Tuesday, June 29, 2010

Insurance and Modern Portfolio Theory

Through the years, the insurance and financial investments industries have taken a lot of criticisms from those who did not want anything to do with them. To the uninitiated and uneducated, insurance is an industry of racketeers looking to sell pieces of paper, while financial investing is a fabricated field of expertise created by self-important gamblers. While this might seem to ring somewhat true, it is also important to remember that these two industries deal with assets and liabilities vis-à-vis the ever illusive predictability of the future. And who is best equipped to hold a “tinge” of capability and credibility in analyzing the probabilities of tomorrow than these two industries? Statistics and advanced mathematical tools have helped insurers and investment professionals gain a glimpse of what could happen tomorrow. It is indeed impossible to be completely knowledgeable of events and circumstances that have not yet manifested, but perhaps no one else comes closer to the skill, knowledge, and facilities that these two industries possess in doing what they do.

The business of insurance and the conduct of financial investments are intertwined. They find common ground in what most financial pundits refer to as the concepts of Risk and Return. While insurers focus on risks, they are also concerned with pricing the risks they take on in order to reap some profit. This is precisely what capitalists find worthwhile in establishing insurance companies. Why else would they shoulder somebody else’s risks? Investment professionals, on the other hand, pay attention to returns and this is how they convince investors. Although pricing assets and relevant cashflows are integral components of the investment profession, risks represent the probability that these professional investors would be unable to deliver on their promise to hit or surpass a specified percentage, rate or benchmark of return/income. In these two professions, Risk and Return are core foundations in exercising a livelihood.

Although many people might acknowledge Warren Buffett as the ultimate investment professional, a lot of people might not know how the insurance industry served as a key platform to his success. Here are three weblinks that reveal something about Buffett and his affair with the business of insurance:


At the bottom of the third weblink, are impassioned comments between the blogger and a reader regarding the interpretations of Warren Buffett’s 2009 annual letter and his views on the business of insurance.

An important point to remember is how Warren Buffett values the concept of float. While banking and financing institutions give much weight on the time value of money (i.e., interest rates), the concept of float for the insurance industry is a bit different. In the field of traditional banking (i.e., borrowing and lending), interest rates reign supreme and are tied interdependently together (across global markets and economies, in fact). The movement of rates affects the values of other financial assets that are being handled by financial professionals, as well. Insurance business, on the other hand, although somewhat affected by interest rates, primarily leans on the assumptions of event risk and statistics. Float in insurance does not necessarily imply that a timeframe is strictly specified and the cost of money is tied to the domino-effect-ridden financial markets. Mr. Buffett finds value in writing profitable insurance policies that are guaranteed to make unrestricted profits after the term of contingent liabilities has lapsed. There is no debt to be repaid, only an underwritten premium to be kept/deployed as long as it is properly, yet competitively, priced and which has an imbued profit margin.

Modern portfolio theory emphasizes maximizing returns while minimizing risks, while giving recognition to the existence of systematic and non-systematic risks. These concepts are usually referred to when discussing financial investments. Insurance being influenced by Risks and Returns as well, also finds meaning through modern portfolio theory. Concentration risk is probably an appropriate phrase to use when alluding to the expression, “Do not put your eggs in one basket.” Although, for the sake of mentioning, Warren Buffett is famously quoted to have said, “Diversification is protection against ignorance. It makes very little sense for those who know what they are doing.” Of course, astute investors usually do not want to get ahead of themselves. The assumption is Mr. Buffett leans on the merits of his achievements and therefore has the savvy to go against established academic thoughts regarding diversification.

Diversification is the solution against being a victim of concentration risk. Over-reliance on an asset/similar assets’ profitability and hopes that a contingent liability/similar contingent liabilities do not become actual obligations are risks that can wipe-out risk-portfolios in an instant. As with financial assets, there are systematic risks that cannot be insured and are simply givens of the environment. A good example would probably be the risk of an asteroid hitting the Earth. That is not something that can be hedged against because an occurrence of that magnitude is tantamount to a near or absolute extinction event. Non-systematic risks and alphas are the main items that give underwriting skills meaning. Non-systematic risks can be eliminated by widening the coverage of insurance over more Assureds. In doing so, diversification is achieved. Alphas, on the other hand, represent the surprise return or inherent profitability of an asset and in converting this concept onto the insurance industry, this is perhaps the inherent traits/characteristics of an insured property/person/event and how the hazards and other circumstances are minimized, wherein it is more probable that the premiums paid by the Assured will eventually be kept at the end of the insurance policy coverage period. While financial assets are capable of delivering abnormal returns, insurable risks are also able to remain abnormally intact and avoid transforming into real obligations for the insurance company.

All compositions, statements and opinions of the author are copyright © Earl T. Malvar 2009-2010. All rights reserved. There is no honor, respect, admiration, intellectual and academic dignity garnered through plagiarism.

Sunday, June 20, 2010

Unpegging the Yuan to the US Dollar and Then Some


The Chinese economy, in recent years, has found favor among the pockets of consumers around the world. China has been supplying the world with cheaply priced goods and in the supply-chain diagram, no one else is agreeing more than Western corporations who have found better opportunities of value creation and margin widening offered by China's super factory (i.e., it's cheap labor force + economic and socio-political stability). For profit-oriented organizations, it can be a pretty convincing decision to invest in China, especially when customer demand for their goods and services aren't regressing, while quality and capacity on the other hand are manageable and are not sacrificed (although quality control remains a huge criticism against the Chinese).

I find it disappointing though that some Americans continue to blame their government (the Obama administration) and antagonize China (the U.S.'s biggest creditor for U.S. Treasuries by the way) for their economy's decimated state. Fine, China has been pegging its currency at a fixed exchange rate to encourage U.S. buyers to buy more goods made in China, but that is only a small component of what's happening in their economy. The laws of Supply and Demand continue to ring true.

It's probably a lot messier if we try to dissect the situation and the underlying circumstances between these two superpowers. Just to thicken the plot, if the U.S. were to disapprove of China's currency practices of pegging and suddenly cut-off trade relations (where, right now China is obviously the benefactor as net exporter), would the tension between political philosophies (democracy vs communism) remain even after the end of the Cold War and the fall of the USSR? Instead of an isolated and secretive state (think North Korea), we are now seeing China enjoy the benefits of a capitalist economy, even though it remains a communist state. And of course the West is egging it on to continue its socio-political transformation. Who would want the progress that has already been achieved to regress to a polarized global political arena again? This question is significant especially when the war on terrorism has allowed the battle of "Order and Chaos" to become a battle between current civilization and stateless theological extremism (a movement that does not necessarily belong to any race, nation, state or political movements btw, only something controversially affiliated to a version of religious fervor).

Indeed, Americans really have to make-up their minds. If they believe in a stronger American economy, than they should buy American. The problem is they find more bang for the buck when they buy what the Chinese make. Allowing the Yuan to strengthen is extremely beneficial to smaller exporting nations, like the Philippines and other South East Asian nations (that's right, it's not only the U.S. that has issues with this Yuan pegging M.O.). ASEAN economies are being raped by cheap Chinese goods and services, and guess what, the stamp of approval is coming from the West and the U.S., itself, because again, cheap is cheap. ASEAN societies being "pseudo-democracies" have always had problems with inflation and labor forces. We want our cut of the pie (and some cake) as well. While China remains communist in nature, Chinese citizens have no qualms about their standards of living. It seems like they take it as it is (knowing the government is behind their back), although I may be wrong on this because I am no sociology expert on Chinese society. I must also add that it seems like the Chinese have learned how the capitalist system works,


and that egalitarianism has started to fade as citizens ask for better pay packages and benefits even though we all know that outside a certain company (say, Honda) other employees earn less.

Interestingly enough, it has occurred to me (as I was watching a History Channel segment, "Iran: The Hundred Year War") http://www.historyasia.com/synopsis.aspx?libId=1132&sId=628&sTime=1260"

that because of the Cold War and the fear of a Marxist contagion taking over the globe, the bastion of Democracy that is the United States, sought to take preventive measures and/or place neutralizing factions by putting local leaders into power and providing support. These people were supposed to be committed to upholding democracy as what the forefathers of the United States had intended when they emancipated themselves from British rule. Unfortunately, the noble premises and intentions did not translate no matter how educated these people supposedly were and most of them turned out to become despots and dictators.

The very people that were put into place by the democratic superpowers as champions of democracy against communism became the templates of dictatorship that citizens of third world nations learned to despise. Ironically, this was what the U.S. wanted to prevent, Stalin-like leaders who hoarded power. Then again, such is the unavoidable problem in creating an authentic democracy. Oppositions will exist and they will manifest through what Constitutions provide for as freedom of speech, expression, demonstration and whatnot. I believe that up until today, among third world nations (like in ASEAN), leaders (prime ministers, presidents, dictators or what have you) and their "entourage" have often been tempted to take a cut of the pie and enrich themselves while in power, while the opposition keeps a look out and would cry foul whenever something is amiss or is being plundered. This cycle has gone on ever since. The U.S. remains committed to poise itself as the best and viable template of democracy, however, where people have the right to say what they think, as long as these are legal and do not step on other people's rights. Unfortunately, this very system is where "in-house" terrorists and extremists thrive, because they can make it look as if they are simply expressing their opinions and beliefs when in fact they are plotting for the destruction of the existing systems/structures of order and governance.

When the smoke had cleared after the Cold War, China, meanwhile, remained intact and stable. The communist state that was once a concern for democracies everywhere had found potential in free markets. Deng Xiaoping was one of the advocates of China's transition (http://en.wikipedia.org/wiki/Deng_Xiaoping") and apparently the transformation had started not from the ground up, but from the top down, from the leadership down to general society.

While China had initiated changes from the top, other dictatorship-ruled third world nations found a re-calibrated version of democracy only after revolting against their once pro-democracy leaders (who were also once supported by the West). This meant that the change was from the bottom-up. With the top spot left open for everyone to take a shot at (a position at the top is indeed tempting) and the democratic mode of empowerment (elections) serving as the mechanism, citizens of third world democracies have found themselves where they are today. Ironically, feeling lost and clueless as to the ultimate direction of their politics, society and economy.

And so, after getting sidetracked, we move back to the main subject of our discussion. The United States must figure out ways to sell their first-world goods/services at cheaper prices that citizens of poorer countries can afford. It can't expect itself to become a net exporter overnight. The third world has long been preconditioned to think that it works and supplies goods/services for the U.S. economy when in fact it can work both ways. Roles should and might eventually get reversed in time, wherein the Chinese (being wealthy with their appreciated currency) become net importers/consumers, while Americans learn to buy their own goods and become net exporters/suppliers to some other country. This observation, of course, simply comes from a by-stander from a small South East Asian country, which will probably remain (together with its ASEAN counterparts) as suppliers for both China, the U.S. and the rest of the world. It may probably even be for the best.

All compositions, statements and opinions of the author are copyright © Earl T. Malvar 2009-2010. All rights reserved. There is no honor, respect, admiration, intellectual and academic dignity garnered through plagiarism.

On Plagiarism

Being an avid reader of online articles around the net, I find it disappointing for some people to assert that some ideas they have were originally conceived by them, when in fact it belonged to someone else.

Of course the timing of 'discovery' plays a crucial part. It's a question of who concluded or thought of the idea first. Moreover, I can't argue that complex ideas are indeed built upon the basic premises and conclusions made by other people who have come before us. I'm really curious if anybody knows the identity of the dude who concluded that 1+1=2 or if we are aware of the identity of the original "concluders" of other blatantly obvious and observable facts that we now consider as irrefutable truths or givens that people use when they start formulating new equations. Synthesis and creation, after all, is a unique human ability and talent.

So what really is my point? Why am I writing this? I'm probably so self-absorbed with the "brilliance" of my self-generated thoughts, right? How egotistical can I be? Actually, I would like to believe or I'm hoping to believe that I've not been blinded by any narcissistic tendencies that us human beings so often find ourselves falling into.

There is a certain order to things and I believe that there are only two constant forces at work in the known Universe and these are Order and Chaos. Unfortunately for the minions of Chaos (sorry chaos-lovers!), I'm rooting for the Order side. Now, I don't want to wallow in a very controversial concept such as Order. Order is order (in reference to organization). Among people, it will vary. Your version of order is different from my version of order. Islamic extremists' version of order will be different from a Pacific island monarch's version of order. A kindergarten student's version of order will be different from a college student's version of order. I hope you're catching my drift, because I'll run out of space with examples if I go on.

So am I starting a cult as I throw my thoughts out there? I'd like to believe that I'm not because the contents of these blogs are opinions after all. Now, it's come to my attention that poor ole "opinion" has become a scapegoat of sorts to a lot of people when they assert their beliefs, but that IS actually the truth in the exercise. We all have something to say, whether we agree with each other or not.

I sort of chuckle whenever I recall a line that was said a few times in the TV series Lost, "If you allow him to speak, it is already too late."/"If he speaks, it will already be too late." Choices can be a burden, especially when the options are embedded with ideas/knowledge/facts/opinions. A person can choose to react (favorably or unfavorably) to an idea or simply ignore it (as a non-factor to a decision), but in any case, the decision-maker would have been conscious of the idea's existence. He may allow it to affect him or not, but it's undeniable that it was thrown out there (just because). Whether someone agrees with the thoughts posted here or not is up to that reader. I publish my thoughts to share to the world, for their consideration and their independent choice to acknowledge it (whether they see it as truth or mere hogwash). I would like to think that, on my end, I've fulfilled my responsibility by throwing the ideas out there for anyone lucky/unlucky enough to have to digest them.

And so, after much meandering (guess what, you could've skipped the first 6 paragraphs), I give you my copyright declaration below:

All compositions, statements and opinions of the author are copyright © Earl T. Malvar 2009-2010. All rights reserved. There is no honor, respect, admiration, intellectual and academic dignity garnered through plagiarism.