Sunday, April 30, 2006

A great man.

He was a giant in economics both literally (he was 6'8") and figuratively. Not so much for his technical expertise, but with his free-thinking style, independence, integrity, and good-natured humility. John Kenneth Galbraith died today aged 97.

I am sure a pantheon of writers and correspondents will comment on his amazing life and place in history. I found (and will continue to find) myself at odds with much (all?) of his arguments concerning the proper way to incentivize individuals to achieve wealth and prosperity, but I can think of no other "economist" (if that label can be applied to such a multi-discliplinarian) that brought forth the great equalizer of "common sense" to economic debate, nor used the english language so well as a means of communicating rather than obfuscation.

I can only say with my deepest respects that a great man has been called home. I hope for this country's sake that there will be more like him...but a man like that only comes along so often. A great man. Rest in Peace.

The incredible diversity of insurance securities.

One of the main focal points of this blog is to emphasize that intellectual distinctions between insurance, derivatives, and other risk management tools are quickly collapsing.

This offering by Swiss Re is a case in point:

"Concerning the hybrid debt offerings, Swiss Re said: "Dresdner Kleinwort Wasserstein, HSBC and UBS Investment Bank will act as joint bookrunning lead managers on a Reg S euro-denominated transaction. The offering will be structured using a repackaging vehicle (ELM B.V.), which will issue perpetual step-up notes secured by perpetual subordinated loan notes to be issued by Swiss Reinsurance Company."

More information about the specifics of the issue can be found here:

This is a good example of a hybrid security that exibits debt-like characteristics, but also can morph into something that looks like equity (read closely the paragraphs in the above link regarding "deferral", and you will get the picture.)

The structured finance vehicle (ELM B.V.) issues step-up notes (notes whose interest payments increase over time) that are deeply subordinated (in the event of a "credit event" with ELM B.V., they will have lower priority than other creditors), but are secured by debt issued by Swiss RE. The security "looks" like debt because the payoffs are linked to the performance of the Swiss RE debt. It "looks" like equity becuase the step-up and deferral interest payments increase when the performance of Swiss RE is good.

Thursday, April 27, 2006

If you scratch my back...

Greetings China. My name is Ben. Say, we have this problem, or at least its a perceived problem with my boss (whom I serve at the pleasure of...whatever that means). Your currency is too high. I get nervous about something called the current account deficit. This is an economic relic from the days when currency was readily convertible to gold. We still get freaked out by big deficits because we think that someone will sell all of their U.S. dollar denominated assets (thereby depreciating the dollar, and appreciating their own currency).

So, I will tell ya' what. You increase your interest rate, and I will stall this rabid beast we call "wall street" until your economy can cool off a little (hey, mutual benefit right buddy??) and your currency weakens to a level we both feel comfortable with. I will say something like "the Federal Reserve may decide to take no action at one or more meetings" or something like that...because you know if I keep raising rates, our currency will appreciate and our current account deficit will continue to grow...and I just don't like seeing those numbers like that.

so whaddya say???

Wednesday, April 26, 2006

Interesting confluence.

The data-driven trading goes on. Today, yields rose considerably after favorable economic reports presaged a "definite" 50bps increase in rates.

Some "predictions":

This summer will be interesting. Gulf waters at record (at least, since temperatures have been recorded) highs, interim elections, and rising rates. Equity markets will finally pop (probably on some seemingly innocuous event) then recover for the rest of the year for a year on year gain.

Japan is still attractive. Germany and France more so. I continue to think that the dollar will not weaken appreciably against the euro due to continued capital account surplus. The commodity currencies will depreciate as the big fish in the passive funds take their profit and go off to higher a world of increasing interest rates.

On numerous occasions, the Fed has implied it will bail out homeowners. Look for rates to stabilize then decrease in early 07.

The major factor in all of this is Bernanke. His interpretation of rate lags is crucial, as he is an academic and they all think that it takes 6-12 months for rate increases to be felt.

Sunday, April 23, 2006

All aboard...come ride the commodities train

What a ride on the silver and gold train. There is only a tenuous connection between gold prices and inflation (despite what gold bugs claim), and this is no different. Inflation appears to be in check, and “Helicopter Ben” probably has at least a tacit inflation targeting system in place (as silly as I think that is given the $ is the world’s reserve currency and is not, for the umpteenth million time, backed by gold) and has access to the most and best information regarding same.

No, the reason the price of gold is rising is because the price of gold is rising. It is now a competition between the predators of our little capital markets ecosystem…hunting, attacking, and shaking the daylights out of weak shorts (and weak longs, like Friday's vertiginous ride). They are saying to the would-be commodities investor (witness the explosion of people who are “experts” on gold, silver, oil. It is a truism that the growth in "experts" is a linear function of the price of the underlying commodities) “come on in…the waters fine!!! It reminds me of a pack of Hyenas bleating about a kill…everything goes well until the Lions arrive.

Some would brazenly refer to this as a “bubble”. Count me among their number. How long until the “Grandmas of the world” to start melting down her gold jewelry (yes, I know its not the same in bullion, but you get the point) to increase supply?? China and India cannot (and are not, in my opinion) grow 10% per year indefinitely.

I also do not believe oil will remain at these levels. Every indication of actual oil supply reveals ample stocks. And yet, the refinement capacity remains an issue. Now, there is no way that oil companies would ever think of colluding to limit refining capacity, (right?) so one would expect refinery capacity to increase, or consumption to decrease.

Like Milton Friedman said (paraphrasing): “There is no better cure for high prices than high prices”.

But: Bubbles go on a lot longer than most “rational” economists would account for in their nice little equilibrium models. The increases and decreases effecting economic systems are not instantaneous by any stretch. The big guys want to lure every last sucker before they turn out the lights…

Tuesday, April 18, 2006

And higher yields were so tantalizingly close...

Reinsurance concerns were probably a little dejected today after the stock market rally (which was preceded by the bond rally which was preceded by the Producer Price Index figures, excluding food and energy, coming in below expectations). The 10 year T-bill only hit 5% on Monday to be smashed down once again. The ALM (asset-liability management) issues that RE companies (life reinsurance, especially since the obligations are longer-term) have had to deal with are now back on the table.

Of course, if certain regulatory agencies would remove their restrictions on investments, perhaps chasing yield would not be one of the central focal points for RE firms.

Gold (which some believe acts as a proxy for inflation expectations...I do not take this view) and most of the other metal are going through the roof, Oil is at an all-time high, there is a housing "bubble", etc. Today's rally is more evidence that the U.S. market is the most resilient and vibrant in the world.

Monday, April 17, 2006

A time tested solution...

...if you encounter an unsolvable problem is to redefine the question via logical titration until a solution is apparant.

I am not sure about the reliability of this article:

which claims that the Florida Legislature is considering "using" the Florida Hurrican Catastrophe Fund , but this would seem an excellent example of the above "solution". Ex-ante disbursements of the catastrophe are not "supposed" to be the reason for the funds existance (according to sample contracts on the FHCF website indicating it will reimburse for net losses over retention levels)...but hey, if the money is there (or will be there after increased taxes or debt issuance), why not use it??

A band-aid over a bullet wound.

Friday, April 14, 2006

Wall Street, Hedge Funds, and REinsurance.

The proliferation of hedge fund-backed reinsurance concerns has interesting ramifications. Hedge funds are becoming increasingly “institutionalized” with myriad regulations and “transparency” requirements. (as if the private investors who capitalize hedge funds require this type of protection)

The idea is that reinsurance negatively correlates with fund returns. Now, while I have railed extensively about the impossibility of long-term asset corellation due to the constant of “ever changing cycles” within and among asset classes, the entrance of hedge funds into the reinsurance industry seems to marry the compentancies required of both types of businesses. Both rely heavily on statistical modeling (most hedge funds have personel who are quantitatively astute), retrospective and prospective anlysis regarding a complex object, and good fortune to turn a profit. In addition, there is little danger of the all-too common “front-running” that hedge funds must endure in the securities markets by way of their primary broker…

Here is how this works: A hedge fund will devote considerable resources analyzing the capital markets in preparation of taking a market position by buying or selling securities. The hedge fund places an order with their prime broker, which proceeds to walk straight over to their own “proprietary desk” and inform them of the hedge fund’s position. The prime broker then freerides off the hedge fund’s market intelligence, often times taking its own position prior to filling the order of its client. This occurs (very) frequently. Not only are the positions of the hedge funds compromised, but the funds must pay exhorbitant fees to borrow securities from their “prime brokers”.

Which is why neither this:

Nor this:

Comes as a surprise.

Hedge funds are now searching for more advantageous pools to tread…private equity and reinsurance being the most tepid and familiar waters...and without so many circling sharks.

Thursday, April 13, 2006

...getting further into the alphabet with these its PXre

Again, this is beneficial for the industry. There are several startups in Bermuda (as there are every year) who will take up the charge to provide CAT reinsurance. This does nothing to the total capacity. Inefficient (and/or/rather "unlucky") reinsurers will continue to seek "strategic alternatives (read: beg an investment bank to broker a purchase or be subsumed by a larger RE player who happens to be interested). The Price/Earnings ratio for the industry as a whole hovers around SEVEN (7). Name another major industry with the capitalization and positive business prospects that reinsurance is, and is going to, enjoy in the coming years.

Again, as I have said before, the overconfidence in CAT models is partially to blame. I am surprised Benoit Mandelbroit has not come up with a theory that explains why the frequentist or Baysian statistical models are not the proper analog for major CAT risk.

Bermuda is still the most "liquid" market for insurance. A firm can be liquidated and find a home in no-time in that friendly jurisdiction. However, The Recapitulator notes that Malta is becoming a hot-spot for European firms.

Wednesday, April 12, 2006

RE firms suffering in 1st usual.

To no-one’s surprise, it was not a banner quarter for big reinsurers. Swiss Re continues to have their problems (which are fully deserved considering their arrogance of the past two years). Repeated calls for clarity in regards to the books were continuously rebuffed and critics ignored. Who has any idea what the real reserves and capital adequacy figures are for these firms? The rating agencies?

Still, all is certainly not lost. ROE is acceptable and early pricing appears favorable, but these firms remind one of the labyrinthine hey-day (pre-Spitzer/SarbOx) of AIG. At least Munich RE seems to be attempting something approximating transparency as apparently they will release RORAC figures soon. Lets hope that the other large players follow suit since most of their reinsurance exposure is in North America.

Notwithstanding the above, large firms that are managed well can do very well, especially in this environment of rising global interest rates and more advantageous pricing. Hannover RE is a perfect example of this. They ceded 30% their large P&C exposure with a “sidecar” securitization agreement (called “K5”) and should experience an increased share price as they have differentiated themselves as superior managers.

But the big guys are under increasing pressure…from the capital markets, reinsurance purchasers, the burgeoning start-ups in the Caymans and Bermuda, and, of course, the brokers who are (nominally at least) acting as agents for their clients and getting the most coverage for the least price. And the near commoditized models used by the ACE’s, XL’s, and Partner RE’s of the world are obviously not any worse than the “proprietary” (as if attaching a fancy word to a model increases its accuracy) models utilized by the big guys, who need to worry about this equation:

Relationships + Bermuda incorporation + RMIS model + capital = instant RE competitor

Monday, April 10, 2006

And now Goshawk RE...

More fallout from Katrina/U.S. Hurricanes.

The counter-intuitive result of these closing will result in additional capital and start-up formulation (primarily in Bermuda and the Caymans). You don't have to be a statistician or actuary to place a bet on a "100 year occurrence" happening two consecutive years. (never mind "ye olde" Bernoulli condition of independence as a precursor to this kind of rationale)

This is all beneficial in the long run...unused and inefficient capital is re-deployed to better performing and newer firms that can learn from these mistakes and/or failures. It is no different than detritus-recycling organisms in an ecosystem.

Saturday, April 08, 2006

The Bermuda triangle is useless vs. Private Equity Firms...

Stone Point Capital (via the Trident Funds that it manages) has made an offer for Axa's Reinsurance business. The article does not give details regarding the structure of the deal (debt/equity/cash and the future capitalization picture of the purchased entity) but this appears to be a positive step for the industry.

Private Equity firms are flush with cash, and need to deploy this capital lest returns evaporate. Why Axa is in "exclusive" talks with Stone Point is a mystery to me, however. With Hedge Funds getting involved in setting up their own RE companies, one would think that this would be more of an auction.

The Trident funds appear to have a world-class management team (the biographies are replete with the usual Harvard/Penn/Cornell/Columbia east coast suspects), and most are refugees from Marsh Private Equity.

Tuesday, April 04, 2006

The swamp hardens...

Fresh after winning the National Championship in Basketball, Floridians are hit with huge increases in property premiums. (but notice the use of the maximal requsted amount to lure the reader)

Well, not yet anyway. The venerable Florida department of insurance ("DOI", like every other state-run insurance regulatory agency) must approve the rates. Has not the DOI caused part of the problem with another layer that distorts normal market processes? Might a putative price shock have been avoided via disintermediation?

The usual suspects have been lined up and identified. It's those confounding reinsurers. Of course, if reinsurers are determining the pricing stucture, why does the Florida DOI not hold a public hearing for them?? It benefits the market that they have no jurisdiction...and it benefits the DOI which has political oversight. "Its the reinsurers...they are the source of all of our sorrow!!!"

Monday, April 03, 2006

Quanta going nuclear...

...the article explains it all. Whislt we may never know the exact causes (the Cat season seemed to have a major effect on the .25c per share loss), it would seem that for some of the reinsurers, the over-confidence in Cat models is coming home to roost.

This is similar to the problems that the "high finance" industry faced after the Russian bond default and the asian crisis of the late 90s. An influx of "uber-intelligent" (read: mathematicians) people swooped in upon the finance sector and started modeling everything in sight based upon extremely sophisticated mathematical models. Most of these models had analogues in physics. Sophistication and complexity somehow lead these "uber-intelligent" people to disregard the underlying economics of the risks involved. In the Russian bond case, LTCM ("Long Term Capital Management") lost billions by not forseeing the economic and political consequences of a sovereign bond default. Maybe they had the financial derivatives priced correctly...but priced correctly for what? A good thematic account of the LTCM:

Now, there is nothing wrong with attempting to calculate probability distributions per se (such is the nature of our lot in life in the insurance business), but there is something very wrong when one's overconfidence leads one to believe that we have the only objective view of the "true" probability distribution.

The central problem is best described by this quote from the great Nassim Nicholas Taleb (for the statistical neophyte "Gaussian"="normal distribution")

"Circulatity of Statistics (The Statistical Regress Argument):
We need data to discover a probability distribution. How do we know if we have enough data? From the probability distribution. If it is a Gaussian, then a few points will suffice. How do you know it is a Gaussian? from the data. So we need the data to tell us what is the probability distribution, and a probability distribution to tell us how much data we need. This causes a severe regress argument."

(RE)Insurance could learn alot from that. The central limit theorem cannot be applied to everything.

We should see more of these types of things until the zeitgeist of overconfidence in quantitative methods slowly begins to commingle with traditional risk and financial analysis. We are already seeing the effects in finance and insurance research.

Saturday, April 01, 2006

The AIG/GenRE dance moves north...

A court finds that the proper jurisdiction for this saga is Conneticut. Choice of law is typically never straightforward in these types of cases...does one prioritize the location of the contractual formation? The venue where the damages are alleged? The location of the players? If one uses a combination of these (and other) factors, how are these to be weighted??

The effects of the finite reinsurance transaction are fairly well-documented. This was a case where the irrepressible Hank Greenberg needed to increase his reserves without violating capital requirements - a reinsurance transaction is treated differently than a loan, which is what this particular transaction with GenRE "looks" like.

The net result of all this is another feather in the cap of the attorney general of New York, who uses his power with more astuteness than Bismark: identify, publicize, settle for $$$, let the Feds bring their case, rinse, repeat.