Tag: Risk management

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What We Really Learned from Silicon Valley Bank

The Takeaways:

  1. Decentralized finance (DeFi) with smart self-regulations through technologies like blockchains, smart contracts & generative pre-trained transformer GPT inside each financial institute represents the future of efficient risk management.
  2. We can establish interest rates markets to allow different parties with different financial profiles and different needs to trade to their desires rates based on their needs, risk levels, time lengths, credit ratings, insurability, and expected returns from fund investment.
  3. FDIC should raise its coverage cap above $250,000 — partly paid by depositors with an excess amount — because uninsured deposits proved riskier this time than we assumed due to the self-fulfilling prophecy.

Not All Lessons Were Born Equal from SVB

Learning the right lesson is the key for the better future. There are so many potential lessons out there and everyone can and will have a different opinion on what to learn and how to prevent future crisis of financial institutions like banks.

Part of reason is that the case itself is very complicated, making it possible to have many things to say. If someone fell down from his bike, there is one or at most two lessons to learn: Either the road is too slippery or the rider was not focused. But when a bank with billions of dollars of asset fell, having only one or two lessons sounds like a failure in learning. It has to be more involved in it.

Not all lessons were born equal. For one thing, we must focus on risk management more than rescue scheme. The best that a rescue scheme can do is to arrive at a “no-loss + loss” result, while the best of risk management is to achieve a “win + win” for all parties.

Another relevant point is mindset more than demographics. For example, a lesson that I have heard many talking about is to attract a diverse pool of clients and avoiding over-exposure to any single sector, single industry or single type of clients. This is always true and always makes sense. However, I do believe we can do things without for an ideal client base. After all, having a special type of clients is not always a bad thing. For one thing, they allow us to develop the best resources for serving a unique group of people, rather than serving everybody. Imagine such a boring landscape picture, in which all banks have the same customers. I would rather see a more diversified picture in which banks are proud of their unique clients.

It’s an open secret that regional banks always face a bigger challenge in attracting diversified clients than national banks. The way the former compete with the latter is not in size and types of clients but in doing one or two things better than the latter.

Ultimately, the key is not about client type but always about risk management. A good risk management strategy starts with, and grow on, the existing clients, not betting on changing them.

With SVB clients, we can learn to (1) know the existing clients well, especially their demand liquidity; (2) do periodical stress tests and (3) possessing bond funds and/or bond ETF. All these can be done without waiting for a safer diverse client base to come by.

A Deeper & Bigger Lesson

If there is one forward looking lesson out of all lessons, if we must say something fundamentally important, it is this: Stop trusting central human regulators and switch tech enabled decentralized smart regulations, where the word “tech” refers not only to FinTech but all the new technologies in and out of financial world.

We can start from the recent report on Fed’s San Francisco branch that missed the red flag of SVB. More generally, the time of central bank intervention determines everything. Regulators need to allow a time cushion following a quick turn of monetary policy. For example, banks with maturity mismatch should have access to funds to keep liquidity and to avoid “fire sale” of their portfolio with huge losses.

But it is always easier said than done with the current system. We have witnessed the modern bank run this time but there is no guarantee that it will not happen again. Humans are not always smart learners and we do have a tendency of repeating the same mistakes over time. In my last post, I highlighted two lessons from SVB: interest risk and liquidity risk. We have been talking about them since day one in financial world, and yet we are still struggling with them decades later.

How do we truly make progress in financial risk management from now on for the future?

The first thing I want to say is this: Although one of the direct casualties this time was the Signature Bank with strong crypto link, the message that carried by the dead messenger is more relevant than ever: The future lies in decentralized and proactive “smart regulations” that assist each bank, including those led by “zombie leaders” like in the case of SVB whose only strength is to guard self-interest but little else (尸位素餐), to constantly monitor current and future risks.

“Smart” More Than “Decentralized” Regulations

The name “decentralized” may sound exclusive rather than inclusive. In my mind “smart regulations” will reserve a big seat for central banks instead of eliminating them. The SVB case tells us that sometimes only words and resources possessed by central authorities would work, and does so dramatically.  

Here is another example from the insurance industry. According to this commentary of AM Best, the largest credit rating agency in the world for the insurance industry, that had the U.S. government not stepped in to make all depositors whole, underwriters of directors and officers insurance for startups and venture capitalists, as well as the financial institution insureds supporting such entities, could have faced financial distress given that they are operating on very thin capital.

This is because “’startups are by nature much more agile and less risk-averse than other companies, their directors and officers often make decisions quickly,’ said David Blades, associate director, industry research and analytics, AM Best. ‘Therefore, the potential for D&O claims for startups would have been high in the case government had decided not to help the depositors.’”

There will be lawsuits for sure no matter what. According to this report of AP, “A class action lawsuit is being filed against the parent company of Silicon Valley Bank, its CEO and its chief financial officer, saying that company didn’t disclose the risks that future interest rate increases would have on its business.”

“It is looking for unspecified damages to be awarded to those who invested in SVB between June 16, 2021 and March 10, 2023.

“In particular, the lawsuit said that annual reports for 2020 through 2022, “understated the risks posed to the company by not disclosing that likely interest rate hikes, as outlined by the Fed, had the potential to cause irrevocable damage to the company,” the lawsuit stated.”

“It also claims that the company “failed to disclose that, if its investments were negatively affected by rising interest rates, it was particularly susceptible to a bank run.”

With the above being said, let’s go back to remedies and we can do two big things toward smart regulation.

Decentralized, Flexible FDIC Caps

We have already seen solutions include raising FDIC insurance coverage cap above the current $250,000 line. Lawmakers all seem to be open on this idea, with the focus on how much the new cap should be.

This is a good idea because we have learned this time that non-FDIC insured deposits can post a big risk. It directly triggered the bank run of SVB, and explains why the share price for the First Republic Bank has been down by 70%. Uninsured deposits prove riskier this time than we assumed due to the self-fulfilling prophecy.

However, unlike the old cap of $250k, this time we probably do not want to have a fixed, nationwide new cap of FDIC coverage. Instead, we want FDIC’s new coverage cap determined through a negotiation process by individuals, and to be paid partly by depositors with an excess amount, sort of like copayments in the healthcare business. This way, depositors will share the responsibility and will be given personalized choices in determining how much risk they want to take.

The range of caps can go from 100% to 0% theoretically, and it’s up to the depositors to decide. Those who choose 0% extra coverage can always take advantage of the existing cap of $250k by having multiple accounts across financial institutions for excessive amount of money, not leaving all eggs in a single basket.

Depositors can either spread fund across banks or using Certificate of Deposit Account Registry Service CDARS, opening a cash management account, relying on MaxSafe by Wintrust or finally using Depositors Insurance Fund (DIF).

Either way, each depositor will sign a legally binding contract with FDIC and the bank where they deposit their money, stating that they fully understand the risk and in case of bankruptcy, only the amount they have purchased will be covered by the program.

Establishing National and Regional Interest Rates Markets

This is a bigger deal and of course will be subject to discussions and debates. But the basic idea is simple and interest rate swaps already exist and are an important component of the fixed-income market according to a Smartasset.com article. We just need to expand it to make market interest rate floating rather than fixed and to allow variation

The first thing about interest rate swap is that they are financial derivatives traded over the counter, where investors will typically exchange a fixed-interest payment for a floating-rate interest payment, which is known as vanilla swaps. Investors use these contracts to hedge or to manage their risk exposure.

But we do more than vanilla swaps, including allowing parties with different needs and profiles to trade directly among themselves.

The basic driver of an interest rate market or markets is different needs and different financial profiles of different parties. On the profile side, entities with low credit rating are willing to offer higher interest rates to attract buyers of their products, while the opposite holds true for the high credit rating entities.

The other profiling factor is time of economy. During a booming economy, parties don’t mind paying a higher interest rate because their returns from the fund are expected to be higher. On the other hand, when a future project does not have big expected return the owner of the project is only willing to pay lower rated fund. To the extent that a region is growing fast, many investment projects can expect high return, which push up a higher interest rate in that region.

At the end, we just need to calculate the average bidding interest rate in a region to come up with a region specific & time specific interest rate as the “going rate” for all.

On the need side, some entities are willing to pay a higher interest rate when getting funds quickly matters more than higher interest rates. Other entities do not have any urgent need for fund and will only pay low rated funds. The average of the ongoing highest price a fund buyer (the bid price) is willing to pay will be the “going bidding rate” of interest. The average of the ongoing lowest price fund sellers (the ask price) are willing to accept will be the “going asking rate” of interest. The average of the going bidding interest and going asking interest will be the market going interest rate.

The idea is to replace the single nationwide interest rate set by central banks to a diversified and decentralized, market determined interest rates, in which central banks can still set basic rates but anything beyond is subject to market forces.

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Silicon Valley Bank: New Casualty, Old Causes

The Takeaways:

  1. Bank runs are still possible today because although we have learned to tighten centralized financial regulations, we are still weak in financial risk management that proactively predict risk and take preemptive steps — even for highly predictable and familiar risks.
  2. We have seen textbook examples of (1) how interest risk grows to a bank run through the well-known inverse relationship between bond price and (2) how liquidity risk from duration mismatch exacerbated by dramatic change in interest rate has created enough momentum to kill a solvent bank.

Silicon Valley Bank: The Good Beginning Story

Silicon Valley Bank (SVB, NASDAQ symbol SIVB) is not exactly a household name even in northern California where the bank is located (in Santa Clara County, one of the nine counties in the San Francisco Bay Area.) Frankly, I heard the 6 season comedy TV Series “Silicon Valley” since 2014 but don’t recall the bank’s name on top of my head, even though it is the 16th-largest lender in America, with about $200 billion in assets.

According to this article by Seeking Alpha, “ from 2019 to late 2022, SIVB total deposits more than tripled, growing from $61.7 billion in 2019 to $173 billion as of December 2022.”

A great story, right? Sure it is or was. But then comes the bad one. It all started from what the bank did with the deposited money. Normally this is not a problem, because most of the time most banks will lend the money out to individuals and businesses who can make a better use of the money than the depositors can, and earn a higher interest than they pay to the depositors.

This is what most banks do for living, among other activities.

For example, say SVB received a total deposit of $1 million from a startup firm called NuLife in Santa Clara County. SVB pays NuLife $20,000 (2% of the $1 million) in interest for putting their money in the bank, while keeps the rest of $980,000 in its account. The bank will not let the money sit there collecting dust but will lend it to another business called OldBuz at 5% interest, which is $980,000 x 0.05 = $49,000. In so doing SVB will earn a net amount of $49,000 – $20,000 = $29,000.

Earning a higher interest rate from the loan recipients than the interest rate banks pays to the depositors, this is the basic business model and SVB is not different from others. The only difference is that it did better than many others by attracting more depositors, especially tech startups and venture capital firms.

The Pandemic Shocks & the Changed Course of Government

Then the pandemic changed everything. I agree with this article of Business Insider that the SVB fallout “was a byproduct of the Federal Reserve’s hiking of interest rates by 1,700% in less than a year.”

But to fully understand the impact of the quick change of course by Fed, we must understand how much Fed had done during the pandemic, or how hard the Fed worked to make sure all lenders and borrowers can have easy access to money.

This paper of the Brookings Institute summarized the key changes by the Fed during the pandemic months, which has been credited with staving off an economic crisis and bolstering financial markets at a time when there was a “sharp contraction and deep uncertainty about the course of the virus and economy sparked a “dash for cash” — a desire to hold deposits and only the most liquid assets — that disrupted financial markets and threatened to make a dire situation much worse.”

First of all, the Fed purchased large quantities of government bonds and other securities, famously known as Quantitative Easing or QE, to make it easier for individuals and businesses to access credit, to stabilize financial markets and to support economic activity.

The Full Package of Stimulus from the Pandemic Era

The pandemic stimulus is not a single step but a full package of multiple programs, spanning not just monetary but fiscal steps. Let’s begin with the four (new and renewed) programs to promote financial liquidity for banks:

  1. Money Market Mutual Fund Liquidity Facility (MMLF), a program introduced in March 2020 to provide liquidity to money market mutual funds (MMFs), which are investment in short-term, low-risk securities like commercial paper, certificates of deposit, and Treasury bills. Fed lent money to eligible MMFs at a low interest rate in exchange for collateral in the form of high-quality assets, such as Treasury securities and agency debt.
  2. The Primary Dealer Credit Facility (PDCF), a lending program introduced in March 2020 to provide short-term funding to primary dealers, which are firms that have a trading relationship with the Federal Reserve and participate in the buying and selling of government securities, such as Treasury bonds and bills. These firms, which include SVB since 2015, are considered essential to the functioning of the financial system. Under PDCF, primary dealers can borrow funds from the Fed for a period of up to 90 days, using a variety of eligible collateral such as Treasury securities, agency debt, and mortgage-backed securities. The interest rate charged on these loans is set by the Fed and is typically lower than market rates.
  3. Direct lending to banks with a lowered rate by 2 percentage points (from 2.25% to 0.25%). It’s said that eight big banks agreed to borrow from the discount window in March 2020, just so that other banks won’t feel bad and fear that markets and others will think they are in trouble.
  4. Temporarily relaxing regulatory requirements to encourage banks to use their regulatory capital and liquidity buffers to increase lending during the pandemic.

The above are not the only game in town, as the Fed had other things in mind. Turned out that the liquidity it added to the shocked economy covered corporation (through the Primary Market Corporate Credit Facility or PMCCF, Commercial Paper Funding Facility or CPFF, Supporting loans to small- and mid-sized businesses, Supporting loans to non-profit institutions), households and consumers (through Term Asset-Backed Securities Loan Facility or TALF) and state and municipal borrowing (through Direct lending to state and municipal governments, Supporting municipal bond liquidity).

The following answer from Perplexity.ai, which integrates current web search results into the GPT (Generative Pre-training Transformer) process, tells us more about the fiscal stimulus on top of the monetary policy changes:

“The US government implemented both fiscal and monetary stimulus measures to mitigate the economic impact of the COVID-19 pandemic. Fiscal stimulus measures included direct payments to individuals, paycheck protection, student loan forbearance, eviction and foreclosure moratoriums. The economic impact of the pandemic sent the US economy into a recession in February 2020, with unemployment rates rising as high as 14.7% in April 2020.The direct payments to individuals were referred to as “economic impact payment” checks amounting to up to $1,200 per eligible adult.

“There were three rounds of such checks, including additional payments of up to $600 and $1,400 per person in 2021. The size and scope of these direct checks was a new experiment for the US government.

“The Federal Reserve Bank estimated that US fiscal stimulus during the pandemic contributed to an increase in inflation. However, economists largely agree that the money helped local governments shoulder significant pandemic-related costs and many governments avoided deep budget cuts. Many states have even reported surpluses.”

Here we have it: a teamwork of government branches toward the same goal of avoiding pandemic induced recession.

The Insightful Warning

Installing stimulus is one thing, foreseeing its full consequences is another. It is the latter that is the key for risk management. For that we must thank the former U.S. Treasury Secretary Lawrence H. Summers, who was the first to point out the danger of inflation following fiscal and monetary stimulus during the pandemic. The following answer from Perplexity.ai tells us that “In February 2021, he warned that additional government stimulus efforts to combat a pandemic slowdown raised the risk of inflation. He has since sent several warnings to Washington urging them to tap the brakes on stimulus or risk unleashing a serious burst of inflation.” Not only that, but Summers disagrees with the common belief that inflation is transitional as points out by this article of Barrons.com. “He was right: Consumer prices rose 8.6% year over year in May, the fastest pace in 40 years.”

Coordinated Stimuli Require Coordinated Risk Management

I agree with this article by Business Insider that cites Lundy Wright, partner at Weiss Multi-Strategy Advisers, that “(w)hen you raise interest rates quickly, after 15 years of overstimulating the economy with near-zero rates, to not imagine that there’s not leverage in every pocket of society that will be stressed is a naive imagining.”

Wright used a “double negative” sentence that is not the easiest to understand. His message is simply that we should expect some passengers to fall off of the bus when the driver made a sharp turn without reducing the speed.

Once again, much attention has been given to Fed’s monetary policy but not enough to the fiscal side, at a time when coordinated risk management is called for.

The aforementioned article of Business Insider points out that Fed’s “prolonged period of low interest rates created many financial dislocations that are now flaring up.”

In the SVB case, the “dislocations” came from two familiar places. The first is interest risk showing as the inverse relationship between interest rate and bond prices; the second is liquidity risk as maturity mismatch between long term asset holdings and short term liability demands. The SVB management has done a lousy job in handling both risks. These when combined with the startups’ high liquidity demand, led to the collapse of SVB.

The First Dislocation After QE: Interest Risk

Let’s begin from the inverse relation between interest rate and bond price. I’ll simply call it interest risk because what drives the inverse relation is the changed interest rate.

Long story short: The pandemic QE made it hard for banks to earn high interest income from writing loans to businesses and individuals. This is because when money is everywhere available, charging a high interest for bank loans is a mission impossible, it only drive customers to your competitors.  

So here is the problem: SVB was sitting on a big pile of deposited money and must find a place to keep it safely and profitably. SVC chose to park its money in treasury bonds, which is known as “risk free” because they are backed up by federal government tax revenues so there is no need to worry about default, meaning no need to worry about the bond issuers (the Treasury Department) to go bankrupted without paying off their debts to bond buyers or investors.

Of course, hardly anything under the sun is entirely risk free. Although the Treasury Bond (or “T-Bond” as it is often called, or simply “Treasuries”) itself is very safe, it does have a time related problem, where T-Bonds fight with each other to turn it into a risky game.

To illustrate, let’s think of a car dealership selling both used cars and new cars. The Treasury department is a new car dealership and only sells newly issued T-bond to investors. Bond buyers however don’t have to keep their bonds until maturity, just like car buyers don’t have to keep the same cars until they are no longer functioning. Bond buyers can sell their bonds before maturity just like a car buyers can sell his used car before it is dead — in a secondary market.

But here is where a risk free product becomes risky: In the secondary market where bond owners trade among themselves like used car owners do to their second or third hand cars, the price is not guaranteed. Some “used” T-bonds can sell a high price while others low, just like “hot” and not so hot brands of used cars.

One thing different in the used car market is that the price is almost entirely determined by the age of the car. A 1998 Civic will be sold cheaper than a 2011 Civic, other things equal. Another thing that is almost certainty is that nobody will ask a price higher than his original purchasing price — unless the car belongs to some rare classic models.

Unlike used cars, the old T-Bond can be resold in the secondary market either above or below the original purchase price. The age of bond has little impact on the resale price, only the difference between new and old interest rates.

Yes, in the bond game interest is the king, almost nothing else matters as much. Most people expect that the principal will be returned at the end of the maturity date, so This is so because people buy bond for the one reason of receiving interest payments, much like people buy car for driving. Buying bond is lending your cash to the bond issuer, who must pay interest to entice bond buyers.

Imagine someone wants to borrow $1,000 from you. Your first response is “Why would I lend you the money? I don’t even know you.” Well, the shortest — but convincing — answer from the stranger will be “I’ll pay you interest every month before I return your $1,000 in two years.” For most people, that’s a reason good enough.

Back to the old or secondary bond market, the key question buyers ask sellers is not how old the bond is, like in the used car market, but “what interest did you (or do I) get?” The reason is simple, if the seller gets 2% interest, that’s the rate the buyer in the secondary market will get after buying.

Here is the question: If the newly issued bond is paying 3% interest, why would anyone buy the “used bond” that only pays 2%? The only reason for a rational buyer is when the used bond (paying 2% interest) is offered at a lower price than the seller paid before. This is where an inverse relation between current interest rate and bond price comes into play.

This is similar to selling your old, gas inefficient car today at a lower price because buyers have more gas efficient new cars to buy from someone else in the new cars market.

SVB got itself into such a troubled situation as the bond seller: The bank needed to sell bonds for quick cash to pay depositors, but the only way for anyone to buy the bond is when SVB lowers the bond selling price. Every transaction when the bond changed hands means a loss for SVB.

The Second Dislocation After QE: Liquidity Risk

Liquidity risk, in its simplest term, means you are out of cash when you need them the most. It differs from poverty, which means no money anywhere in any form, people facing liquidity problem have money but in the wrong form or wrong places other than cash.  

SVB got itself into a liquidity trouble because it invested heavily into mortgage backed securities (or MBS for short), in addition to Treasuries.

For those not familiar with MBS, starting from mortgage loans would help. Strictly speaking, a mortgage is a loan, so you don’t have to say, “mortgage loan,” just “mortgage” is fine. Mortgage is a loan specifically for buying a home or property. Of course, lenders are not charities and then offer mortgage because they will receive interest payment from homebuyers.

When you take out a mortgage, you agree to pay back the money you’ve borrowed (called “principal”), plus interest, over a set period of time like 15-30 years, in addition to taxes and insurance. If the borrower fails to make payments on their mortgage loan, lenders have the legal right to take the home (or commercial property) back and put them in the market for sale through a foreclosure auction.

Generally speaking, mortgages that last anywhere at or above 10 years are long term loans. Most mortgages are therefore long term loans. The other feature is that individual mortgages are not considered securities because they have little risk — lenders can always take back the properties from borrowers, called collateral, for failure to make loan payments. Finally, a mortgage cannot be traded in the market because it is not an investment vehicle but a loan involving two parties: borrower & lender.

The story with MBS is different. First, it is created when banks issue mortgages to homebuyers and then pack or bundle up many mortgages and sell the package to a group of investors. As such, MBS is always an investment product bought and sold through a broker by investors, which include individual investors, corporations, and institutional investors on a secondary market.  

MBS is designed to free up the capital of the original mortgage lenders, often banks, credit unions and other financial institutions, so they can lend to more potential homeowners by leveraging investors who want to have a low risk investment at a discounted price.  

Secondly, most mortgages in the US are securitized, meaning they exist in the form of MBS that is traded in the markets for profit. Thirdly, most MBSs are issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and Ginnie Mae that buy mortgage loans. Fourth, they are considered relatively low-risk investments especially if an MBS is guaranteed by the federal government, investors do not have to absorb the costs of a borrower’s default.

That said, an MBS is only as safe as the mortgages that back it up. During the subprime mortgage meltdown of 2007-2008, many MBSs were vastly overvalued due to non-payments. More generally, interest rate risk always exists with MBSs, as its price can drop when interest rates rise — just like the Treasuries (remember the discussion we had earlier?) In many ways MBSs are like bonds, both are fixed-income securities that pay a set amount of interest over time.

Interest risk explains “reinvestment risk” because when interest rate is low, borrowers want to refinance to take advantage of the lower interest rate. Let me illustrate with a hypothetic example.

Imagine you are currently paying off a fixed-rate mortgage with a 30-year loan term at 6% interest rate. Now, say the current interest rate is only 4%. You decide to refinance, which means to take out a new loan to pay off an existing mortgage. 

To make it easier to understand, say you have two investor friends, Fred and Sam. You met Fred first when the prevailing interest rate is 5%. Fred offered you $2,000 at 5% interest a year for two years, you thought you did not have choice, so you agreed. One year later you met Sam when the prevailing interest rate is 3%. After hearing your story with Fred, Sam says he’d be happy to lend you $2,000 for two years at only 3% interest.

Guess what you will do? You will borrow $2,000 from Sam and give it to Fred right away, telling him the deal is over as you find a lower interest to pay — assuming you’ve already paid $100 interest (5% of $2,000) to Fred for the last year. This is refinance and you saved yourself $80 because instead of paying $200 in two years to Fred, you only pay $120 to Sam in two years (3% of $2,000).

Fred now has a “reinvestment” problem because his money (a loan) was prepaid by you so he must find another borrower to lend the money to. Knowing Sam’s is willing to go as low as 3%, Fred will have to go down with the lower interest rate.

In addition to interest risk, credit and default risk is also associated with MBSs. This is straightforward: investors will experience losses if borrowers fail to make their interest and principal payments. Importantly, MBS investors are not the owner of the mortgage, so if a borrower defaults, not only the investor’s income will be interrupted but they do not claim any proceeds from foreclosure sales.

The Macroeconomic Risk of MBS: Negative Convexity

Interest risk, reinvestment risk and credit and default risk are all real but in the case of SVB, the macroeconomic risk associated with MBS is negative convexity.

First of all, convexity means curving outward—like the shape of the outside of a contact lens. The opposite is concavity, which means curving inward—like the shape of the inside of a contact lens. Put differently, a concave shape can be “filled,” while a convex shape creates a dome.

In our context, to understand convexity we need to understand duration first, which measures how sensitive bond price is to changes in interest rates. For example, if a bond duration is 3, it means when interest rate increases by 1%, bond price will decrease by 3%.

There are two contributing factors: time to maturity and coupon rate. The longer time before bond or MBS maturity, the higher the duration. This is easy to understand: If you lent money to someone and the borrower will pay you back tomorrow, you don’t care much about interest rate change because the loan has the “time to maturity” of just one day. Now, if you loan money to someone for 20 years, then interest change matters much more to you because your interest risk is higher over a longer period.

Similarly, the larger the coupon rate, the lower the duration, because a part of money has been paid back through coupons, which is just another name for “annual interest.” In an extreme case, we have bonds that are zero coupon bonds, meaning do not pay any coupon or annual interest at all until it’s maturity date, then duration is equal to time to maturity.

Now, convexity is measuring the rate of duration changes. Turns out duration is an approximation of the change in bond price in response to interest rate changes. For small changes in interest rate, it is accurate but not for larger ones as it always overestimates the price change if interest rates rise a lot, like the situation we are seeing today. Convexity helps correct this overestimation and provide a more accurate estimate of how much a bond’s price will change given a certain change in interest rate (or “yield” as commonly called).

With negative convexity, when the interest rate increases (like we are seeing today), the price of a negatively convex bond will fall by a greater rate. This does not hold for the opposite case when interest rates decrease. In other words, bond or MBS price is more sensitive to a rate increase than a rate decrease. A rate increase (like we see today with inflation) poses a bigger risk on bond price than a rate decrease. This makes negative convexity a bigger issue for SVB this time.

Callable bonds and mortgage-backed securities are examples of negatively convex bonds.

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Did You Know?

Why Bundled Insurance Policies Are Good for You

The Takeaways:

  1. Bundled Insurance policies are often promoted by insurers, but many insurance consumers see them as gimmicks and quickly say “No” to them.
  2. Unlike bundled packages from most car dealers, bundled insurance policies are transparent and should not be seen as gimmicks. They can bring real savings to consumers, in addition to the extra convenience, additional coverage and improved customer service experiences.
  3. There is a solid statistical reason for insurers to offer discounts to bundled policies: The joint probability of two or more independent events is always smaller than that of individual event.
  4. The most common bundles are home and auto policies for homeowners or renters and auto policies for renters.
  5. Many insurance consumers do not know that Business Owners’ Policy or BOP is a bundled policy by itself. Umbrella policies are also bundled policies.

What Are Bundled Insurance Policies?

The best short and concise answer is provided by this article of Forbes: “Bundling insurance is when you buy two or more insurance policies from the same company and get a discount.”

Most insurance consumers (i.e., people like you and me) own multiple insurance policies, such as health insurance, auto insurance, home insurance or life insurance. Given that you are the only owner to them all, are they “bundled policies” around you?

Not really. As long as these policies are written by different insurers, they are not bundled. You may have a life policy from New York Life, an auto policy from Progressive, a home policy from Farmers, and a health policy from Kaiser Permanente. Each insurer cares little or wants nothing to do with another insurer. Why would New York Life care about whether you use Progressive or Allstate or Geico to insure your autos? Either way does not make any difference for their life insurance business.

The only case you have a bundled insurance policy is when you buy at least two policies from the same insurer.

Is Bundled Insurance Good for Insurers Only?

This article from Harvard Business Review offers a seemingly simple and straightforward rule of thumb for bundled pricing or bundled packaging: “Should you prefer to purchase it as a breakdown of the base car plus handpicked options or are you better off buying it as one all-inclusive bundle? There is a simple and pretty consistent rule of thumb on the question. Here it is: Unbundling or a la carte pricing benefits the buyer and packaged or bundled deals give the advantage to the seller.”

The reason according to the article is that if you are the customer, “unbundled pricing creates transparency and allows you to pick exactly the options you want. Most bundles make margin in giving you some of the things you want, but also some of the things that you will rarely use.”

This is true in car shopping but obviously not true for everything. In insurance, for example, auto insurance and home insurance are most likely required by the law or by lenders. When two things are both required, buying them together from the same seller makes sense, because it creates a win-win case for both sellers and buyers.

Why Insurers Want to Offer You Bundled Policies

Insurance companies or insurers all want you to buy bundled policies from them because, as this article points out, “it’s cheaper for them to service one customer who has multiple policies than it is to service multiple customers who each have only one policy. In that case, insurers are not any different from any retailers who always want you to buy more from them, and they will be happy to offer you discounts for doing that.”

There is another realistic advantage that I want to call “consumer stickiness,” which means, as the aforementioned article says, “bundling makes it less likely that you’ll switch to another company, which saves the insurance company both the cost of acquiring a new customer and the risk of losing money if that customer files a claim.”

In other words, bundled customers tend to be loyal customers.

Risk Management Advantage for Bundled Polices

In my view the biggest advantage for insurer is in risk management. Believe it or not, offering both auto and home insurance policies helps reduce insurers’ overall risk exposure, which can result in cost savings for both the insurer and the customer. Here is how it works.

Say you have both auto and home insurance with Farmers, it is less likely for you to file claims for both policies at the same time. This is because the risks that could result in a claim for one policy (such as an accident or theft of a vehicle) are less likely to also impact the other policy (such as damage to a home from a natural disaster).

Simply put, Farmers is betting that the chance for them to pay you on both auto and home damages at the same time is smaller than just paying you on one policy. This is how they save the cost of doing business with you.

The Law of Probabilities Favors Bundled Policies

Is it smart for insurers to bet that way? Yes. The multiplication rule for independent events, one of the basic rules of probability, says that the probability of two or more independent events occurring together is equal to the product of their individual probabilities.

I know the above sounds complicated but let me make it simple. Say you like to drink every Friday afternoon after work and sometimes you drive under influence or DUI. Seeing one ticket from your DMV record, all auto insurers will see you as a bigger than normal risk, and almost nobody wants to write you a policy unless you pay extra dollars for a higher premium.

On the other hand, drinking at home Friday afternoon presents little risk there, and your home insurers are unlikely to raise your premium just because you drink once a week in Friday afternoons.

What I am saying is that the risks from drinking behind wheel and drinking at home are almost independent — in terms of causing accidents or property damages — even though the two events are not entirely independent from each other. For one thing, they involve the same person (you).

Now, as long as two events are independent (for insurance purposes), the chance for them to happen at the same time is equal to the product of their individual probabilities. Since a probability cannot be smaller than 0 and larger than 1, the product of two probabilities is always smaller than the probability of one event.

You are probably confused by now so let’s continue with the Friday drinking example. Say the chance for you to get a DUI ticket is 1/180 days or roughly every six months, while the chance for you to set your house in fire after being drunk is 1/1,095 days or once every three years. The chance for you to get a DUI ticket and to set the house in fire is then 1/180 x 1/1095 = 1/197,100 days or roughly one out of 200,000 days (i.e., roughly 540 years). Apparently the result is much smaller than 1/180 or 1/1095.

This is why insurers are betting it right and they have nothing to hide from you when they say they want to give you a discount if you buy auto and home policies together from them.

Bear in mind however that when there are catastrophic events like hurricanes or earthquakes, the events that both your home and you cars will be damaged are no longer independent. This is why insurers need to buy reinsurance to cover themselves as they often must to make payments to many claims at the same time.

Why Bundled Packages in Car Dealership Are Often Not to Your Advantage

The story is different with a car dealership. You see each year car manufacturers always try to introduce some new features to their cars. It goes without saying that it costs money to introduce new features. Say for the 2024 model year, Toyota wants to introduce a new feature called “Auto on Cartoons” that the backseat screen will automatically detect when a child is seated and starts playing the Cartoon Network programs for them during the entire trip.

Apparently such a feature only makes sense if there will be children around in the house, but not for the “Empty netters” whose children all left out of the household. However, Toyota decides to make this feature available to all cars in the 2024 models in order to quick cover the cost from doing research and development. Meanwhile all Toyota dealers will get an extra bonus of $20 every time they successfully sold this feature to a new car buyer — whether they need it or not.

In other words, car dealers do have something to hide from you and the bundled package only benefit sellers but not necessarily buyers.

Underwriting Advantage in Bundled Policies

Working with packaged policies has another (subtle) advantage for insurers for underwriting purposes.

What is underwriting? It is the process of evaluating and assessing the risks associated with insuring a particular individual or entity, and determining the appropriate premiums to charge based on that assessment.

In other words, it is all about knowing customers or potential customers. The more insurer knows potential customers, the better they can come up with the right price for premium.

By bundling policies, insurers can gain a more complete view of the customer’s overall risk profile, which enables them to price the policies more accurately.

For example, if an insurer offers both home and auto insurance, they can analyze the customer’s driving record and credit history in addition to information about their home, such as its location and age. This information allows the insurer to assess the customer’s overall risk and set premiums accordingly more accurately. The insurer can also better predict the likelihood of claims related to both policies, which helps them manage their risk exposure.

Bundled Policies Are More Common Than We Think

You don’t have to wait for your insurance agent to offer you a bundled policy, some policies were born to be bundled. The best example is Business Owners’ Policy or commonly called BOPs, which is a type of commercial insurance policy that bundles together several different types of coverage into one package.

Typically, a BOP will include property insurance, liability insurance, and business interruption insurance. By bundling these coverages together, insurance companies are able to offer a comprehensive insurance solution for small and medium-sized businesses at a lower cost than if the policies were purchased separately.

Additionally, purchasing a BOP can be a more convenient and streamlined process for business owners, as they only need to manage one policy instead of several. The policy can be customized to meet the specific needs of the business, and the coverage can be adjusted as the business grows and evolves.

A BOP is customizable, because BOPs are designed to be tailored to the specific needs of a business. Businesses can choose the coverages they need and adjust their policies as their needs change.

It is designed primarily for small and medium-sized businesses. However, it can also be a good insurance option for larger businesses that do not have complex insurance needs.

Another common type of bundled policies is umbrella policies. All umbrella policies are bundled policies. An umbrella policy is a type of insurance policy that provides additional liability coverage beyond the limits of the primary insurance policies. It is called an umbrella policy because it provides coverage that “sits on top” of the primary policies, like an umbrella. An umbrella policy is considered a bundled policy because it covers multiple underlying policies, such as homeowners insurance, auto insurance, and other liability policies. It provides an additional layer of protection for businesses or individuals who may face significant liabilities that exceed the limits of their underlying insurance policies.

Categories
Did You Know?

When a State Has 80% Homeowners Lawsuits in the Country, How Can We Do Better in Risk Management?

The Takeaways:

  1. Risks are inevitable, losses don’t have to be — if we do risk management right.
  2. One-way attorney fees and assignment of benefits (AOB) are the two big legal loopholes pushing up insurance cost and lowering down private insurance affordability and availability in Florida.
  3. Four technological platforms or tools are very useful in risk management: ChatGPT, Smart Contract, Internet of Things (IoT) & Tango. Together they have the potential to revolutionize insurance business by significantly reducing insurance costs and increasing fare & efficient insurance coverage.
  4. ChatGPT will be trained to read and explain lengthy and complicated legal documents such that ordinary citizens can quickly understand the gist of a 200-page contract. This will significantly reduce the currently indispensable role of human attorneys (they may be needed to proof check the ChatGPT answer but that should not take very long.)
  5. Another ChatGPT development is customized, always on, mobile and industry- or even firm-specific ChatGPT. The program will be locally pre-trained by records of past risks and past losses, and then provide intelligent and insightful answers to inquiries of all employees in dealing with new but similar problems.
  6. Smart contract associated with blockchain will effectively reduce the problem of legal system abuse, over-crowed or jammed court rooms, long waiting lists of scheduled litigations — by drafting really smarter contracts that are filled with very detailed, context specific “what if” terms and conditions (ChatGPT can help draft and interpret the document), taking into account all relevant historical cases and eliminating extra spaces for misinterpretation and post hoc litigation, while keeping the feature of automatic execution of a predetermined agreement.
  7. Internet of Things (IoT) will establish a field monitoring network at critical junctions of business operation to record objective evidence admissible to the court of law, deterring frivolous lawsuits and prevent predatory practices of trial attorneys.
  8. Tango is the easiest and most intuitive training tool for employees by providing step by step guides with intuitive screenshots every step of the way that everyone can understand and easy to follow. In the future new employee orientations will be mostly done by watching Tango generated PDF files. Numerous risk management field guides can be developed with context specific Tango flowcharts to reduce the chances of misbehavior and mishandling.

This is a more detailed (and longer) version of my proposal for the “In2Risk23” Conference to be held on October 5-7 in Washington D.C. by the CPCU Society of the Insurance Information Institute or the Triple-I as it is called.  

Bad & Then Good News from Florida

Don’t get me wrong, I only have California state insurance (and financial) license so what happens in Florida does not really concern me. Yet insurance everywhere bears similarities, and it doesn’t hurt to learn from the mistakes in another big state like Florida.

The Insurance Information Institute (Triple I), one of my favorite sources of insurance related information, has recently issued a two page news brief on Florida Property /Casualty (P/C) Insurance crisis. It tells us the bad news first, and then some good news.

Perhaps the best way to start a story is by providing some quick statistics: “Florida accounts for nearly 80% of the nation’s homeowners’ insurance lawsuits, but only 9% of all U.S. homeowners’ insurance claims are filed.”

Wow, there are disproportionally way more insurance lawsuits than other states adding together! As a result of excessive or runaway lawsuits, it “costs every Florida household more than $5,000, and the state more than 173,000 jobs annually,” according to the American Tort Reform Foundation’s “Judicial Hellhole” report.

So what’s going on here?

“Legal system abuse and misuse of assignment of benefits ‘are creating a lose-lose, contributing enormously to the net underwriting losses for the few remaining insurers in the state,’ said the Triple-I CEO Sean Kevelighan.”

The CEO only talked about assignment of benefit or AOB problem in Florida, another is “One-way attorney fees” to be discussed later in more detail.

The good news is that, as the above briefing points out, “Reforms put in place in the closing weeks of 2022 and proposed in the first quarter of 2023 suggest Florida is now quite serious about fixing the fraud and legal system abuse that have contributed to the state’s insurance crisis.”

The Underwriting Losses in Florida

Let’s look at another shocking figure from Florida:

“Florida’s homeowners insurers cumulatively incurred net underwriting losses of more than $1 billion in both 2020 and 2021 and expect larger losses for 2022 when year-end results are tabulated.”

The figure of $1 billion loss in Florida has to be placed in the context of national figures to make more sense. According to this report, “In 2021, the insurance industry experienced a $3.8 billion net underwriting loss, after a $5.2 billion underwriting gain in 2020.” In other words, the entire country had a gain in 2020 when Florida had a loss, and of the national loss of $3.8 billion in 2021, Floridan contributed $1 billion, more than 25% of it.

One crucial term in the above news is “underwriting losses.” According to ChatGPT, “Underwriting loss is the financial loss incurred by an insurance company as a result of the claims paid out to policyholders being greater than the premiums collected from those policyholders. In other words, underwriting loss occurs when an insurance company pays out more in claims than it receives in premiums.”

Simply put, underwriting losses happen when insurance companies have to pay out more money for insurance claims than they received from policyholders’ premiums. You don’t have to be a genius to figure out that is not good.

To be sure, insurance companies make money in several ways, not just from premium. Therefore, underwriting losses are not the only factor to determine the company’s overall financial health. Investment income is another major source of revenue.

When an investment company receive policyholder’s premium payment, they won’t let the money sit there collecting dust. Instead, they invest the premiums to security market to generate additional income.

In addition, operating expenses such as salaries, rent, and marketing costs can also affect an insurer’s bottom line. If an insurer has high operating expenses, it may be more challenging to achieve profitability even if its underwriting results are strong.

Still, other things equal, having an underwriting loss is definitely not a good news.

Trouble with Assignment of Benefit AOB

Assignment of Benefits or AOB is common primarily in property & casualty insurance but also in others like healthcare insurance. it is a legal agreement that involves the transfer of insurance benefits from the policyholder to a third party, such as a contractor or healthcare provider.

It seems to be a harmless arrangement. For example, say you have some illness and your physician successfully treated you. If that illness is covered by healthcare insurance, you know you will be reimbursed. So instead of you paying the physician and then get reimbursed from your insurance, you can choose to assign your physician to get all the insurance payment because he did all the job and earned it, right?

The answer is not that simple. While AOBs can be useful in certain situations, they are generally not recommended because they can lead to a variety of problems for both the insured and especially the insurer (i.e., the insurance company).

A main problem is insurance fraud. In some cases, contractors or healthcare providers may exaggerate the cost of their services to get paid for work they never did. Or they can perform unnecessary work in order to increase their profits, sometimes charging the patients with free medicines they received from marketer, for example.

I know this happens a lot in China, where hospitals over-examine patients because those imported medical equipment (e.g., an MRI scanner) cost a lot of money and hospitals don’t want the machine sitting there collecting dust. Doctors ask most if not all patients to have a medical imaging done first, even though it is clearly not necessary for some, and the procedure sometimes costs enough to send a family back to poverty!

Another issue with AOBs is to make it difficult for insurance companies to manage their claims because there is a third party involved in the claims process. The insurance company have to verify the work that was done and to ensure that the costs are reasonable. Delays and higher costs become common.

The bad news is that ultimately it is the insured person will bear the extra cost due to AOB. If the third party performs work that is not covered by the insurance policy, the insured person may be responsible for the additional costs.

Problems with One-way Attorney Fee

Another major problem in Florida that reduces insurance affordability and availability is the so called “One-way Attorney Fees,” also called “fee shifting.” This determines who is responsible for the litigation cost and to pay the attorney(s) involved in the case.

One-way attorney fees are meant to shield policyholders from legal bills if they need to sue an insurer, but critics say attorneys and contractors exploit the law to file unnecessary suits with the goal of collecting attorney fees.

The Triple-I briefing has this to say: “Before the reform, state law required insurers to pay the fees of policyholders who successfully sued over claims, while shielding policyholders from paying insurers’ attorney fees when the policyholders lose.”

Here is how one way attorney fees work: Policyholder can sue their insurer at limited risk for legal fees. If they win the case, insurance company will pay for their attorney fees; but if they lose, they will only pay their own attorney fees and let insurance company pay their own.

Honestly, the name “One way attorney fees” may have created the impression that win or lose the policyholders won’t have to pay for any legal cost, and insurer will take care of that. That is not true. A better way is to call it “asymmetric attorney fees,” where the asymmetry exists in demanding for more financial responsibility from insurance company such that if they lose the case, they will have to pay for attorneys for both sides. But if they win, they cannot ask policyholder to do the same for their legal cost — although policyholder still must pay for their own lawyer(s).   

Such a legal arrangement is not out of line but rather reasonable. After all, insurance companies have a deeper pocket than an insured.

But perhaps this is one of the things where the rule looks fine on paper but not so in practice. The reality is that there are way too many lawsuits filed by policyholders against insurance companies. As a result, several private insurance companies either had closed down or packed up to leave Florida.   

What are the problems? There are several:

  • Increased Litigation against insurance companies, caused by the asymmetric (i.e., lower) financial responsibility for policyholders than for insurance companies. We have marginal or meritless legal dispute that people just hope to extract a favorable settlement from the insurance company.
  • Difficulty in estimating claims costs, a relatively minor problem: One-way attorney fees can make it difficult for insurance companies to estimate the total costs of a claim, as it is challenging to predict the outcome of a lawsuit, which determines whether the insurance company will have to pay the plaintiff’s attorney fees.
  • Higher Settlements: One-way attorney fees can push up settlement amounts for claims. This is because insurance companies may be more willing to settle claims, even if they have a good chance of winning in court, to avoid the possibility of having to pay the plaintiff’s attorney fees in the event of a loss. This means settlement is better than attorney fees.

Going from Florida to the Nation

Florida insurance crises are basically supply sided problems. I mean look at how many private insurance companies left or shut down there. But if we look around the entire country, you’ll find insurance losses across lines but especially in Property & Casualty.

Prove to yourself by entering the search phrase “News about insurance underwriter loss” and you will see many headline pieces. For example, “Private U.S. property/casualty insurers saw a $5.6 billion net underwriting loss in the first nine months of 2021,” according to this report on February 15, 2022.

State Farm provides another example, as its main auto unit generated $8.6 billion in underwriting losses through the first nine months of 2022.

One obvious solution is to raise insurance rates. This USA Today report tells us that auto insurance rate will go up this year. “Drivers nationally are spending an average of 2.93% of their income on car insurance this year, based on an average annual premium of $2,014 for full coverage insurance.” and “car insurance rates increased by nearly 14% between 2022 and 2023, compared with an overall rise in yearly inflation of 6.5% in December.”

What about California? “Progressive recently received approval for a 19% rate increase for those renewing their policies or buying new ones.”

Risk Transfer & Risk Management

In insurance business, there is a familiar saying that risk is inevitable, loss does not have to be — if we do risk management right.

Compared with raising price, risk management is a more efficient, sustainable and proactive way of lowering insurance cost and ensuring just and fair coverage for losses.

ChatGPT says the following: “Risk management and risk transfer are two different approaches to managing risks, and each has its own advantages and disadvantages. However, risk management is generally considered a better approach than risk transfer for several reasons:

  • Retaining Control: Risk management allows an organization to retain control over the risks it faces. By implementing risk management strategies, an organization can identify and assess potential risks and take steps to mitigate or avoid them. In contrast, risk transfer involves passing the risk to another party, which means giving up control over how the risk is managed.
  • Cost Effectiveness: While risk transfer can be a quick solution, it can be more costly in the long run. Risk transfer often involves paying premiums to an insurer, which can add up over time. Risk management, on the other hand, can involve implementing cost-effective measures to reduce the likelihood and impact of a risk.
  • Tailored Approach: Risk management allows an organization to tailor its risk management strategies to its specific needs and circumstances. This can result in more effective risk management than a one-size-fits-all approach, which is often the case with risk transfer.
  • Reputation: In some cases, risk transfer can damage an organization’s reputation, particularly if the transfer is seen as an attempt to avoid responsibility. In contrast, implementing effective risk management strategies can enhance an organization’s reputation by demonstrating a commitment to responsible and proactive management.”

The above answer provides a good overview of why risk management is better than risk transfer (i.e., insurance). However, the best approach is to do both risk management AND risk transfer. We cannot bet entirely on risk management because there are things out of our control. But we can do everything in our power of control to reduce and/or control risks. I propose the followings along that line:

  1. The key to risk management is to empower employees and/or clients to quickly and easily learn the right and crucial things to improve risk reduction. The term “risk management” sounds like only managers are the stakeholder but that’s not the case. The best risk management is to mobilize all employees and clients to get the job done. Reaching that goal requires first and foremost modern technological tools.
  2. ChatGPT, Smart contract, Internet of Things (IoT) & Tango are the four most important technologies for risk management with the potential to revolutionize insurance business by proactively and significantly reducing insurance cost and making insurance sustainable. Of the four, ChatGPT is likely to play the most important role because it is approachable by ordinary employees and clients. All we need to do is to expand its functionality to make it useful to professionals.
  3. ChatGPT will not just give everyday texts for fun but will be trained professionally to understand, and then to explain, complicated legal documents such that even ordinary citizens can comprehend the gist of a 200 page legal document. This will significantly reduce the currently indispensable role of human attorneys (they may be needed to proof check the ChatGPT answer but that should not take very long.) The key is to reduce our reliance on the middlemen like attorneys by empowering the end users.
  4. Another ChatGPT development is customized, always on, mobile and industry- or even firm-specific ChatGPT. The program will be locally pre-trained by records of past risks and past losses, and then provide intelligent and insightful answers to inquiries of all employees in dealing with new but similar problems. Localized and customized ChatGPT can do many things faster, better and cheaper.
  5. Smart contract associated with blockchain will effectively reduce the problem of legal system abuse, over-crowed or jammed court rooms, long waiting lists of scheduled litigations — by drafting nothing less than really “smarter” contracts that are filled with very detailed, context specific “what if” terms and conditions (ChatGPT can help draft and interpret the document), taking into account all relevant historical cases and eliminating extra spaces for misinterpretation and post hoc litigation, while keeping the feature of automatic execution of a predetermined agreement. The idea is to work with a better beginning to save time and energy toward the end.
  6. Internet of Things (IoT) will establish a field surveillance network at critical junctions of business operation to record objective evidence admissible to the court of law, deterring frivolous lawsuits and prevent predatory practices of trial attorneys. Even with caseload remaining the same as before, having historical field evidence will still speed up the litigation process.
  7. Tango is the easiest and most intuitive training tool for employees by providing step by step guides with intuitive screenshots every step of the way that everyone can understand and easy to follow. In the future new employee orientations will be mostly done by watching Tango generated PDF files. Numerous risk management field guides can be developed with context specific Tango flowcharts to reduce the chances of misbehavior and mishandling.
Categories
Liabilities Insurance

Boy Scouts of America Was Bankrupted from Sexual Abuse Lawsuits, What You Need to Know about Commercial Liability Insurance?

The Takeaways:

  1. The most fundamental commercial insurance is general liability insurance. No business should be doing any business without commercial liability coverage. In my opinion, commercial liability insurance should become mandatory by law, just like nobody should be allowed to drive without auto liability insurance for personal injures and property damages.
  2. Insurance coverage needs to meet the specific nature of business. BSA works exclusively with youth and therefore is exposed to sexual abuse with minors. It is far better to work on risk management to prevent risks from getting escalated and to avoid huge insurance payment.
  3. There will be lawyers trying to leverage the existing lawsuits to make money for themselves by filing unfounded claims. There will also be collusion between organizations and claimants to get insurers to pay. Once again, the best preventative step is to avoid lawsuits preemptively through means of risk management, especially in commercial insurance.
  4. Insurance and lawsuits are closely related. Insurers must pay close attention to legal battles that sometimes can make or break themselves.

The Stories in 2020 & 2023

This insurance journal article did a good job in offering a brief overview of the history of the Boy Scouts of America BSA bankruptcy case and quickly shows where the problem is:  

“When it sought bankruptcy protection in February 2020, the BSA had been named in about 275 lawsuits and told insurers it was aware of another 1,400 claims. The huge number of claims filed in the bankruptcy was the result of a nationwide marketing effort by personal injury lawyers working with for-profit claims aggregators to drum up clients, according to plan opponents.”

Guess what the number of claims is today? “More than 80,000 men have filed claims saying they were abused as children by troop leaders around the country… the staggering number of claims, when combined with other factors, suggests that the bankruptcy process was manipulated.”

Even “a plaintiffs’ attorney acknowledged that some 58,000 claims probably could not be pursued in civil lawsuits because of the passage of time.” That is, many or most men in the lawsuits will have little chance of winning any compensation.

Shortly after the bankruptcy in 2020, BSA had announced several plans (like this and this) to settle down its sexual abuse lawsuits with minors.

Why Insurers Want to Reverse the BSA Bankruptcy Reorganization Plan

Under the bankruptcy reorganization plan, which In September was approved by the U.S. Bankruptcy Judge Laurie Selber Silverstein for $2.46 billion, and described by the BSA as a “carefully calibrated compromise,” the BSA itself “would contribute less than 10% of the proposed settlement fund… The bulk of the compensation fund would come from the BSA’s two largest insurers, Century Indemnity and The Hartford, which reached settlements calling for them to contribute $800 million and $787 million, respectively. Other insurers agreed to contribute about $69 million.”

On the other hand, “Insurers opposing the plan argue that the BSA is contractually obligated to assist them in investigating, defending and settling claims, as it did before the bankruptcy. They say that the BSA, desperate to escape bankruptcy, colluded with claimants’ lawyers to inflate both the volume and value of claims in order to pressure insurers for large settlements, then transferred its insurance rights to the settlement trust. The insurers argue that if the BSA transfers its rights under insurance policies to the settlement trustee, it must also transfer its obligations under those policies.”

In other words, the insurance companies are accusing BSA for working under the table with claimants to inflate the value of claims and to shift the financial responsibility of compensating sexual abuse victims to insurers without working with insurers to verify the claims.

Lessons Learned

The bankruptcy of the Boy Scouts of America (BSA) serves as a case study in the importance of adequate insurance coverage.

Lesson 1: The importance of liability insurance. The organization was facing a large number of lawsuits related to the sexual abuse of minors. In the absence of adequate liability insurance, the BSA would have been forced to pay out millions of dollars in damages, potentially putting the organization’s very existence in jeopardy. However, the BSA had liability insurance in place, which allowed it to weather the legal storm and continue its operations.

Lesson 2: The need for insurance coverage to match the nature of the organization. BSA is a youth organization that works with minors, making it particularly vulnerable to sexual abuse lawsuits. Therefore, it was essential that the organization have liability insurance coverage that was adequate for this type of exposure. Organizations that work with minors should take this lesson to heart and ensure that their insurance coverage is sufficient to protect them in the event of similar lawsuits.

Lesson 3: The need for ongoing review of insurance coverage. BSA should have ongoing review of insurance coverage to ensure that insurance coverage remains adequate, as the insurance needs of an organization can change over time. For example, had BSA reviewed its insurance coverage in recent years and discovered that it was insufficient, it could have taken steps to increase its coverage and avoid the financial strain of the lawsuits it faced.

Lesson 4: The best strategy for all insurers is to manage risks and reduce them before they turn into large scale social scandals for policyholders, which will invite opportunists to seek financial gain from the “no risk, pure gain” legal class actions.

Categories
Property Insurance

Earthquakes Killed 17,500+ in Turkiye & Syria, What Lessons Can We Learn?

The Takeaways:

  1. Insurance matters all the time — oftentimes we don’t see until hit by a catastrophe. In the end, buying insurance could be the best investment you ever make in your life.
  2. Earthquake insurance coverage is not a decoration number to make the insurance book pretty, it can be the difference between life and death.
  3. Coverage must be enforced to save lives and get the places quickly up from disasters.
  4. Reinsurance matters especially for catastrophic events to keep insurance carriers on their feet rather than bankrupted or out of business.
  5. Some governments like China emphasized political mobilization of citizens to stay safe in pandemic, which has its own liability and risk. It is better to have risk management (e.g., massive social lockdown) and risk transfer (i.e., insurance coverage) at the same time.

Earthquake News in the Words of a Financial Rating Agency

According to financial ratings agency Fitch on Thursday February 9, the initial earthquake and numerous aftershocks struck southern and central Turkiye and western Syria on 6 February had claimed more than 17,500 lives so far from a maximum magnitude of at least 7.8, the most severe earthquake in the region since 1999. 

The toll is expected to rise as rescuers comb the rubble for survivors. On top of that, insurable losses are hard to estimate as conditions change all the time. At this time “they appear likely to exceed USD2 billion and could reach USD4 billion or more. However, insured losses could be much lower, perhaps around USD1 billion, due to low insurance coverage in the affected regions.”

“The Turkish Catastrophe Insurance Pool (TCIP) was created after the Izmit earthquake of 1999 to cover earthquake damage to residential buildings in urban areas. However, it does not cover human losses, liability claims or indirect losses, such as business interruption. Moreover, earthquake insurance cover is technically mandatory in Turkiye, but is very often not enforced in practice. As a result, many residential properties are not insured, particularly in many of the affected areas, where low household incomes constrain affordability.”

Six Lessons Learned

  1. Importance of insurance coverage: The low insurance coverage in the affected regions highlights the importance of having adequate insurance coverage. It’s crucial to understand the risks that you face and to make sure you have the right coverage in place to protect yourself, your family and your assets.
  2. Risks in underinsured regions: Natural disasters can strike anywhere and perhaps in least expected times. They can result in significant losses for sure. In regions where insurance coverage is low, the economic impact of a disaster can be even more devastating. This highlights the need for governments and insurance companies to work together to increase insurance penetration in these areas.
  3. Preparedness is key: While insurance can help mitigate the financial impact of a disaster, being prepared in advance is crucial. This includes having an emergency plan in place, taking steps to secure your home and property, and staying informed about potential threats. We don’t have detailed information on how well the Turkish people were prepared but judging from the low coverage rate we have reason to suspect a low preparedness this time.
  4. Reinsurance matters by sharing and spreading risk among insurance companies. Major catastrophes almost always rely on reinsurance to save insurers.
  5. The importance of accurate loss estimates: Accurate loss estimates are critical for the insurance industry to respond appropriately to a disaster. Insured losses from a disaster can have a significant impact on the financial stability of insurance companies and the broader economy. It is reasonable to think that preparedness and accurate loss estimates are linked such that when one is low, the other is low as well.
  6. Some places (e.g., China) have emphasized risk management (e.g., massive social lockdown and tests) during pandemic, but doing that without developing a good system of risk transfer (i.e., insurance) has its own risks. What we need is both risk transfer and risk management.

One Knowledge Point: Insurable vs. insured losses

In the above news by Fitch, there is a big gap between insurable loss and insured loss. Below is the highlighted difference between the two.

Insurable losses refer to the potential losses or damages that an individual or business can be covered from an insurance policy. This could include losses due to property damage, liability, theft, natural disasters, and other covered events as outlined in the insurance contract. Insurable losses are the losses that the insurance companies are willing to provide coverage for.

Clearly not all losses are insurable. Uninsurable losses are risks or events that cannot be covered by insurance due to various reasons, such as reputational risk, regulatory risk, trade secret risk, political risk, and pandemic risk. In addition, some risks may also be considered uninsurable due to the absence of adequate data or the difficulty in predicting the likelihood and severity of the losses.

Insured losses, on the other hand, refer to the actual losses that occur and are covered by an insurance policy. When an insurable loss occurs, and if the individual or business has insurance coverage, they can file a claim to receive compensation for the covered losses. The compensation provided is limited to the terms of the insurance policy, including the maximum coverage amount, deductibles, and exclusions.

From the Turkish earthquake we can see sometimes there can be a huge gap ($3 billion) between insurable ($4 billion) and insured losses ($1 billion), due to a low coverage rate and unenforced mandatory insurance in certain jurisdictions.

But Turkiye is not alone. According to this report, the cost of storm damage in an average year results in USD 19 billion in uninsured losses from flooding in the US, compared to USD 5 billion in insured losses. This is due to the fact that only one in six homes in the US has flood insurance, and many risks related to flooding are considered uninsurable.  

Reinsurance Matters

From the Fitch news we also learned that the bulk of the insurance cost will be covered by reinsurance and there is no major impact on the rating of the insurance companies.

So what is reinsurance? This article provides a highly readers friendly answer:

“At its most basic level, reinsurance is insurance for insurance companies. If there is a catastrophic event that affects many homeowners, like a hurricane or strong earthquake, those losses can be so staggering that paying claims could cause an insurance company to become insolvent.”

Reinsurance works by allowing insurance companies to purchase insurance policies from other insurers, thus spreading the risk across multiple companies. This helps to reduce the likelihood of large payouts for a claim and allows insurance companies to remain solvent by recovering all or a portion of their losses through the reinsurance process. For example, in a hurricane or strong earthquake that affects many homeowners, the losses can be too high for a single insurer to pay all the claims, causing the insurance company to become insolvent. In such a case, reinsurance allows the insurance company to transfer some of the risk to another insurance company, reducing the potential for insolvency.