I’m not at all convinced that any CEO is ever worth a $10 million pay package, but if it wasn’t clear when that deal was signed, it became obvious very quickly that Robert Benmosche was something of a prima donna. That’s far from unusual in people earning 8-figure salaries: indeed, being the recipient of such a massive emolument tends to exacerbate such tendencies in anybody.

The real culprit in this story, however, isn’t Benmosche, who has been something of a known quantity from day one at AIG. Rather, it’s the people at Treasury, who are now zero for two in picking AIG CEOs. Maybe it’s not as easy as they thought.

The problem is that the CEO of AIG isn’t like the CEO of a public company: he’s fundamentally a civil servant, and is much more constrained in his actions, including his ability to hire people at high salaries, than 99% of other CEOs. The leader of AIG is always going to be second-guessed and micromanaged, which will make any CEO type unhappy.

It’s become clear that the Obama administration is incapable of hiring a largely-independent CEO for AIG and then leaving him to his own devices. So if and when Benmosche leaves, they should probably reconsider the whole job, and how much it’s really worth to them. My guess is that the answer is going to be much less than $10 million.

The NYT has an excellent article on the life settlement industry, explaining its pros and cons in a balanced and clear-eyed manner. If you’re interested in such things, you should read it: it was written by Charles Duhigg, and published in December 2006. He mentioned that Wall Street was getting interested in such things:

Trading in life insurance policies held by wealthy seniors has quietly become a big business. Hedge funds, financial institutions like Credit Suisse and Deutsche Bank, and investors like Warren E. Buffett are spending billions to buy life insurance policies from the elderly…

This nascent market illustrates one way that investors are hoping to make money from a large and wealthy generation of Americans as they reach retirement age.

Today, Jenny Anderson covers most of the same ground but adds little in the way of actual news. What she does add is a much more ominous tone:

Wall Street is racing ahead for a simple reason: With $26 trillion of life insurance policies in force in the United States, the market could be huge…

If a small fraction of policy holders do sell them, some in the industry predict the market could reach $500 billion…

Some financial firms are moving to outpace their rivals. Credit Suisse, for example, is in effect building a financial assembly line to buy large numbers of life insurance policies, package and resell them — just as Wall Street firms did with subprime securities.

If Wall Street is really “racing ahead”, it’s been doing so for well over a decade now, and doesn’t seem to have got very far. There have been people on Wall Street trying to securitize and trade life settlements for as long as I can remember, and nothing much ever seems to happen. Is anything different now? Not really: Anderson has managed to find exactly one securitization of life settlements, and even that one she only mentions in passing:

Standard & Poor’s, which rated a similar deal called Dignity Partners in the 1990s, declined to comment on its plans.

In fact, Dignity Partners launched in March 1995, and was the grand total of $35 million in size. “Could” the market “reach $500 billion”, as “some in the industry predict”? Well, anything’s possible. But so far it’s managed to go from $35 million to zero over the course of the past 14 years. Wake me up when something happens: for the time being there’s nothing at all.

None of the big three ratings agencies is involved right now: the closest thing to a news hook in Anderson’s story is that DBRS, which she describes as “a little known rating agency in lower Manhattan”, is thinking about applying ratings to these things. Is there any evidence that investors are going to trust DBRS on this one, in the event that anything gets off the ground? No.

In general, Anderson seems to be at pains to overstate the degree to which there’s anything to worry about here. Not only does she repeatedly say that life settlements could be the next subprime, she also says that they could be damaging to America’s seniors:

“Predators in the life settlement market have the motive, means and, if left unchecked by legislators and regulators and by their own community, the opportunity to take advantage of seniors,” Stephan Leimberg, co-author of a book on life settlements, testified at a Senate Special Committee on Aging last April.

The quote could have used a bit of context. Leimberg thinks that life settlements are a good thing, in principle, and is looking for legislation to ensure that the industry grows up in a healthy and well-regulated manner, rather than being rife with predators. (And please, NYT, if you’re going to quote Senate testimony, would it kill you to link to it?)

The fact is that life settlements can be wonderful things for seniors who get seriously ill. At the same time, however, that’s not what life insurance was designed to do, and trying to make it perform that function has a raft of nasty potential consequences. For one thing, it could mean life insurance premiums rising substantially, since the price of life insurance currently is kept down by people who let their policies lapse. If they sell those policies instead of letting them lapse, that’s very expensive to the insurer.

But there’s another reason, too, why life settlements are potentially very bad for the insurance industry — and neither Duhigg nor Anderson mentions it. Life insurers, unlike most investors, pay no tax on their investment gains. That’s why buying a life insurance policy is generally a very tax-efficient way to invest money you want to leave to your heirs. But if these policies start being traded on the secondary market, with the benefits going not to heirs but rather to hedge funds and traders, then there’s a serious risk that the life insurance industry will lose its tax-sheltered status. The Wall Street banks looking at securitizing life settlements should be very worried about this: if they start showing signs of success, Congress could, at a stroke, kill their golden goose.

Update: I love Blossom’s idea of calling these things “Collateralized Death Obligations”.

Zachery Kouwe has a great article today about Capco, a highly-secretive Vermont-based insurer which looks as though it’s massively insolvent:

By some industry estimates reviewed by the insurance department, Capco could face nearly $11 billion in claims but has only about $150 million with which to meet them. The state is examining whether the company sold policies without the means to cover them, according to a person with direct knowledge of the inquiry who had signed confidentiality agreements.

Capco was in much the same business as AIG Financial Products: selling insurance against the end of the world. Such businesses tend to be extremely profitable most of the time, and then blow up spectacularly. The question is who on earth would ever buy such insurance, given that the chances of ever getting paid out are slim indeed. The answer? The same people who own the insurer!

Capco was created in 2003 by Lehman and 13 other banks and brokerage companies as a kind of marketing tool. The pitch was that while Capco would not insure customers against investment losses, it would compensate them if the firms failed. Capco promises to provide virtually unlimited coverage above the $500,000 offered by the Securities Investors Protection Corporation and its equivalent in Britain…

Capco, which is private, is something of a financial mystery. Its members include Wall Street giants like Morgan Stanley and Goldman Sachs, banks like JPMorgan Chase and Wells Fargo, smaller brokerage firms like Robert W. Baird & Company and Edward Jones, and Fidelity, the mutual fund giant. Capco was initially registered in New York but later moved to Vermont, where state law enables it to operate without disclosing much about its finances…

It’s unclear who actually serves as the current president of Capco, and the company’s main phone number connects to a recording that tells callers they’ve reached a “nonworking number at Morgan Stanley.”

It seems that these banks’ clients essentially got their Capco insurance for free, which is lucky, because it wasn’t worth anything. But that doesn’t mean they won’t go after Capco’s owners if the insurer fails to pay them what they’re owed. One thing’s for sure: a lot of lawyers are going to get a lot of work out of this fiasco.

Mike Konczal picks up on a great Taunter post about conditional probabilities, which comes with a nasty sting in the tail. When you buy health insurance, the main thing you’re concerned about is tail risk: you want to be sure that in the unfortunate event you have stratospheric medical bills, the insurance company will be there to pay them.

The problem here is that you can’t be sure of that. Indeed, by Taunter’s math, if you have stratospheric medical bills (this is where the conditional probability comes in), the chances of the insurance company paying them are quite possibly no higher than 50-50. The term of art for an insurer not paying an insured’s medical bills is “rescission”: the insurer rescinds the policy rather than pay the bills.

Here’s James Kwak:

The legal basis for rescission is that when you sign an insurance application, you are warranting that the information on the application is true; if it turns out not to be true, the insurer can get out of your insurance contract. It’s particularly nasty in practice because the insurer does not immediately investigate your application to determine if it is accurate before selling you the policy (that would be impractically expensive); instead, the insurer waits – years, in many cases – until you actually need expensive health care, and then does the investigation, which at that point is worth it because of the payments the insurer could potentially avoid. Also, you can lose your coverage for innocent mistakes, which are easy to make since the application form asks you if you have ever seen a doctor for any one of a long list of medical conditions that you are certain not to recognize or understand. (In a Congressional hearing, the CEO of a health insurer admitted that he did not know what several of the conditions listed on his company’s application were.)

Kwak’s parenthetical about how insurers can’t examine applications before they’re approved on the grounds that that would be “impractically expensive” misses the true evil here: the insurer wants to cash the insurance-premium checks of people who made fraudulent applications. Those are the most valuable insureds of all, because the minute they make claims which cost more than their premiums, their policies can be immediately rescinded. As Taunter puts it, you are free to play, you just aren’t free to win. And that’s why you get people being denied breast-cancer surgery on the basis of having had acne in the past.

This is a huge problem with any private-sector health insurance: it’s essentially impossible to gauge the quality of that insurance until it’s too late.

More generally, as Konczal says, this applies to other insurance policies too: CDS, for instance, or even hurricane insurance. In general, if you’re making a series of small payments now on the grounds that you will be paid a large sum of money if something bad happens, you’re running some large and unhedgeable counterparty risk. Which just goes to confirm what everybody deep down suspects: that a significant part of the money we spend on insurance policies is wasted.

Scott Patterson reports that Berkshire Hathaway wrote less than half the amount of reinsurance in 2008 as it did in 2006, and that 2009 will be substantially lower still. He relates this development to Berkshire’s credit rating, which was downgraded from triple-A by Moody’s in April:

In its credit opinion, Moody’s also cited the potential volatility of Berkshire’s “catastrophe-exposed business.” Berkshire is a major investor in Moody’s Corp., parent of the ratings group…

A higher book value and a rising cash stockpile could eventually lead to a reinstatement of Berkshire’s Aaa rating, though Moody’s isn’t likely to reverse itself soon.

If and when Berkshire wins back a higher rating, that could pave the way for the company to move aggressively back into the property catastrophe market.

It strikes me that the really important thing here isn’t Berkshire’s credit rating, so much as its CDS spreads. Reinsurers used to feel that they needed a triple-A rating because that connoted utter safety: you could reinsure your catastrophe risk with Berkshire safe in the knowledge that the risk of Berkshire being unable to meet its obligations was significantly lower than the risk of, say, a hurricane hitting New York.

Now that the value of a triple-A rating has plunged, however, in the wake of many formerly triple-A-rated securities defaulting over the past year or two, insurers are going to feel much more need to hedge their counterparty risk when it comes to their reinsurance contracts. As a result, the cost of reinsurance isn’t just the cost of the premiums any more: it’s the cost of the premiums plus the cost of buying credit protection on the reinsurer.

Conversely, from Berkshire’s point of view, every dollar that Berkshire reinsures is another dollar of demand for Berkshire credit protection, and the upward pressure on Berkshire’s CDS spreads will remain. And thanks to delta hedging and capital-structure arbitrage, sellers of Berkshire credit protection will ultimately end up depressing the Berkshire share price.

Berkshire’s shares are looking pretty cheap these days: at $85,000 apiece, they’re lower than they were five years ago. But five years ago, the idea that Berkshire’s insurance products would have to be discounted by its counterparty risk would have been unthinkable. Without its triple-A moat, Berkshire looks much less special than it did back then.

Update: My commenters are saying that insurers don’t hedge their counterparty risk to reinsurers. Either you trust a reinsurer or you don’t; if you do, you don’t hedge counterparty risk, and if you don’t, you don’t do any business with them at all. Maybe insurance regulators should be looking into this.

Patrick Jenkins gives a good example of why insurance is not a sensible way to think about or regulate financial products:

Investment banks, including Goldman Sachs and Barclays Capital, are inventing schemes to reduce the capital cost of risky assets on banks’ balance sheets…

The schemes, which Goldman insiders refer to as “insurance” and BarCap calls “smart securitisation”, use different mechanisms to achieve the same goal: cutting capital costs by up to half in some cases…

Under Goldman’s idea, it would sell an insurance product to a bank with a toxic portfolio, effectively shifting the risk of the underlying assets off the balance sheet. The insurance would require far less capital to be carried against it than the original assets.

The insight here (I believe Goldman considers it “financial innovation”) is that insurance is fundamentally more leveraged than finance. Rolfe Winkler is wrong when he says that regulating financial products as insurance would force banks to reduce leverage — quite the opposite.

Think about a pair of banks, A and B. Each has $1 billion in loans on its books, and needs $80 million in capital to be held against those loans. But then B insures A against any losses on its loan book, while A insures B against any losses on its loan book. Presto, each bank is now fully insured against loss, and needs much less capital. Each bank also, of course, has a large contingent liability should the other bank’s loans go bad. But the amount of capital that an insurer needs to hold against such contingent losses is much smaller than the amount of capital that a bank needs to hold against its own loans.

The fact that it’s Goldman coming up with this bright idea is particularly ironic since it was Goldman which revealed the way in which banks could use securitization to reduce their capital requirements. The bank even proposed a very sensible new principle:

Securitized loans should, in aggregate, face the same capital requirements as the underlying loans would if they were held on bank balance sheets.

I wonder whether Goldman’s financial innovators got the memo.

There’s a meme doing the rounds — I fear it may have been caught by my colleague Rolfe Winkler — that credit default swaps are insurance products, and that therefore they should be regulated by insurance regulators. So before this nonsense spreads any further, it’s worth explaining just why that’s a very bad idea.

First, credit default swaps are not insurance, they’re swaps. A lot of journalists talk about them being “like an insurance contract” when they try to explain what they are, and that’s true, as far as it goes — they do share certain characteristics with insurance. But that doesn’t mean they are insurance. It doesn’t mean that some foolish law should be passed forcing buyers of protection to have an “insurable interest” in some underlying debt instrument, and it certainly doesn’t mean that all CDS should be regulated by some insurance commissioner somewhere.

Many swaps can be thought of as being like an insurance contract, should one be so inclined. For instance, when Larry Summers entered into a massive interest-rate swap while president of Harvard, he essentially locked in a fixed rate on the university’s debt: he was insuring Harvard against the risk that rates would rise. But insurance contracts can’t blow up in the way that the Summers swap did: when rates fell, the university ended up losing a cool $1 billion.

Now let’s say that Harvard had bought credit protection on the state of Massachusetts instead — perhaps Summers, worried about the state running out of money, feared that in an attempt to make up a budget gap, it would start (sensibly) taxing the university’s endowment. Just like with the interest-rate swap, if the spreads on Massachusetts’ CDS had tightened in, then the CDS contract would have cost Harvard a lot of money — protection buyers are just as subject to margin calls as protection sellers are (but as buyers of insurance products are not). It’s the same reason why airlines take large one-off gains and losses from their jet-fuel hedges, even if the purpose of putting on those hedges is to smooth out their fuel expenses.

It’s also worth noting that Harvard might well not be considered to have an “insurable interest”, if it didn’t hold any Massachusetts bonds — even though buying credit protection on Massachusetts might make sense. Defaults have repercussions far beyond the narrow circle of bondholders, and there are many people who might want to hedge against a certain entity defaulting, even if they don’t directly hold that entity’s debt.

A CDS is simply a deal whereby two counterparties promise to pay each other a certain income stream. The buyer of protection commits to paying a fixed amount of money every six months; the seller of protection commits to paying an uncertain amount of money (to be determined via an auction mechanism) should certain events happen in the future. Yes, insurance policies work in a similar manner. But so do, say, office lottery pools — a bunch of co-workers all commit to paying a small amount every week on the understanding that if something improbable happens in the future, they will share a large but unknown amount of money.

Even if some bright spark determines that CDS are insurance contracts, however, that doesn’t mean that they should properly be regulated by insurance commissioners. After all, even if they are insurance contracts they’re also financial derivatives, and it’s pretty clear that financial-derivative regulators are much more likely to be able to effectively regulate financial derivatives than insurance regulators are. What’s more, the SEC looks as though it’s going to be given explicit responsibility for regulating CDS; as we’ve seen in the banking sector, all hell tends to break loose when multiple regulators share responsibility for regulating the same companies or financial instruments.

To make matters worse, there is no national insurance regulator in the US: insurance is regulated on a state-by-state level. Why should a credit default swap entered into between two Delaware counterparties be regulated by the New York State insurance commissioner? It makes no sense at all

And let’s not forget that the New York State insurance commissioner — the only insurance regulator even remotely capable of regulating credit default swaps — was the regulator responsible for regulating MBIA, Ambac, and all the other monoline insurers who blew up as a result of writing far too many underpriced credit-default swaps. The SEC may or may not be an effective CDS regulator, but New York State has proved itself an ineffective CDS regulator.

In any event, if you want strong and effective regulation, the last person you want to turn to is an insurance commissioner. Insurance companies are the most highly-leveraged financial institutions in the world, if you look at the ratio of their contingent liabilities to their book value. That’s one reason why most insurers end up blowing up: they’re generally massively exposed to tail risk. Consider life insurers, for instance: they dodged one bullet, when AIDS ended up disproportionately hitting the kind of people (gay men, intravenous drug users) who don’t tend to have children and therefore normally don’t have much in the way of life insurance. But if a pandemic does start scything down a lot of rich people with children, expect a lot of life insurers to go bust — just as property insurers would disappear en masse if a hurricane were to hit Miami or New York. In theory, insurers hedge their catastrophe risk in the reinsurance market; in practice, they don’t, or not completely. And reinsurers can go bust, too.

What’s more, insurance companies are pretty much the last outpost of extreme opacity when it comes to the effects of the financial crisis. Most of the time, the way that insurers work is that they pay out in claims slightly more than they bring in, in terms of insurance premiums; their profit comes from investing those premiums before they’re paid out. If the investment returns are negative rather than positive, as they almost certainly were last year, then the total losses can be enormous. And I’ve been hearing rumors for months that there are lots of insurance companies which are failing to come clean on their investment losses, especially with respect to their securities-lending operations. AIG was not the only firm investing repo proceeds in subprime-backed securities and losing a fortune in the process — who were the others?

One of the reasons I’m still very bearish on the markets and the broader economy is because I’m convinced that there are lots of enormous financial institutions which haven’t even started to come to terms with their losses yet. Some of those institutions are European and other non-US banks; others are large insurers and reinsurers. I have no faith in the insurers’ regulators’ ability to reassure me that such losses don’t exist or are manageable. And I certainly have no faith in their ability to regulate the CDS market. So let’s not go there.

If Andrew Cuomo tries to become the next governor of New York State — which he almost certainly will — then his current job, attorney general, will open up. And Eric Dinallo almost certainly wants it.

I like two aspects of Dinallo’s decision to step down from his post as New York’s insurance superintendent. The first is the fact that he’s doing it at all: there’s technically no need for him to resign first before running for AG. But clearly a big political campaign would detract from the amount of time and attention he could devote to the insurance industry, and it’s the responsible thing to do.

More interestingly, Dinallo’s resignation temporarily leaves the country without a strong insurance regulator — and that, in turn, should make it much easier for Tim Geithner to push through plans to rationalize the nightmare that is insurance regulation, and bring America’s insurers under one federal regulatory umbrella.

A lot of the consumer-facing aspects of the insurance industry properly should be regulated by a new financial products safety commission: things like variable annuities, in particular, can come close to being predatory, and it’s high time that a regulator with teeth put an end to the sale of the most egregious products. Now would be a great time to introduce legislation creating such a body, and slashing the number of regulators in Washington. If Geithner waits much longer, he’ll only give the entities to be abolished more time to put together a strategy for defeating his bill.

Serena Ng has the non-story of the day, but given the general brouhaha surrounding AIG, you can be sure that all manner of noise will surround it. AIG was a net seller of credit protection on mortgages; it lost a lot of money. Credit default swaps are a zero-sum game, so that means the net buyers of credit protection on mortgages made a lot of money. Among those buyers of credit protection were hedge fund mangers like Steve Eisman, who was famously profiled by Michael Lewis.

Follow the string far enough, then, and you can quite easily manage to justify a headline like "Hedge Funds May Get AIG Cash". But the crazy thing is that the hedge funds didn’t even buy their protection off AIG. They bought it from a special-purpose vehicle as part of a deal to create synthetic CDOs; AIG was then brought in to insure the most senior parts of the structure. The connections here are tenuous, and boring. But of course that won’t stop the pro-forma expressions of outrage.

Reprinted from Portfolio.com

Justin Fox wonders whether we should have just let AIG fail — or at least the holdco and the AIGFP subsidiary. They certainly deserved to fail. So why did we bail them out? Because of the systemic fragility of the CDS market, is the answer — it’s basically the same reason why the government stepped in to prevent Bear Stearns from being forced into liquidation. It feared a cascade of counterparty failures which could kill the entire financial system.

Here’s the fear: AIG goes bust, and can no longer make good on the promises it made when it said that it would pay out on a CDS contract in the event that a certain credit defaults. Default protection sold by AIG, in other words, becomes worthless. Now let’s say you’re a CDS desk at, say, JP Morgan. You’re buying and selling default protection all the time, and so long as the amount you’ve bought, on any given credit, is equal to the amount you’ve sold, you reckon that you have no net exposure.

The minute that AIG fails, everybody else’s net position alters substantially, and in a very unpredictable way. The protection that JP Morgan bought from AIG is worthless, while the offsetting protection that JP Morgan sold to some hedge fund remains outstanding. So JP Morgan now has a large position it never wanted.

Now there’s a good chance that JP Morgan will have hedged its counterparty risk to AIG — but that doesn’t make the risk go away, it just shunts it elsewhere in the financial system. And the web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag. All those AIG losses which are currently being borne by the government wouldn’t have disappeared if AIG had failed: they would simply have turned up somewhere else in the financial system.

But no one would have had a clue where in the financial system, exactly, those losses would have ultimately come to rest. And given the magnitude of the losses, you can be sure that no one would have wanted to have any kind of dealings with the poor schmucks who ended up on the hook for all those billions of dollars. And since those pooor schumcks could be pretty much anybody, no one would do any kind of business with anybody else: you’d get settlement risk run amok. The entire global financial system could grind to a halt overnight, due to the inability of any given institution to persuade any other institution that it was actually solvent.

We don’t know for sure that this kind of worst-case scenario would have happened if AIG had been allowed to fail. But we don’t know that it wouldn’t have happened — and the US government felt that it simply couldn’t take that kind of risk.

What’s more, bailing out AIG had the pleasant side-effect of putting the entire global CDS market on a much stronger footing. Remember that CDS, like all derivatives, are a zero-sum game: for every loser, there’s an equal and opposite winner. Very few institutions were net sellers of protection; AIG was by far the largest. So what that means is that the rest of the CDS market, ex AIG, is now a net winner to the exact extent that AIG is a loser: a hundred billion dollars or more. Given worries about the fragility of the CDS market and the systemic risks that it posed, bailing out the single largest net seller of protection essentially meant injecting a large amount of government cash into the part of the market that regulators were most worried about. It was quite an elegant solution, in its way: rather than trying to unpick the CDS knot institution by institution, you could just bail them all out at once by backstopping AIG.

Remember that what regulators were most worried about at the time was systemic risk. Whether or not AIG deserved the money was pretty much beside the point: the key thing was that if it didn’t get the money, the entire global financial system would be put at risk of collapse. In which light, the cost of the AIG bailout looks positively modest, compared to its benefit.

Reprinted from Portfolio.com