A thought experiment

April 15, 2009

Willem Buiter’s usual brilliant takedown on the CDS and why they are the spawn of the devil! One particular aspect is intriguing

When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance.  This simply means that he cannot be better off if the insured against event occurs than if it does not occur.  Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.

Clearly, CDS contracts don’t require an insurable interest to be present.  Many other derivatives likewise don’t require an insurable interest to be present.

The key sentence is

Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.

Let us do a thought experiment. Assume that there is a Catering company Cooks For Free that provided catering for a major airline Wait Unlimited. This airline constitutes say 60% of their business. Their revenues from the airline are 60 million dollars and they make profits of 5 million from the airline.

Now they obviously have an insurable interest in the airline so they should be allowed to buy CDS contracts. Let’s say they buy 10 million of CDS contracts @ 200 basis points. That costs them 400,000/year and they can write it off as business expense.

Now there are multiple problems that leads to sub-optimal real world outcomes.

There is a moral hazard problem that if the airline gets into trouble Cooks for Free will not do their utmost to cut costs and try and save the airline.

There is an agency problem if the catering company is run by ‘professional managers’, in that they would be happy to take the 10 million and show an excess profit and not worry about future viability of the industry or business.

We run a business not to just hedge risks but to take on risks and create value that generates profits. That 400,000 paid to the insurer is better utilised in innovation t either in improving quality of meals or cutting waste and costs.

This scenario also holds for financial firms who manage money for their clients. Their job is to diversify by investing in various asset classes or by aggressively monitoring the operations of the entities to whom they have lent money.

The oldest lesson of economics is that there is no free lunch. We all have to work to earn a living by creating something of value. Diversifying risks which is in reality uncertainty is never a solution.


Going back to First Principles

March 17, 2009

A fantastic article by FT’s Willem Buiter on gambling vs. insurance

For the insurance industry, the insurance vs gambling distinction was operationalised using the concept of insurable interest.

He goes on to lay out, why insuring things which one does not own, leads to negative externalities

The traditional Islamic opposition to trading risk without there being an insurable risk – to gambling, that is – extends well beyond the financial sphere.  Indeed, in much of traditional Judaism and Christianity as well, gambling and betting are viewed as signs of moral weakness – as sins.  But these moral, ethical and medical (gambling as an addiction) arguments are quite separate from the argument I have explored in this post, that risk trading without an insurable interest may be economically inefficient and destructive, not (just) for familiar moral hazard or micro-endogenous risk reasons but for macro-endogenous risk reasons.

Worth the 15 mins it would take to read and understand it!