the Wealthy Canadian

Just about everybody seems to be frustrated with insurance.  High premiums, large deductables, and coverage that never seems to match what we end up needing.

By and large, however, the insurance industry works as it should.

• The premiums are based on risk and coverage.  An 18 year old male insuring a Ferrari is going to cost.. alot.  Short driving exprerience and statistical likelihood of an accident, and the value of the asset being insured.
• Deductables are there, IMHO, to prevent us from making frivolous claims.  Consider that a smashed windshield might cost 100$ to replace, but in total might cost $150 insurer once they pay administrative costs.
• The coverage can be somewhat sneaky, e.g., they may pay for floods but not sewer backups, and we never realize it until it is too late.  However, you do get the coverage that you pay for.

So whatever our feelings on insurance, it works as intended.  Usually.

Insurance works best when only a few of the many insured make claims.  When widespread catastrophe strikes it becomes very difficult for the insurer to cover all payments.  It’s not like an insurance company puts our premiums under their mattresses, they invest the money. They invest your premiums in the same market that has seen your savings and retirement plans lose 50% of their value in a few short months.

I’m not doomsaying, I’m not predicting that you won’t be able to get your car fixed after your recent fender bender.  I am merely pointing out that insurance is not a guarantee.  For more of a gloomy perspective check out this from Bankruptcy Law Network

Where I am going with this is how this relates to the Credit Default Swap (CDS) market and our current ‘credit crisis.’

CDS’s are similar to insurance, except that they insure against loan defaults.  Your bank will pay a premium for insurance against people not paying back their loans.  The good folks at places like Bear stearns will gladly accept premium payments at the risk of having to pay out the full amount in case of default.  Unfortunately, if a large number of these loans do default then the insurer may not be able to meet the payments.  Your bank paid their premiums for insurance but did not receive the benefit.

Consider this hypothetical example.

Balgonian International Group (BIG) commences a leveraged buyout of Louisiana Trust Insurance (LTI) for $2B.  It’s leveraged because they need a loan, which they get from Bull Steers Investment Bankers (BSC).  BSC implements a Credit Default Swap to remove the risk from their books, Frehman Sisters (FEH) accepts the swap.  FEH gladly accepts the premiums and invests them wisely in an up and coming insurance company called Louisiana Trust, whose shares have seen a dramatic increase lately (since the announcement of a buyout).

Unfortunately a bad hurricane season, and the fact that LTI only services Louisiana, has bankrupted LTI.
BIG has also been hit hard and they can not make the payments on their loan, they default.
BSC attempts to recoup their losses on the loan by asking their swap counterparty (FEH) to pay up.
FEH invested the premiums so they sell their stake in LTI.  Unfortunately, due to the bankruptcy of LTI, their stock has dropped 99%.
Everyone loses.