The Nossiter Net
The net that shall enmesh them all
Edited, Written, and Published by Josh Nossiter
The Morning Mendacity
Friday, April 1st, 2005
The Nossiter Net is cast  to snare some of  the riper rascalities of the day.  Comments?
Insurance is a lovely business.  Subscribers like you and me pay our premiums.  Right now.  In cash.  In return, the insurance companies promise to repair our cars and homes and health – at some future time, should it become necessary, under many restrictive conditions, and only if the insurer decides it’s obligated to do so and can’t, despite its best efforts, evade our claim.  Meanwhile all those premiums flow in, tiny trickles of cash from millions of individual subscribers, month after month, year after year.  Collectively, over time, they add up to mighty torrents of dollars.

All that cash doesn’t just sit around.  It gets reinvested, generating income and capital gains that simply add to the oceans of lucre already flowing in.  The biggest problem for insurers is one the rest of us would love to have:  what to do with all the cash.  A lovely business.  Just ask Warren Buffet, whose legendary investing is financed largely from the insurance premiums generated by Berkshire Hathaway’s insurance operations.

Occasionally things go wrong for the insurers.  A natural disaster or two, a couple of grounded supertankers, and pay-outs on huge claims can soon add up to real money.  That’s what happened to Lloyds of London not long ago, where the “names” – the partners – took a bath.  But most insurance companies hedge their bets on big policies more efficiently than Lloyds did.  They build vast reserves of cash against possible claims (and get nice returns on the investments the reserves are parked in), and they also buy reinsurance.

Reinsurance works like this:  suppose your company insured the Exxon Valdez supertanker for $100 million.  You earn handsome premiums from Exxon, but in the unlikely event that anything should happen to the Valdez, a $100 million payout wouldn’t look good on your bottom line.  So you contract with reinsurance companies, paying these specialty insurers to assume part of the risk should the Valdez run aground and start leaking (as it did).  Reinsurance cuts into your revenues, but it reduces your risk.

Your accountants make sure you get credit for reducing the risk of a massive payout.  Reinsurance contracts appear on your books as reductions in your liabilities.  Investors eyeing insurance company stock take careful note of how well risks are spread this way.  They also pay attention to the size of reserves.  Healthy readings of these indicators help boost an insurance company’s stock price.

Now suppose a very naughty big insurance company, call it AIG, acquired chunks of another insurance company whose reserves looked healthy in relation to claims risks, but in fact were grossly inadequate because many of the claims would subsequently need to be paid out. Temporarily, AIG’s reserves would get a boost, lifting the stock.  In fact the company is assuming more risk and weakening its balance sheet... “paging Mr. Spitzer, Mr. Elliot Spitzer to the white courtesy phone please.”

Further suppose that this very naughty insurance company seemed to have spread its risks efficiently by buying reinsurance policies. Good for the balance sheet, good for the stock.  But what if AIG secretly owned the very companies it reinsured with?  It’s not really reducing risks, merely camouflaging them.

And that’s not all.  Other reinsurance contracts held by AIG, with legitimate, independently-owned reinsurers, only insure against things like interest rate movements or investment timing issues.  They’re not insurance against claim payouts at all, even though they appear that way on AIG’s books.  The term of art for reinsurance contracts of this type is finite risk reinsurance, a perfectly legal dodge – for the moment.  Mr. Spitzer has his eye on it.

The giant insurer AIG has been caught engaging in all these shady practices.  The company may be worth over a billion less than it appears on paper, and counting.  Why would a participant in such a lovely business do such terrible things?  Their top executives were very expensive:  $270 million dollars worth over the past couple of years.  And those executives hold stock, and options, worth far more than that.  Anything AIG does to improve the appearance of its balance sheet makes the company execs that much richer.

Of course, AIG is far from the only naughty insurance giant.  There’s Marsh and McLennan, which has been paying huge kickbacks to brokers who steer business their way.  And Marsh is far, far from alone in doing so;  fact is, it’s standard practice in the industry.

So the next time you get socked with another hefty insurance premium increase, or read a headline about run-away medical insurance costs, and Mr. Bush and his minions blame frivolous lawsuits, don’t believe it for a minute.  Somebody has to pay for all those kickbacks to brokers, and mammoth executive salaries, and improperly hedged claims payouts.  Not too happy about being that somebody?  It’s a free country; change your insurance company.  Just don’t expect to pay a lower premium.

April Fools' Day is the perfect occasion to reflect that when it comes to insurance, the joke's on us.

©Joshua C. Nossiter, 2005
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