The expansionist post war era has been characterised by the development of the FIRE economy (finance, insurance and real estate), with a greater and greater dependence on leveraged risk. A necessary consequence has been increasingly sophisticated mechanisms for operating at financially rarified levels far removed from any basis in real wealth. As the network of economic and financial connections has broadened exponentially, and become increasingly complex, greater attention had been paid to apportioning and diverting risk, and to anticipating and avoiding losses through insurance.
Insurance is the equitable transfer of the risk of a loss, from one entity to another in exchange for payment. It is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss…The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer’s promise to compensate (indemnify) the insured in the case of a financial (personal) loss.
The use of, and dependence on, insurance has spread throughout society in developed countries, and has led to changes in the perception of risk. Rather than addressing risk directly through prudent behaviour or due diligence, risk management has become highly abstract. Being able to pay to officially offset risk can lead to the perception that risk has somehow disappeared. The supposed insulation, or buffer, adds to the comfort level of operating at high levels of leverage, in the same way that driving a vehicle with many safety features can lead to people driving more recklessly, because they feel more secure in taking risks they feel they control, or have paid to minimise.
To pursue the driving analogy, if we are interested in controlling driver behaviour for the benefit of all, perhaps instead of more car safety features, we should consider installing a large spike in the middle of the steering wheel, pointed directly at the driver’s chest. Making risk apparent and personal makes us pay attention to it and adapt our behaviour accordingly. Faced with an obvious an immediate threat, we would drive in such a way as to avoid the consequences. If everyone were driving slowly and cautiously, road safety would improve significantly, although the frenetic pace at which our society operates would have to slow down as well.
The point is that human beings appear to have an internal risk set point, which will vary from person to person. When we perceive external factors to have reduced the risk we face, we adjust our risk-taking behaviour upwards. When we perceive external factors to be magnifying our risk, our actions become much more risk averse. It is the combination of actual external risks and our perception of them that determines where our collective risk set point lies at any given time.
Unfortunately, spreading risk around on paper and in the virtual world does not make it disappear, whatever our perception may tell us. Instead it makes risk systemic. Expansion eras are typified by risk insulation and complacency, while the contractions that follow are characterised by risk aversion. The knock on consequences of risk perception skewed in one direction or the other can be considerable, and are a major factor in creating self-fulfilling prophecies, or spirals of positive feedback, first in one direction, then in the other.
Insurance is a ubiquitous feature of life in modern societies, in the ordinary lives of citizens and between large organisations and institutions. It operates at all scales simultaneously. Insurance premiums paid for risk indemnification are set based on a combination of the probability of an adverse event and the cost of the consequences should it occur.
Complex risk models are used to quantify both factors, and risk may then be shared among many parties, depending on how much capital is required to back a given risk. Chains of reinsurance cover may be necessary, which of course increases the impact of counterparty risk. Coverage fails if the weakest link in the chain cannot meet its obligations when called upon to do so. Counterparty risk has been growing substantially behind the scenes as systemic leverage has increased.
Not all risks are insurable, as some are far too likely and others have potentially catastrophic consequences too expensive to back. The nuclear industry is a case in point. States must act as insurers of last resort for risks on that scale, and even they may not be able to do much if those risks are realised (witness Fukushima). A risk is privately insurable if an insurance provider can make a profit while charging a premium that enough people can afford to pay, so that a large enough pool of premium payments comes in to be invested and generate income to cover potential payouts plus profits.
If circumstances change, and covering a specific risk is no longer profitable (or not longer acceptably profitable from the point of view of the insurer), insurers are going to have a problem. They could stop issuing policies covering that risk, or they could limit payouts on policies, or both. In recent years, insurance payouts have been considerable, at least partly due to very costly natural disasters, but also increasingly due to fraud.
Certain risks are ceasing to be insurable, such as hurricane damage on the Gulf coast, and insurers are deeming some aspects of their business to be unacceptably profitable. Getting out of the business of issuing cover means limiting premiums coming in, whereas merely tightening conditions for payouts allows incoming premiums to be maintained while limiting out-goings. Unless a risk is clearly uninsurable, this has to be a tempting option.
It is indeed becoming more difficult to extract payouts on existing policies in many fields of insurance. Many people are continuing to pay premiums, either because insurance is required, or on the expectation that cover will be available if needed, but more and more often, when risks are realised, payments are not forthcoming as expected.
Caveat emptor when it comes to purchasing insurance cover. Insurance is not a substitute for personal risk management. Often it will be sold in a manner seemingly designed to be confusing, so that people may fail to fill in the form correctly, or may make understandable mistakes in doing so, or may leave out a triviality that can later be used as a pretext to deny a claim. It is instructive to look at a few cases.
Home Insurance:
Contents insurance may hinge on the insured having a detailed list of their possessions, complete with photos and receipts for their purchase:
A couple whose belongings were stolen from their downtown Vancouver condominium garage can’t understand why TD Insurance denied their claim — despite video surveillance evidence, police reports and witnesses that all attest to the crime. “We’re left in the hole,” said Daniel Parlee, a certified commercial transport mechanic. “My life savings of tools are gone — and we are denied every single penny of our loss.”
TD Insurance records indicate the claim was refused because Daniel and wife, Sepide, couldn’t prove they owned the tools and other items they claim were stolen…Daniel said he had several thousand dollars worth of specialized tools collected over a 20-year period in the back of his truck. “I don’t have any receipts, because the tools are so old. I don’t keep receipts for that long ago,” he said….
The Insurance Bureau of Canada (IBC) said it’s common for claims to be denied when claimants have no documentation to prove they owned what they lost. “You have to be able to bring yourself within the contract to say that I had these specific items,” said IBC spokesperson Lindsay Olson.
“It’s not enough to say ‘I had 50 pieces of tools’. You have to be able to say these are the specific items I had – and here are the receipts or the instruction manuals for those, or here are the photographs of them.”
Most people would not be in a position to justify their claims in this way, and would not even be able to rectify the situation of lack of receipts. Many may well be paying for insurance cover that will not pay out when needed.
Weather damage to property is increasingly problematic for insurers, particularly in areas prone to experiencing such damage. Exclusions and deductibles are increasing, and damage from multiple causes may not be covered, even if one of those causes is:
After Hurricane Irene hit in August 2011, more insurers tucked hefty wind and hurricane deductibles into their policies. They run 2 percent to 5 percent of the insured value of your home, says Charles Hahn, an insurance agent in Little Falls, New Jersey, where “we’re known for flooding a lot.”
Keep in mind that many insurers have “anti-concurrent causation clauses” in policies now that say if you have damage from multiple causes, say wind and flooding, where wind is covered but flooding is not – they won’t cover anything at all.
Some major classes of home risks may not be insurable at all, even if one has insurance for related issues. People may not realise the exclusions that apply to their policies:
Amidst the power outages, gas shortages, mass transit shutdowns and school closures left behind in Superstorm Sandy’s wake, there’s one issue few people are talking about, and that’s the cost that homeowners will incur from mould damage. Aside from the health risks associated with mould from flooding, mould removal is extremely costly and is not covered by most home insurance policies, according to the San Francisco Chronicle.
The average homeowner could be forced to shell out anywhere from $200 to $30,000 for mould removal. In a recent report on Sandy’s destruction obtained by Business Insider, Citi strategist Jeffrey Berenbaum wrote, “mould damage could likely be the largest risk to properties that remain flooded for weeks.”
Travel Insurance
The success of travel insurance claims can rest on minute details:
Complaints about seemingly arbitrary rejections cross my desk at regular intervals. No surprise: Travel insurance is a $1.8 billion-a-year industry, according to the US Travel Insurance Association (www.ustia.org), an industry trade group. And it has been growing steadily, from $1.3 billion in 2006 to $1.6 billion two years later to the latest figure, from 2010.
It’s no shocker in another sense, too: The travel insurance business is generally profitable, the occasional volcanic eruption or tsunami notwithstanding, and critics say that the only way it stays that way is by rejecting most claims, particularly the expensive ones.
The most trivial or irrelevant discrepancies in filling out the paperwork can be used to deny a claim:
When it comes to travel insurance claims, Hannah Yun was about as sure as anyone that hers would be successful. She’d bought a gold-plated “cancel for any reason” policy for a trip to South Korea. When her boyfriend proposed and she decided to call off the trip to start planning her wedding, she thought that collecting a check would be just a formality. Travel Guard, the company she’d purchased the policy through, turned down her claim on a technicality. Yun, a college student in Salt Lake City, had originally told the company that her plane ticket had cost $1,090; she’d actually paid $1,092.50.
Failure to board a flight to a destination where one knows in advance something bad is about to happen counts as grounds for forfeiting the cost of the trip despite insurance, as it amounts to ‘disinclination to travel’ unless a specific government travel warning has been issued:
It was meant to be the family holiday of a lifetime, an expensive, but much anticipated, half-term five-night trip to see the sights of New York with our two children, aged 18 and 14. But it turned into the holiday from hell as we were virtually confined to our hotel, in a city in lock-down, with all public transport systems, tourist attractions and virtually all shops and restaurants, closed as Hurricane Sandy did its worst…
…What was really galling was that we knew before leaving the UK that this was going to happen, yet could find no way of cancelling and rescheduling without losing all our money – despite having paid £90 for comprehensive travel insurance.
Where insurance companies have been found not to be liable to make payouts, courts are sometimes looking for other parties to cover passenger losses, where or not those parties were in any way responsible for the losses. For instance, airlines have been found liable for the costs of passengers stranded by the ash cloud following the eruption of Eyjafjallajökull:
The volcanic eruption left millions of passengers unable to return home because it was deemed too dangerous to fly through the ash clouds. Today’s ruling could leave airlines open to a raft of future claims. The court recognised compensation claims could have ‘substantial negative economic consequences’ for airlines, but said a high level of protection must be afforded to passengers …. Mr O’Leary [of Ryanair] said the court’s decision made the airlines ‘insurers of last resort’ and said whoever was responsible for cancellations should pay compensation.
He blamed the Government for closing British airspace in 2010, even though ‘there was clearly no ash cloud over the UK.’ He said: ‘We now have a position that when the next time there’s an ash cloud or the skies are closed by Europe’s governments, the travel insurance companies will walk away and wash their hands and say it was an act of God and the airlines will become the insurers of last resort.’ ‘Somebody who has paid us fifty quid to travel to the Canaries, who may be stuck there for two weeks, two months, six months, will now sue the airlines and you will have airlines going out of business, and the ones who stay in business will be putting up the air fares to recover these crazy claims.’
The fight over who must bear the consequences of realised risks is hotting up. We can expect both the base cost of travel and the premiums for travel insurance to rise. As people’s ability to pay is going to be heavily compromised over the next few years, travel will be very much less frequent than today. Already, older people are increasingly priced out of travel, as the insurance premium can be significantly higher than the cost of the trip. Travel for the elderly is becoming an uninsurable risk.
Medical Insurance
Out of country emergency medical expenses can be extraordinarily high if uninsured risks materialise:
Australia’s foreign affairs minister is looking into the case of a Sydney couple stuck with a million-dollar hospital bill after their daughter was born in Vancouver last August. John Kan and Rachel Evans had taken out travel insurance and extra cover for Ms. Evans’ pregnancy without realising the policy would not cover birth or the baby. They were about to return to Australia after their B.C. vacation when Ms. Evans went into premature labour at the airport.
Piper Kan stayed in the neo-natal ward of the B.C. Women’s Hospital and Health Centre for three months and the bill ended up being about $1-million. Australian media reports the couple negotiated a payment plan with the hospital at about $300 a month, which would take 278 years to pay off.
In terms of medical coverage, ‘pre-existing conditions’ people did not know they had are an increasing barrier to claims, even where the insured had been cleared to travel by a doctor:
Gojevic came down with what he thought was a bad cold just days before heading to Las Vegas to celebrate his wife Arleatha’s birthday in February. An X-ray suggested he might have pneumonia, so an emergency doctor prescribed him a 10-day course of antibiotics. The doctor said he was good to go on vacation….But the 53-year-old started having difficulty breathing on the plane as the Las Vegas strip came into sight. He was administered oxygen on the plane and was met on the jet runway by paramedics.
He was rushed to Desert Springs hospital in Las Vegas….After the couple was flown home via B.C. Air Ambulance they received a double whammy of horrible news: Mike was not suffering from pneumonia, but a life-threatening lung disease called pulmonary fibrosis. He was put on the list for a double lung transplant. Then One World Assist denied the travel insurance claim, saying he was on the hook for $140,000 in medical expenses.
The company said he didn’t qualify because he was treated stateside for a “pre-existing condition.”….But Mike Gojevic argued that it was the pulmonary fibrosis that was the health problem that kept him in hospital, and he hadn’t been diagnosed with the serious lung condition at the time. He had only been diagnosed with pneumonia — a condition considered minor by the insurance company.
Discrepancies between doctors’ definitions of diagnosis and treatment and those used by insurance companies can be a major obstacle to making a claim:
A B.C. couple on a fixed income is facing a $50,000 US hospital bill, despite buying travel health insurance for their last trip….Last year, they bought full medical coverage as usual, through their broker, from Prime Link Travel Medical Insurance. While in California, Anna had to go to hospital with a blood clot in her leg.
The Friesens struggle to understand English, so said they relied on broker Barrie Cartmell to fill out their application. He read them several questions from the form, including: “In the last 36 months, have you received treatment for kidney disorder (including stones)?” Anna answered no. She’s had weak kidneys for several years, but has not actively been treated….Despite letters submitted since from doctors, insisting she is not receiving any treatment for her kidney condition, the insurance claim denial letter reads, “You do have a chronic kidney disease for which you have undergone investigations which is considered treatment.”…
The Friesens are now getting calls from a U.S. collection agency and are afraid to go south for their usual trip….”I don’t even lift up the phone anymore. I see it’s a number from outside, I don’t even lift up the phone anymore,” said Anna. “Because [the collection agent] told me last time I am supposed to pay him $5,000 a month.”…
Bullock says the forms are ambiguous, and he thinks that is intentional. “I’ve come to the conclusion that it’s a deliberate tactic,” he said, citing several examples of what he calls “trivial” denials. “A lady didn’t disclose that she had an ear infection four years ago. Another lady didn’t disclose that she had hemorrhoids during her pregnancy two years ago. A fellow didn’t disclose that his brother had a heart attack. He didn’t know his brother had a heart attack. That didn’t matter. He didn’t disclose it,” said Bullock….He said seniors should realise insurers can and will look at all medical records, so it’s best to disclose everything, even if it costs more for coverage. He said some medical conditions trigger premium increases of 300%….
David Rivelis of Prime Link, the Friesens’ insurance agent, said even when a customer’s doctor states they are not being treated for a condition, the adjuster’s interpretation can supersede that. “The insurance company ultimately determines the term of the contract,” said Rivelis. “How the doctor defines something may be different from how it’s defined by an insurance company.”
Coverage can be denied on the basis of pre-existing conditions documented only in medical files the insured did not have access to, even if those pre-existing conditions were unrelated to the problem that required treatment.
In Florida, Bill had chest pains and numbness in his arm. He discovered he had suffered a heart attack and needed emergency surgery to remove five blockages in his heart….Recovering back home, Bill was stunned to receive a letter six months later, saying his travel health insurance claim was denied and he owed $346,000 US in medical bills. Manulife says Bill should have answered yes to this question about two conditions:
“In the last two (2) years, have you been prescribed or received treatment for and/or been hospitalised (as an in-patient or seen in the emergency department) and/or been prescribed or taken medication for any of the following conditions: diverticular disorder or gastrointestinal bleeding?”
Bill insists that he didn’t know what was spelled out in his medical file or that he’d been diagnosed with those two conditions. He thought all his symptoms were related to the colon cancer he’d had surgery for 19 months earlier. “Most importantly to me would be the question, ‘What does anything, what does anything related to this have to do with Bill’s heart?'” Tracy said. “Absolutely nothing. Absolutely nothing.”
Susan Eng of CARP, a Canadian advocacy group for people over 50, says the system is set up for claims to be denied. “Ordinary people are out thousands and thousands of dollars because they did not get the protection they thought they had — only because they made a mistake on the form that they could not possibly have done correctly,” she said.
Life Insurance
Failure to disclose trivial health details and indulging normal behaviour can be used as a pretext to deny claims from critical illness and death due to completely unrelated conditions:
Nic Hughes, 44, died in October after battling cancer of the gall bladder leaving his wife Susannah Hancock, 44, and twin eight-year-old son and daughter. But insurance company Friends Life have refused to honour Mr Hughes’ critical illness policy saying he did not give full disclosure of his health. The insurers say Mr Hughes should have told them his GP suggested he cut down his alcohol intake – and that he experienced pins and needles. But medical records show he drank just 10 to 20 units of alcohol a week – below the NHS recommended weekly allowance of 21 units. Nic’s consultant oncologist Dr Rubin Soomal, from The Ipswich Hospital, said neither alcohol, nor pins and needles were linked to his death.
Pre-existing conditions can even be used to deny a life insurance claim for a victim of murder:
The widow of a man killed last year when he was shot in the back is suing the life insurance company that refuses to pay a claim because the man had a “pre-existing condition,” unrelated to the cause of his death. According to the lawsuit filed by Stephanie McCraw, widow of Curtis McCraw, who was gunned down by unknown assailants last April in Knoxville, Tenn., Settlers Life Insurance denied her claim because her husband had Hepatitis C.
(In this case it appears there were extenuating circumstances that probably meant paying a claim would have been inappropriate, but nevertheless, the basis for the official denial of the claim is clearly problematic.)
Car Accident Insurance
Insurers may deny, or seek to reduce, a claim if they can place some, or all, of the responsibility for an accident on to the victim:
An insurance giant is appealing against paying up to £5million compensation to a schoolgirl left brain damaged in a car accident – because she wasn’t wearing a high-visibility jacket at the time. Bethany Probert was 13 when she was hit by a car while was walking home from riding stables along a country lane on a December evening.
The schoolgirl, now 16, suffered a broken collarbone, lung damage, and devastating head injuries which have caused permanent brain damage. A High Court judge found the driver 100 per cent liable for the crash but his insurers, Churchill, have appealed, claiming it was partly Bethany’s fault….The test case will decide to what extent children can be held responsible for their injuries in road accidents.
Outrageously, insurance companies may decide it is in their financial interests to avoid a payout to relatives of a victim by defending an accused perpetrator in an attempt to avoid liability:
Baltimore resident Kaitlynn Fisher, 24, was involved in an automobile accident which stole her life on June 19, 2010. She was struck at an intersection by Ronald Kevin Hope III, who ran a red light. Hope had minimal insurance, but Fisher’s policy had a special clause which called for her insurer, Progressive Insurance, to cover the difference if and when she was involved in an accident with someone who was under insured. Rather than pay Fisher’s $100,000 life insurance policy Progressive opted to aid in the defence of her killer, in hopes that if found innocent they would not be required to pay out her policy. This is despite a witnesses account that Hope struck Fisher.
The Fisher family has been reeling for over two years in disbelief that their trusted insurance company would behave in such a way, while having to absorb court costs all along.
‘Bad Faith’ and the Insurers Perspective
Denying a claim is usually all an insurance company needs to do in order to avoid making a payment. Alternatively they can make a low offer to settle the claim. Most individuals lack the resources to take on giant insurers in court, or find the prospect far too intimidating. If the insured walks away on denial of claim or accepts a low offer as being better than nothing, then the case is over. People can take a legal case, but it generally requires legal representation that knows how to secure a fair offer.
If claimants do take a legal case, courts have been known to punish insurers who appear to have acted in ‘bad faith‘ by allowing the insured to make a larger claim than they had been asking for under their policy:
Until about 22 years ago, it seemed that the idea of real discipline and punishment for the general insurance fraud against policyholders was a real joke. Interestingly enough in California the courts provided policyholders and those who represented them a very powerful legal weapon: the “bad faith” concept.
From that point, many other states adopted some sort of bad faith law. As stated simply by William Shernoff, the crusading consumer rights lawyer who has halted big insurance companies for years and won, the law of bad faith states that if policyholders’ claim have been unreasonably denied they can sue for more than the amount of their benefits. The insured can collect damages for mental suffering and all economic loss caused by the company’s refusal to honour legitimate claims.
If it can be shown that the insurance company’s conduct demonstrated a conscious disregard for the rights of a policyholder, then the policyholder can sue and recover for punitive damages. The purpose of punitive damages is to punish and make examples of companies that engage in outrageous behaviour.
In states with a ‘bad faith’ precedent on the books, peace of mind can be regarded as a deliverable of an insurance contract, and the lack of it as a breach of duty of care.
In its judgment in McQueen v. Echelon General Insurance Co. on Nov. 16, the Court of Appeal refused to overturn an award of $25,000 for mental distress caused by the denial of benefits.
The case involved a plaintiff who had been in a motor vehicle accident in which she sustained injuries. Prior to the accident, she was already suffering from bipolar disorder and upper back pain. After the incident, the defendant insurer refused to pay for some of the benefits applied for and limited the plaintiff’s access to medical assessments. In fact, there were 21 denials of 16 separate benefits over a period of three years.
As well as the benefits, the plaintiff claimed extra contractual damages, bad faith, mental distress, aggravated damages, and punitive damages. In supporting the trial court’s finding that the mental distress warranted compensation, the Court of Appeal declared: “People purchase motor vehicle liability policies to protect themselves from financial and emotional stress and insecurity.
An object of such contracts is to secure a psychological benefit that brought the prospect of mental distress upon breach within the reasonable contemplation of the parties at the time the contract was made. As an insured person entitled to call on the policy, Ms. McQueen was entitled to that peace of mind and to damages when she suffered mental distress on breach.”
Naturally, insurers take a different view of claims denied. They would say that there are clear rules to be followed and clear distinctions between what is covered and what is not covered:
The folks I met were proud of their product and could offer case studies of the many customers they’ve helped. But because of the way travel insurance policies are written, they often see the world in a binary way: yes or no, covered or not covered. Every exception to that worldview must be approved at a high level. When customers grumble about having their claims denied, these insiders are genuinely baffled. “Didn’t you read the policy?” they ask.
As I stood in the understated suburban headquarters where every Allianz claim is processed, it all made perfect sense. Rules are rules, after all. Mark Cipolletti, an Allianz vice president, says that his company has no choice in the matter. Insurance providers are strictly regulated by the states where they do business. “We’re subject to scheduled and unscheduled audits or reviews of our products and claims,” he says. “When we adjudicate a customer’s claim, we must follow the policy, or the contract with the customer, because if we deviate from the contract or treat one customer differently from another, then we become subject to fines and other punitive actions — like not being able to sell in that state any longer.”
At the end of the day, private insurance is a business, and it will act in such a way as to maximise profitability. What constitutes a reasonable level of profitability to expect, is, however, set to change. We have all come to expect historically very high levels of return on investments in the rentier economy, but the rate of return depends on the health of the economy, and on people’s ability to pay premiums in sufficient numbers to make a risk insurable. The rate of return on invested premiums is set to fall as the economy slips into contraction, and many financial asset investments are very likely revalued at a substantially lower level in the approaching era of historic financial upheaval. Ability to pay premiums will also be heavily impacted as people lose purchasing power.
This is a deadly combination from the point of view of the insurance model. If relatively few people can pay premiums, there are few secure investments and the rate of return on those investments is low, then very few risks will be insurable in comparison with today. Loss will increasingly lie where they fall, and risk management will once again hinge on prudent behaviour and due diligence.
Derivatives and Large Scale Risk Management:
Insurance extends well beyond the individual and company level. Financial risk management is an enormous business that has facilitated the development of the derivatives market. Credit default swaps, a market worth tens of trillions of dollars, are effectively insurance contracts against a fall in asset values. Like an ordinary insurance contract, a regular premium is paid to a party offering to indemnify its contractual partner should a loss occur.
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994. In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.
At this scale, the risk management business is based on highly complex, probabilistic value at risk models seeking to predict the likelihood and consequence of a given adverse financial event. As long as a reasonably smooth expansion is underway, a measure of consistency tends to hold, and the quantitative models develop a track record of apparent reliability. However, they have not been fully tested following a major trend change. The events of 2007-2009 were a preliminary test, but the level of defaults was relatively contained. In a larger crisis, such as we are headed for over the next few years, far more financial assets will be marked to market and trigger credit events requiring payouts.
In recent years, more events outside of the ‘normal range’ have been occurring. During the expansionist bubble era, the risk management models generated a false sense of security through creating the perception that risk was under control and not therefore a concern. Risk control is an illusion, but human beings are good at placing faith in quantitative models (that most do not understand) when there are profits to be made. Suspension of disbelief is much easier when it is profitable, and the longer the models appear to be reliable, the more complacent people become. The quants themselves become a sort of priesthood, in the sense they only they have access to how the ‘black box’ risk calculations work. Others must simply accept their opinion.
As expansion morphs into contraction, the full extent of counterparty risk is going to be revealed. There is no trading transparency, nor capital adequacy requirement, in the derivatives market, hence one can make promises to indemnify without having to prove it to be possible to keep those promises. This can amount to a licence to sit back and collect premiums for years, in the full knowledge that meeting promises, should that be necessary, would not be possible. It becomes yet another form of the pervasive financial fraud our global ponzi finance is grounded in. In addition, it is possible to ‘insure’ against a failure of an asset one does not actually own. This is akin to allowing people to take out fire insurance on their neighbours’ homes, giving them a perverse incentive to burn the home down for profit.
Rather than genuine insurance, CDS are just another vehicle for excessive speculation. Where a credit event is triggered, but the losses cannot be paid by the counterparty, those losses can cascade through the financial system. Winning and losing bets do not net out under such circumstances. The combination of lack of transparency, huge counterparty risk and perverse incentives is toxic.
Essentially the CDS market has a built in meltdown mechanism which poses a major systemic risk. Warren Buffet once called derivatives ‘financial weapons of mass destruction’, and they are exactly that. Extending the concept of insurance to the level of covering global speculative flows is a bridge too far. Even the relatively plain vanilla insurance industry is on the verge of seeing its business model fracture, but the significant impact of that will be dwarfed by the consequences of the wholesale failure of global-scale risk management.