,000 life insurance policy Progressive opted to aid in the defence
of her killer, in hopes that if found innocent they would not be required to
pay out her policy. This is despite a witnesses account that Hope struck
Fisher.
The Fisher family has been reeling for over two years
in disbelief that their trusted insurance company would behave in such a way,
while having to absorb court costs all along.
'Bad Faith' and the Insurers Perspective
Denying a claim is usually all an insurance company needs to do in order to
avoid making a payment. Alternatively they can make a low offer to settle the
claim. Most individuals lack the resources to take on giant insurers in court,
or find the prospect far too intimidating. If the insured walks away on denial
of claim or accepts a low offer as being better than nothing, then the case is
over. People can take a legal case, but it generally requires legal
representation that knows how to secure a fair offer.
If claimants do take a legal case, courts have been known to punish
insurers who appear to have acted in 'bad faith' by allowing the insured to make a larger claim than
they had been asking for under their policy:
Until about 22 years ago, it seemed that the idea of
real discipline and punishment for the general insurance fraud against
policyholders was a real joke. Interestingly enough in California the courts
provided policyholders and those who represented them a very powerful legal
weapon: the "bad faith" concept.
From that point, many other states adopted some sort
of bad faith law. As stated simply by William Shernoff, the crusading consumer
rights lawyer who has halted big insurance companies for years and won, the law
of bad faith states that if policyholders' claim have been unreasonably denied
they can sue for more than the amount of their benefits. The insured can
collect damages for mental suffering and all economic loss caused by the
company's refusal to honour legitimate claims.
If it can be shown that the insurance company's
conduct demonstrated a conscious disregard for the rights of a policyholder,
then the policyholder can sue and recover for punitive damages. The purpose of
punitive damages is to punish and make examples of companies that engage in
outrageous behaviour.
In states with a 'bad faith' precedent on the books, peace of mind can be regarded as a deliverable of an
insurance contract, and the lack of
it as a breach of duty of care.
In its judgment in McQueen v. Echelon General Insurance
Co. on Nov. 16, the Court of Appeal refused to overturn an award of $25,000 for
mental distress caused by the denial of benefits.
The case involved a plaintiff who had been in a motor
vehicle accident in which she sustained injuries. Prior to the accident, she
was already suffering from bipolar disorder and upper back pain. After the
incident, the defendant insurer refused to pay for some of the benefits applied
for and limited the plaintiff’s access to medical assessments. In fact, there
were 21 denials of 16 separate benefits over a period of three years.
As well as the benefits, the plaintiff claimed extra
contractual damages, bad faith, mental distress, aggravated damages, and
punitive damages. In supporting the trial court’s finding that the mental
distress warranted compensation, the Court of Appeal declared: “People purchase
motor vehicle liability policies to protect themselves from financial and
emotional stress and insecurity.
An object of such contracts is to secure a
psychological benefit that brought the prospect of mental distress upon breach
within the reasonable contemplation of the parties at the time the contract was
made. As an insured person entitled to call on the policy, Ms. McQueen was
entitled to that peace of mind and to damages when she suffered mental distress
on breach.”
Naturally, insurers take a different view of claims denied. They would say that there are clear rules to be
followed and clear distinctions between what is covered and what is not
covered:
The folks I met were proud of their product and could
offer case studies of the many customers they've helped. But because of the way
travel insurance policies are written, they often see the world in a binary
way: yes or no, covered or not covered. Every exception to that worldview must
be approved at a high level. When customers grumble about having their claims
denied, these insiders are genuinely baffled. "Didn't you read the
policy?" they ask.
As I stood in the understated suburban headquarters
where every Allianz claim is processed, it all made perfect sense. Rules are
rules, after all. Mark Cipolletti, an Allianz vice president, says that his
company has no choice in the matter. Insurance providers are strictly regulated
by the states where they do business. "We're subject to scheduled and
unscheduled audits or reviews of our products and claims," he says.
"When we adjudicate a customer's claim, we must follow the policy, or the
contract with the customer, because if we deviate from the contract or treat
one customer differently from another, then we become subject to fines and
other punitive actions -- like not being able to sell in that state any
longer."
At the end of the day, private insurance is a business, and it will act in
such a way as to maximize profitability. What constitutes a reasonable level of
profitability to expect, is, however, set to change. We have all come to expect
historically very high levels of return on investments in the rentier economy, but
the rate of return depends on the health of the economy, and on people's
ability to pay premiums in sufficient numbers to make a risk insurable. The
rate of return on invested premiums is set to fall as the economy slips into
contraction, and many financial asset investments are very likely revalued at a
substantially lower level in the approaching era of historic financial
upheaval. Ability to pay premiums will also be heavily impacted as people lose
purchasing power.
This is a deadly combination from the point of view of the insurance model.
If relatively few people can pay premiums, there are few secure investments and
the rate of return on those investments is low, then very few risks will be
insurable in comparison with today. Loss will increasingly lie where they fall,
and risk management will once again hinge on prudent behaviour and due
diligence.
Derivatives and Large Scale Risk Management:
Insurance extends well beyond the individual and company level. Financial
risk management is an enormous business that has facilitated the development of
the derivatives market. Credit default swaps, a market worth tens of trillions of dollars, are
effectively insurance contracts against a fall in asset values. Like an
ordinary insurance contract, a regular premium is paid to a party offering to
indemnify its contractual partner should a loss occur.
A credit default swap (CDS) is a financial swap
agreement that the seller of the CDS will compensate the buyer in the event of
a loan default or other credit event. The buyer of the CDS makes a series of
payments (the CDS "fee" or "spread") to the seller and, in
exchange, receives a payoff if the loan defaults. It was invented by Blythe
Masters from JP Morgan in 1994. In the event of default the buyer of the CDS
receives compensation (usually the face value of the loan), and the seller of
the CDS takes possession of the defaulted loan.
At this scale, the risk management business is based on highly complex,
probabilistic value at risk models seeking to predict the likelihood and
consequence of a given adverse financial event. As long as a reasonably smooth
expansion is underway, a measure of consistency tends to hold, and the
quantitative models develop a track record of apparent reliability. However,
they have not been fully tested following a major trend change. The events of
2007-2009 were a preliminary test, but the level of defaults was relatively
contained. In a larger crisis, such as we are headed for over the next few
years, far more financial assets will be marked to market and trigger credit
events requiring payouts.
In recent years, more events outside of the 'normal range' have been
occurring. During the expansionist bubble era, the risk management models
generated a false sense of security through creating the perception that risk
was under control and not therefore a concern. Risk control is an illusion, but
human beings are good at placing faith in quantitative models (that most do not
understand) when there are profits to be made. Suspension of disbelief is much
easier when it is profitable, and the longer the models appear to be reliable, the
more complacent people become. The quants themselves become a sort of
priesthood, in the sense they only they have access to how the 'black box' risk
calculations work. Others must simply accept their opinion.
As expansion morphs into contraction, the full extent of counterparty risk
is going to be revealed. There is no trading transparency, nor capital adequacy
requirement, in the derivatives market, hence one can make promises to
indemnify without having to prove it to be possible to keep those promises.
This can amount to a licence to sit back and collect premiums for years, in the
full knowledge that meeting promises, should that be necessary, would not be
possible. It becomes yet another form of the pervasive financial fraud our
global ponzi finance is grounded in. In addition, it is possible to 'insure'
against a failure of an asset one does not actually own. This is akin to
allowing people to take out fire insurance on their neighbours' homes, giving
them a perverse incentive to burn the home down for profit.
Rather than genuine insurance, CDS are just another vehicle for excessive
speculation. Where a credit event is triggered, but the losses cannot be paid
by the counterparty, those losses can cascade through the financial system.
Winning and losing bets do not net out under such circumstances. The
combination of lack of transparency, huge counterparty risk and perverse
incentives is toxic.
Essentially the CDS market has a built in meltdown mechanism which poses a
major systemic risk. Warren Buffet once called derivatives 'financial weapons
of mass destruction', and they are exactly that. Extending the concept of
insurance to the level of covering global speculative flows is a bridge too
far. Even the relatively plain vanilla insurance industry is on the verge of
seeing its business model fracture, but the significant impact of that will be
dwarfed by the consequences of the wholesale failure of global-scale risk
management.
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