Fund Insider

Can We Insure Against Systemic Risk?

All insurance is designed to protect against what is called idiosyncratic risk but can also suffer from system risks.

Take for instance your home owners insurance. The property insurers can easily withstand a single claim on a single home, but a hurricane can potetnially wipe out an insurer if enough damage is done, that's systemic risk. They used to price a policy considering the potential that YOUR home will be damaged, but they got smarter and started charging higher premiums if your home was in an flood zone, coastal area etc. Problem is, in financial insurance the persons at AIG needed to be able to identify such hot spots and charge appropriately. They didn't know, nobody knew how easily then entire real estate market could collapse. The closest we have come to this in decades was the S&L collapses of the early 90s when mainly real estate in Texas was affected. Once could price a policy differently for mortages concentrated geographically than one distributed, based on that bit of history, but when the entire country goes down the tube, yes, systemic risk impacts us all.

Let's hope there is no plague. Whomever is left living will criticize life insurers for not forseeing the potential that a very large % of policy holders would die in a short span of time ! If they considered that potential, you couldn't affort life insurance. In the end, our society is always backed by the govt, or not and then you end up with the great depression under Hoover.

Can We Insure Against Systemic Risk?

Acccording to Michael Lews (a prolific writer on Wall Street greed)
AIG went against industry practice and refused to post collateral to dealers when they first started trading CDS (selling insurance).
It is this lack of collateral obligation that allowed them to run amok writing unlimited amounts of insurance, they didn't need any collateral at hand to fund them. At some point they had to do it, but could only do so with govt help to fund the collateral payments to Goldman, etc.

Interesting read
www.vanityfair.com/pol...

On Jul 15 01:26 PM Gtarras wrote:

> Here are two major points nobody mentions:
>
> 1. AIG was brought down not by the REAL losses on these tranches,
> but by mark-to-market SWINGS. It was offering to post collateral
> through a mechanism called CSA, if prices went too far against the
> protection buyer. Other players like AIG (monolines), did not offer
> these margin posting service.
>
> 2. It is still not clear whether the real losses that AIG will suffer
> will be enough to wipe out its capital. For example, MBIA seems to
> be ok in this regard.
>
> The CSA offer from AIG was a suicide. Their exposures were close
> to $1 billion in each deal, with VERY ILLIQUID deals 5-8 years in
> maturity. With this type of setting, if a price on your tranche jumps
> from 10 bps to 100 bps, you get slaughtered. (they clearly thought
> it would not happen.)
>
> For example, if you sell 5y protection, $10 mill exposure on a liquid
> name and things go against you, i doubt you'd suffer that much.<br/>
>
> Thats the reason its critical that this systemic risk issue is brought
> up. NOBODY is big enough to withstand this type of hit (except the
> govt). Of course, there was a reason the banks wanted to unload these
> tranches- to free up capital. Easy fix would be to make changes in
> Basel to view these types of exposures as "capital light".