Black Swans, the Sub-prime Crisis and Systemic Risk

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Actuarial Society of Greater New York

James W. Macdonald, ARMJW Macdonald Associates, LLC

November 10, 2008

“Black Swans”, the “Sub-primeCrisis” and Systemic Risk:

One underwriter’s Perspective

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Presentation Overview

• How did we get here?

• Who is to blame?

• What have we learned?

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How did we get here?

Financial Risk Policies: Not new to insurance…

• Surety Bonds (predate industrial revolution)

• Municipal Bond Insurance (1971 – Present)

• Credit Insurance

• Title Insurance

• Warranty Insurance

• Other expense related covers (e.g., products recall

insurance)

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Financial Risk Insurance:Underwriting Challenges

• “Business Risk” – “Insurable Interest”?

• Moral Hazard / Adverse Selection

• “Transaction Value” – Is a Zero Loss Ratio assumption

Valid?

• Collateral - Liquid, fungible?

• Recourse - Unlimited?

• Pricing – Credible, equitable?

• Coverage: Non-standardized, complicated - understood?

Source: Insurance Information Institute

Financial risk Insurance ProductsAccelerated growth in soft markets

Domestic P&C Market Cycle -Growth in Net Written Premium: 1970 - 1984

1980-1984: Newgeneration of financial

insurance products1971 AMBAC

1973: MBIA

1975: NYC FinancialCrisis

1983: WPPS!

1980-90: S&L Crisis

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WPPS and S&L CrisisResulted in full limits losses to D&O and E&O Insurers

• WPPS Bond Default (1983)

• $2.25 billion municipal (revenue) bond default

• Largest municipal default in USA history

• In litigation almost ten years

• Losses included D&O of 30 municipalities with “take-or-pay”

obligations, A&E, Accountants, Lawyers

• S&L Crisis (1980-1990)

• Over 2,400 savings and loan association failures

• Estimated losses of $560 billion - $320 B paid by US Government

• Major D&O losses sustained by F&D, MGIC and others

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Early Eighties Soft Market (1980-1984):New Financial Insurance Products “to the rescue”?

• MGM Grand Fire Retroactive Liability Insurance

• Residual Value Insurance

• Limited Partnership Surety Bonds

• Homeowner’s Warranty Insurance Company (first RRG)

• Systems Performance insurance

• “Career Guard” Insurance

• NYIE: Baseball Strike Insurance

• Excess SIPC Insurance

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MGM Grand Fire Retroactive Liability Insurance

• In early 1981, thirty insurers agreed to multi-layered placement of

$120 M limits insured for

• Approximate $40 M premium

• Arguably the first, high profile “finite” deal

• Resulted in detailed industry debate over risk elements to permit

“insurability” (including payout timing, and investment income)

• Fronting insurer went into liquidation in March 1995

• Several years later, MGM settled out-of-court for $87.5 million,

shortly after jury selection.

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Residual Value Insurance

• Typically characterized, like municipal bond insurance, as low-risk

credit enhancements to otherwise solid transactions,

• Normally related to asset-based financing, with sale / leasebacks;

• Recourse to insurer / guarantors was normally limited to taking

ownership of underlying assets;

• Assets varied widely – included trains, planes, buildings, and even

movies.

• Extremely complicated multi-party contracts with numerous possible

events of default.

-5%

0%

5%

10%

15%

20%

25%

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

Current $ Real $

Source: A.M. Best, Insurance Information Institute

Financial Insurance 1986 -2007:Key developments…

1995-2000: Extensive use of finitereinsurance

Domestic P&C Market Cycle -Growth in Net Written Premium: 1986 -2007

1989: New York Article 69 – requires FGIsto be “mono-line”

1988: Centre Re

1986: Federal Tax Reform Act

2000: Reliance offersEarnings Insurance

1992: FASB 113

19995-1998: PLSRA enacted, D&O insurersgive full allocation, entity coverage

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Limited Partnership Surety Bonds:Another “Black Swan” event?

• Guaranteed General Partners full payment of scheduled 5 year

investments by high net worth individuals. No collateral but full recourse

was required;

• Partnerships highly leveraged with gross deductions permitted by early

eighties tax code;

• Tax reforms were expected but almost everyone thought the risk to

existing deals was zero

• 1986 Tax Reform Act eliminated gross deductibility; no “grandfathering”;

• Wealthy investors defied expectations: refused to make future payments;

• Huge initial losses paid by Surety insurers were eventually recouped.

-5%

0%

5%

10%

15%2

00

0

20

01

20

02

20

03

20

04

20

05

20

06

Current $ Real $

Sources: Insurance Information Institute, Fortune Magazine (10/08)

2000-2008“Black Swans” (Extreme Events), Market Softening, and the“Panic of 2007”

Domestic P&C Market Cycle -Growth in Net Written Premium: 2000 -2007

2003: Hurricane Spitzer –Mutual Fund Timing Scandal 2004: Hurricane Eliot – Bid-

Rigging, Finite Reinsurance

Katrina, Wilma,Rita: New Capital

Flows to P&C

01-02: Corporate Scandals,SOX

“Panic of 2007”

2001-2005: Fed Funds Rate 1%,negative real cost of capital to banks

9/11/01 Attacks

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Presentation Overview

• How did we get here?

• Who is to blame?

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Who is to blame?

“It is hard for us, without being flippant, to even see

a scenario within any kind of realm of reason that

would see us losing one dollar in any of those

transactions.”

Joseph J. Cassano, a former A.I.G. executive, August

2007

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Who is to blame?

• “Perfect Storm” (Everyone, ergo: No One?)

• Greed (i.e., human nature?)

• Late nineties legislative pressure on GSEs?

• “NINJA” and “Alt A”loans – What possible

justification?

• Ideological faith in deregulation?

• “Market Conduct” Regulatory Failures (e.g., Is any

cost to consumers - be it premiums or mortgages -

too cheap?)

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Who is to blame?

• Unprecedented Gross Leverage

• No Originator Risk-Taking (“Fronting”/ “Pass the Trash”)

• Synthetic Financial Instruments?

• Financial rating agencies?

• Flawed mathematical models (i.e., empirical data

suggested “all Swans are White”)?

• CPA auditor failures

• Fed Funds Rate, 2001-2005, too low, too long.

• Post-Enron, Mark-to-Market Accounting

• GLB, Sarbox: Bring back Glass Steagle?

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Presentation Overview

• How did we get here?

• Who is to blame?

• What have we learned?

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What have we learned?

• Financial insurance product growth is pervasive in

soft market cycles.

• Regulatory response has been consistently slow,

generally ineffective.

• Paradigm shift is occurring: Need alternatives to

reliance on private sector self-regulation, e.g.,

NAIC is currently discussing forming new

financial rating agency.

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Financial & Insurance Underwriting:Back to the Future?…Many lessons learned

• “Business Risk” – “Insurable Interest”?

• Moral Hazard / Adverse Selection

• “Transaction Value” – Is a “Zero Loss Ratio” assumption

Valid?

• Collateral- Liquid, fungible?

• Recourse - Limited?

• Pricing – Credible, equitable?

• Coverage: Non-standardized, complicated - understood?

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Financial & Insurance Underwriting:Some positive examples under discussion…

• Real Estate / Recourse: Require the lender to have

full recourse in the event of default, not just rights to

given real property (similar to surety bonds – limits

moral hazard).

• Originator: Require some financial risk retention –

“skin in the game” – recalls “fronting” and “MGA”

legislation in response to insurer insolvencies, e.g.

Failed Promises – 1990 Dingell report.

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Financial & Insurance Underwriting:Some positive examples under discussion…

• Require some underlying “insurable interest” in

short selling or CDS transactions – classic difference

between “insurance” and “gambling”.

• Introduce new modeling approaches such as

terrorism risk “deterministic” scenarios to better

anticipate tomorrows “Black Swan” events, e.g.

Nassim Taleb’s “counterfactual reasoning”.

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Bibliography

• Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High

Rollers and the Great Crash, Public Affairs, March 2008

• Bruner & Carr, The Panic of 1907: Lesson’s Learned from the Market’s

Perfect Storm, Wiley & Sons, 2007

• Gary Gorton, The Subprime Panic, NBER Working Paper 14398,

Available at: http://www.nber.org/tmp/1063-w14398.pdf

• Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly

Improbable, Random House 2007

• Subcommittee on Oversight & Investigations, Failed Promises:

Insurance Company Insolvencies, February 1990, US Government

printing Office

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Q&A

Contact Information

Jim Macdonald is an independent consultant based in Philadelphia.Macdonald has 35 years of experience as an insurer, reinsurer, andconsultant with market-leading companies such as AIG, ACE-INA,

C.N.A., Munich Re, Conning & Company, Navigant Consulting, andGeneral Re . His consulting services include expert witness services inarbitrations and litigations, as well as strategic assessment services forinvestment bankers and the public sector. Macdonald is also a Senior

Fellow with the RAND Corporation.

This presentation does not express or imply any opinion on the subjectby RAND and offers solely the personal opinions of the author.

Phone: 215-925-2188

Email: [email protected]

Web: http://www.jwmacdonald.net