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:

http://www.buffettsecrets.com/warren-buffett-biography.htm
http://www.insurancejournal.com/news/national/2005/03/08/52382.htm
http://www.propertyinsurancecoveragelaw.com/2009/03/articles/insurance/playing-the-float-and-the-wisdom-of-warren-buffett/

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.

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