Bet your sweet potatoes on the weather and take the pot!

Insurance has a steep learning curve – and understanding what a policy covers, believe it or not, is the bottom of the curve. Some say learning is more caught than taught; and, if that’s the case, I caught a lot more than I bargained for last week – and learned even more from research over the weekend.

Before I explain why you need to invest your sweet potatoes on the weather, you need to take a look at this picture of the the insurance industry. It’s the one I had in my head – although far more developed (understatement) – when I posted this link on the ALL Board in response to a comment from Slabbed’s friend cominglatersooner.

Now. about those sweet potatoes – or commodities as they’re known when they’re not groceries.

Federal regulators with the Commodity Futures Trading Commission are investigating whether large institutional funds and hedge funds are behind the sharply rising costs of oil, food and many other commodities in recent months. Investigators are concerned that futures contracts for oil and other commodities may have skewed the market and are behind the price increases.

The Commodity Futures Trading Commission recently held a hearing where testimony was heard from investment experts that indicate that the same forces that were behind the global financial crisis has moved into the commodity market and dumping huge funds into buying commodities that has resulted in the rising prices consumers are seeing at the gas pumps and in grocery stores.

At risk is more than what people pay at gas pumps. There are growing concerns that the commodities markets have been compromised and that if not checked, the result could undermine the national and world economies.

In a May 20, hearing in Congress, Michael Masters, a hedge fund portfolio manager, said the sheer number of investor dollars flowing into the commodities markets had skewed the relationship between oil supply and demand. In his testimony, Masters said that only $13 billion traded in commodities indexes in 2003, compared with $260 billion in March 2008.

Masters testimony is a warning to Congress that serious problems are developing in the futures market regarding the impact of hedge funds and institutional funds pouring money into the commodities market.

In other words, some folks are making a lot of money and driving up the cost of gas and groceries to the extent that a whole lot more folks are unable to afford the cost of gas to get to the grocery store and still have money to pay for groceries – and they’re making that money in the capital market by investing in related hedge funds including those where the risk involves the weather.

Now, who might be doing that and how?

…adverse weather creates adverse financial conditions, which can be managed by financial instruments or insurance policies built around the weather element to which the buyer is exposed. The outcome of purchasing the risk transfer instrument is to limit the adverse impact of weather on the buyer’s economics and to finance the consequences of adverse weather conditions when and if they take place. Insurers, banks, financial houses, specialist companies and exchanges make their business in assuming weather risks from those with natural exposures, often through brokers and other intermediaries.

You got it – the same folks bringing higher cost insurance to coastal areas because of the increased risk from the weather are among those betting on the weather and making money from the risk of the adverse weather conditions that make insurance cost more.

Talk about a perfect match. What industry is better positioned to make money predicting the weather than one that relies on weather modeling to predict its own exposure to risk?

Reportedly, investments in weather derivatives are increasing as other changes take place as well.

According to a survey jointly released in June 2006 by the Weather Risk Management Association (WRMA) and PricewaterhouseCoopers, the total weather derivatives market had grown more than ten-fold over where it stood two years before, to more than $45 billion notional in size.

Folks, that’s a lot of sweet potatoes – although it’s far more likely folks are betting on corn given the flooding in the mid-west. Nonetheless, it’sa sure bet the insurance industry is going to continue to bet on hedge funds, including those where they’re betting on the weather.

When I began putting all this together, my plan was to make a transition at this point noting that

Not all reinsurance is created equal…[and we now have ] custom hedges in a reinsurance wrapper –

and suggesting the real “hedge” is that reinsurance is now all “wrapper” and no “fund”.

From there I planned to suggest that the solution appeared to be holding on to this year’s crop of sweet potatoes, pulling out a copy of Farmer’s Almanac, and hoping for a break in the weather.

All that was before I discovered folks had been performing some “unnatural acts” with the sweet potatoes we’ve given them over the past several years –

Currently, there is industry discussion concerning the pending convergence of capital markets and reinsurance; in reality, it is a “past tense” event – the convergence has, in fact, occurred and is beginning to radically transform the traditional global insurance carrier and broker distribution models. (emphasis added) –

Well, now do I see it – how about you? I suppose one could call NFIP “reinsurance” – assuming the wind blew the wrapper off some hedge fund.

20 thoughts on “Bet your sweet potatoes on the weather and take the pot!”

  1. Nowdy I feel like a proud pappa after reading your post and seeing the level of understanding you’ve gained on these complex issues.

    Throw in securities law and Allstate’s then CEO’s 8-29-05 reinsurance comments and man o man do we have us a delicious pot of gumbo. He’d didn’t sell did he? You bet your sweet ass he did while telling the world something else.

    Mr CLS has never posted with us here on slabbed but I know he’s proud too.

    sop

  2. Thanks, Sop – speaking of CLS, at one point I had added to his “identification” that I called him “later” until you explained he was saying good-bye but then I just flat ran out of space for chat.

    I do hope folks will link to the weather website – it was fascinating and I failed to give a h/t to CLS for the link in the post so I’m doing that now.

    How the industry can insist more federal control is needed with a straight face is beyond me – I think Gene Taylor ought to take what little Katrina left of Jefferson Davis’s money to DC and see if the Senate will exchange it for gas and grocery money.

  3. Missing from your diagram and discussion is how much liability is being dumped on taxpayers and/or inland ratepayers because companies are dumping risks while they are jacking up premiums.
    They are dumping more and more coastal risk into state pools, but the pools are not allowed to build sufficient reserves so they have to overpay for reinsurance in the global market. Eventually, state taxpayers subsidize the state pools or insurers will have to pay assessments that they pass on to their in-state ratepayers.
    With no competitive insurance market, coastal rates are about five times higher than the expected losses predicted by risk models. At that level, it does not make economic sense to buy insurance if you are not required to do so. So more coastal property owners are underinsuring their properties rather than pay annual premiums that are 1/10 to 1/8 of the coverage amount of a 1 in 40 or 1 in 50 risk.
    When disaster hits, everything that is not covered by insurance will be subsidized in some way by taxpayers, through disaster assistance, casualty loss tax deductions, subsidized loans, or the general economic dependency of communities that cannot recover.
    The current market is a failed market. There is no competition based on price or service or value. The companies all try to cherry-pick risks while still creating the public perception that they need to raise premiums to cover the disasters that they are not covering.

  4. You’re absolutely right, Brian, there’s much more to this story – and I hope to capture it all here on SLABBED with all of us contributing what we can.

    You are correct about the market – the insurance industry as a whole is unable to offer people the protection they want and need at a reasonable price.

    The size of the market is reduced as a result, – and as a result of the smaller market, coverage is reduced and cost is increased.

    Meanwhile the industry builds up billions of dollars in surplus funds for a level of risk it no longer faces – and taxpayers pick up more of the risk – as well as the risk of worthless paper instead of real dollars.

    Unfortunately, the government is a little “short” right now (duh).

    We have a midwest version of Katrina and tens of thousands of our citizens we are going to have to help get back on their feet – if such is possible given the price of gas and groceries.

    Lowering the cost of gas and groceries is not an immediate option but getting in a position where the government can assume both the surplus and the risk can be done rather quickly.

    States can not assume the risk – and frankly need to get out of the insurance business (put our windpool money back in the budget and you pretty much solve medicaid for example).

    If the property/casualty insurance industry wants to be a part of the banking system, Brian, get those folks a drive thru window and let them go – must make them leave insurance behind.

    I firmly believe working with independent agents and independent adjusters, and state government, we can come up with a unitary system of health and property insurance that functions on a sliding fee scale like Medicaid.

    The question is how to we get Chris Dodd to see that his position on insurance is undermining all that has done and still needs to do for our nation’s children and families, particularly those most vulnerable.

  5. Oops, forgot to say that I’ll create a diagram that does just that. If you have something in mind that won’t post very well, please fax or email Sop.

  6. Brian,
    you made the comment above “They are dumping more and more coastal risk into state pools, but the pools are not allowed to build sufficient reserves so they have to overpay for reinsurance in the global market.” Why can’t the wind pools build up sufficient reserves? I know at one time I read that the Texas Windpool had reserves of sufficient to handle certain sized storms, and from what I read it was a chunk of change. They got hit with Rita, and I don’t know how much of an impact it took, but haven’t ever read that they ran out and were applying assessments on carriers, or policyholders. I know that the FLA windpool/Citizens has never been close to solvent and probably never will be based on what I read about them. I am just curious why wind pools can’t build up enough reserves to handle storms? is it because it they get X amount in reserves they have to lower premiums, or give $ back to the policyholders like a mutual does? Is it because they pay out more in losses then it takes in in premiums? If that is the case, should their rates be based on actuary data like carriers do? Since they wouldn’t need to show a profit, I would guess that element of the rate wouldn’t be included. I for one would like to see the windpools charge rates that are actuarilly sound, and be able to build up plenty of reserves in lean years (storm wise) to take care of the busy years.

  7. So what exactly are you guys saying? That no one should write weather derivatives? Are weather derivatives per se evil now?

    Or that insurance companies shouldn’t write such instruments? And why would that be? If not them, who?

    As for rates on the coast, if Brian Martin is correct, there is one tremendous business opportunity awaiting the captialist who undercuts prevailing prices and takes that risk. Since new carriers with new capital get formed all the time to take advantage of such things (remember all the new carriers that were formed post 9/11 to take advantage of the hardening market?), why wouldn’t that happen here? Have the laws of supply and demand been suspended on the coast?

    Or could it be that the “five times higher” number is a fantasy, dreamed up by people with no money at risk and a political axe to grind?

    It is really easy to tell others how to spend their money (and expect a government bureaucrat to be good at THAT) but it is a wholly different exercise when you are thinking about risking your own money or those funds entrusted to you by your shareholders. Then you will probably insist on a reasonable relationship between risk and reward. And it is hard to see much reward from writing Cat-exposed homeowners on the Gulf Coast, isn’t it?

    But if Brian is right, he is sitting on the business opportunity of the century. He should raise some capital and get into the game.

  8. Mr. Beau I don’t have Brian’s depth of knowledge about individual state’s wind pools but in Mississippi the amount of reserves our Wind Pool is allowed to accumulate is capped by law.

    Mr. Claimsguy the new entrants you describe is happening in Florida. the problem with our fragmented state by state regulatory setup is smaller states like Mississippi are left out.

    Hopefully Brian will stop back in to give you gents a more detailed answer.

    sop

  9. Thanks for the info sop, and hopefully Brian can add his input. In MS, if the reserves reach that cap amount, what do they do with the excess and how does it affect the future rates of the windpool policyholders? I’m wondering if it gets rebated to the policyholders like the mutual set up mentioned before, or ends up going into the general fund?

  10. That’s a good question Beau. Since the legislature has had to give the Mississippi pool money since 2006 we haven’t had to worry about accumulating any reserves. The Mississippi pool buys reinsurance so it does not need a big surplus per se though the abilility to retain some of the risk could help with premiums.

    I think the logic behind the cap is to keep the pool from being an effective competitor to the private marketplace as it is the insurer of last resort and not meant to be a competitor to the private marketplace.

    That said if there is no private wind marketplace for the 6 coastal counties the original intent of the Mississippi Windpool is no longer valid but that is the subject for another post.

    sop

  11. Brian’s got a lot of information on reinsurance on Gene’s blog. Click on the link under “blogroll” on the left sidebar.

  12. SOP:

    I am not sure that you are right about FL.

    I think the growth there has been in the so-called “takeout” companies, which exist due to an idiosyncracy in the FL Citizen’s structure.

    Here is the best explanation of that game that I have read (from the Truck Insurance Extremist):

    With one exception: “Take Out” speculators love Florida. The speculators who form these thinly capitalized insurance companies do little more than bet on hurricanes. Here

  13. I don’t dispute that Mr Claimsguy but we have a post here on a homegrown Florida company that is small, growing, financially solvent and profitable. I don’t disagree with you on the overall Florida market being sick but there are some signs of life. I’ll see if I can dig up that old post.

    Nowdy Brian also has info on the state pools on Gene’s blog. He is sometimes very busy during the day but he also stops in with us in the evenings and early morning. I hope he finds time to add some color to his posts and Beau’s questions.

    sop

  14. Sorry to come back so late.
    Before Katrina, the MS wind pool was set up so that the insurance companies kept the “profits,” i.e. the excess in premiums when there were no major events. Of course, after Katrina, they had to pay assessments back to the pool far in excess of any profits they took.
    Since Katrina, the rules have been changed to allow reserves to build up, but now the pool has to pay so much for reinsurance that it is not economically possible to collect reserves. Even if we went 40 years without a hurricane, we could not build up reserves, because every penny of premium that does not pay claims or administrative expenses will go to Bermuda or Lloyds or Berkshire Hathaway investors.
    The MS wind pool is paying $65 million in premiums for reinsurance to cover $470 million of the first $570 million in losses. The state pays the first $20 million and then another $80 million in other layers in between coverage layers. I don’t know what the risk models say, but I would bet the chances of a $570 million loss to the wind pool are longer than 1 in 40.
    The state is using federal and state funds to subsidize the pool, so we have federal taxpayers paying reinsurers to loot six counties in Mississippi.
    The Texas wind pool is paying more than $200 million for the $1.5 billion layer after the first $600 million. The Texas pool has reserves, but it is up to $60 billion in liability, with $18 billion in Galveston alone. If Galveston or Corpus Christi ($12 billion) gets a direct hit from a major hurricane, the pool would run through the reserves and reinsurance. There is pressure from insurers in the pool to raise premiums much higher in order to buy more reinsurance.
    North Carolina’s Beach Plan has increased in liability from $18 billion to $68 billion in the last five years. New Hanover County (Wilmington) concentrates $17 billion risk in the pool. There is pressure from insurers in the pool to hike premiums to buy more reinsurance.
    The source of my statement that the reinsurance rates are about five times the estimated losses is an otherwise industry-friendly report from the Wharton School. That ratio has generally been confirmed by the rate requests in Texas and Mississippi.

  15. The Wharton Risk Center excuses the prices as necessary to ensure high rates of return for investors, but in doing so acknowledges that coastal rates are 5 to 10 times higher than the estimated losses.
    What this doesn’t say is that it is not economically rational to pay for insurance that costs 5 to 10 times more than the expected loss.

    MANAGING LARGE?SCALE RISKS IN A NEW ERA OF CATASTROPHES
    http://opim.wharton.upenn.edu/risk/library/Wharton_LargeScaleRisks_FullReport_2008.pdf

    From the preface, page vii:

    16. Due to the unpredictability and sizable losses associated with catastrophes, insurers need to allocate more capital to cover the losses in the tail of the probability distribution. The need to secure an adequate rate of return on capital is not sufficiently understood. In particular, the prices charged for catastrophe insurance must be high enough, not only to cover the expected claims and other expenses, but also to cover the costs of allocating capital to underwrite this risk. For truly extreme risks, the resulting premium can be as much as 5 to 10 times higher than the expected loss, so as to provide investors with a fair return on equity and also maintain the insurer

  16. Here is the great passage by economist Lloyd Dixon of the RAND Corporation in his report on Gulf Coast commercial insurance price and availability:

    “Government is also not subject to the private-sector factors that produce large swings in premiums around expected loss in private insurance markets. Thus, compared with the private sector, government should be able to set insurance prices closer to expected loss for hurricanes and other catastrophic risks, and keep those prices closer to expected loss over time.”

    http://www.rand.org/pubs/occasional_papers/2007/RAND_OP190.pdf

  17. Thanks Brian, I’m working on a post right now and needed this kind of information – great stuff and perfect timing.

  18. Again, if reinsurance pricing is so irrational, then there is a significant opportunity for someone to start a cut-rate re-insurer and scoop up all that Cat Re business down on the coast. Since reinsurers are even easier to start than direct insurers (as they need so little infrastructure), such an exercise ought to be fairly simple: raise the capital, form the company, get a charter (in Bermuda or the Caymans or someplace, to minimize taxes and red tape) and you are good to go.

    As I noted before, new carriers spring up all the time in reaction to such opportunities. Why hasn’t one sprung up to address this?

    My answer would be that the opportunity is illusory. But if I am wrong, then you are sitting on a gold mine, Brian. Go for it! Get in the game! Raise some money and put your own assets and reputation at risk.

  19. You miss Brian’s point Mr Claimsguy. The model is broken when pricing forces ppl to go naked or inhibits or outright kills otherwise good projects because rates are not priced in proportion to the insured risk.

    The private market simply is not efficient at delivering coverage for the “right tail” events of the Cat bell curve. That is why Uncle Sam is on the hook for Terrorism coverage.

    So the question becomes does this country, as a matter of public policy, let 52% of it’s population and the local areas they reside wither and die economically so an offshore reinsurer can attract enough capital to cover events that happen once every 100 years?

    Us voters are fixing to give John McCain the answer to that question.

    sop

  20. Claims guy,
    One or two or three companies cannot fix the market. They can’t set aside enough reserves for a catastrophic hurricane for the reasons the Wharton guys pointed out. You would need at least 30 companies willing to take 2 to 5 percent of the coastal market to even approach a stable market.
    Once the market fails and companies retreat, it becomes necessary for other companies to retreat to limit their exposure.
    Coastal wind risk eventually will be covered by the federal governement for the same reason that flood insurance and Medicare became federal responsibilities – because no one else will cover it.

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