Finance people…chime in!

[bsrsharma]

“My bet is that the insurance company isn’t making any net profit once the two are netted out. But the Nips are famous for tolerating break-even/unprofitable enterprises”

I think there is some confusion here. The insurance company wants to make profit in insurance business i.e. estimating cost of risk payout and charging premiums to cover that and profit. Buying treasuries is not any more interesting to them than you and me keeping a few hundred $ in checking/savings account. They have enough risk to manage in insurance business and would probably do a bad job if they try to manage money risk – that may blow up their insurance business if something goes wrong. Imagine getting hit with hurricane Andrew or Katrina in a down market – fast ticket to bankruptcy (and may be even to jail – for underwriting much more than loss reserve)

[asragov]

It’s not the yield.

The dollar has been a pretty lousy investment as currencies go, and holding a currency that is depreciating is not something that everyone wants to do.

Here is a chart of the dollar versus the Euro over the past five years.

http://finance.yahoo.com/q/bc?s=USDEUR=X&t=5y

[asragov]

It’s not the yield.

The dollar has been a pretty lousy investment as currencies go, and holding a currency that is depreciating is not something that everyone wants to do.

Here is a chart of the dollar versus the Euro over the past five years.

http://finance.yahoo.com/q/bc?s=USDEUR=X&t=5y

[davelj]

bsrsharma, you’re right, I think there’s some confusion. I don’t think you have a good understanding of how insurance companies operate. I’ll try to explain without getting into too many gory details. (I analyzed insurance companies for a hedge fund several years back – not particularly well, I might add.)

Of course the insurance company WANTS to make a profit in its “insurance business,” as you call it – this is known as an “underwriting profit.” The measure of that profit is the “combined ratio.” A combined ratio of above 100 means that the company isn’t generating an underwriting profit; that is, its insurable losses exceed its premium revenues. A combined ratio of below 100 means there’s an underwriting profit.

Unfortunately (for them), in a normal year, in aggregate, P&C companies don’t generate an underwriting profit. My guess is the average combined ratio for the industry is 105 or so for the last 25 years. They stay in business by generating a profit on their investments that exceeds their underwriting losses. Add in a little leverage and – voila – you can still make a little bit of money. Therefore, your statement, “They have enough risk to manage in insurance business and would probably do a bad job if they try to manage money risk” is incorrect. Most P&C companies pay big money to their in-house and external asset managers to maximize the returns on the investment portfolio (that is, “to manage money risk” in your words) because that’s generally the sole source of profit. Where do you think the lion’s share of Berkshire Hathaway’s equities are held? By Geico, GenRe and Berkshire’s supercat business – Berkshire’s insurance companies.

Now, insurance companies need liquidity, they’re regulated and they also get rated by AM Best (among others), so they can’t go totally crazy with their investment portfolio without some repercussions. So there’s plenty of conservative stuff in their investment portfolios (treasuries, corporate bonds, etc.). But there’s plenty of risky stuff as well – equities, hedge funds, private equity, real estate, etc. It’s typically the returns on the risky investments that makes the difference between overall insurance company returns.

If you want to understand more about this I’d suggest reading all the Berkshire Hathaway annual reports dating back to the 70s. They are a great primer on P&C insurance.

Life insurance companies tend to generate a small underwriting profit and therefore take less risk in the investment portfolio. Life insurance is a more predictable business than P&C insurance due to far better actuarial data (it’s much easier to determine how many people are likely to die in a particular age cohort in a given year than it is to predict how many hurricanes will hit the North Atlantic in a given year). But, even so, all life insurers invest in riskier investments as well – equities, hedge funds, etc. But they do so less than the average P&C insurance company.

The point is that taking and managing investment risk is a CRITICAL part of running an insurance company. They don’t just stick the money in treasuries and pray that the competition will be rational enough for everyone to enjoy an underwriting profit. The insurance markets just don’t work that way.

Hope that clears things up a little bit.

[davelj]

bsrsharma, you’re right, I think there’s some confusion. I don’t think you have a good understanding of how insurance companies operate. I’ll try to explain without getting into too many gory details. (I analyzed insurance companies for a hedge fund several years back – not particularly well, I might add.)

Of course the insurance company WANTS to make a profit in its “insurance business,” as you call it – this is known as an “underwriting profit.” The measure of that profit is the “combined ratio.” A combined ratio of above 100 means that the company isn’t generating an underwriting profit; that is, its insurable losses exceed its premium revenues. A combined ratio of below 100 means there’s an underwriting profit.

Unfortunately (for them), in a normal year, in aggregate, P&C companies don’t generate an underwriting profit. My guess is the average combined ratio for the industry is 105 or so for the last 25 years. They stay in business by generating a profit on their investments that exceeds their underwriting losses. Add in a little leverage and – voila – you can still make a little bit of money. Therefore, your statement, “They have enough risk to manage in insurance business and would probably do a bad job if they try to manage money risk” is incorrect. Most P&C companies pay big money to their in-house and external asset managers to maximize the returns on the investment portfolio (that is, “to manage money risk” in your words) because that’s generally the sole source of profit. Where do you think the lion’s share of Berkshire Hathaway’s equities are held? By Geico, GenRe and Berkshire’s supercat business – Berkshire’s insurance companies.

Now, insurance companies need liquidity, they’re regulated and they also get rated by AM Best (among others), so they can’t go totally crazy with their investment portfolio without some repercussions. So there’s plenty of conservative stuff in their investment portfolios (treasuries, corporate bonds, etc.). But there’s plenty of risky stuff as well – equities, hedge funds, private equity, real estate, etc. It’s typically the returns on the risky investments that makes the difference between overall insurance company returns.

If you want to understand more about this I’d suggest reading all the Berkshire Hathaway annual reports dating back to the 70s. They are a great primer on P&C insurance.

Life insurance companies tend to generate a small underwriting profit and therefore take less risk in the investment portfolio. Life insurance is a more predictable business than P&C insurance due to far better actuarial data (it’s much easier to determine how many people are likely to die in a particular age cohort in a given year than it is to predict how many hurricanes will hit the North Atlantic in a given year). But, even so, all life insurers invest in riskier investments as well – equities, hedge funds, etc. But they do so less than the average P&C insurance company.

The point is that taking and managing investment risk is a CRITICAL part of running an insurance company. They don’t just stick the money in treasuries and pray that the competition will be rational enough for everyone to enjoy an underwriting profit. The insurance markets just don’t work that way.

Hope that clears things up a little bit.

[bsrsharma]

davelj,

Thank you for shining light on the dark underbelly of insurance. I had this notion that insurers are all very conservative and eschew risk outside of their chosen field. It is a frightening thought that just when we have an economic down turn, say a bubble bursting event, the insurers may also go belly up if a catastrophe occurs. I guess CA people have to redouble their prayers that there won’t be a 7+ earthquake or wildfires during next few years! (and FL folks should pray for fewer Cat5 hurricanes)

[bsrsharma]

davelj,

Thank you for shining light on the dark underbelly of insurance. I had this notion that insurers are all very conservative and eschew risk outside of their chosen field. It is a frightening thought that just when we have an economic down turn, say a bubble bursting event, the insurers may also go belly up if a catastrophe occurs. I guess CA people have to redouble their prayers that there won’t be a 7+ earthquake or wildfires during next few years! (and FL folks should pray for fewer Cat5 hurricanes)

[stansd]

Davelj,

I was trying to respond to some of the other posters who possibly haven’t thought about this as much as you have. I may have hit reply to yours.

Lets keep the posts constructive…argue substance all you want, but there’s no need to be condescending.

On your point about the shape of the yield curve: Typically, I’d agree, you wouldn’t want to buy the longer duration maturities without a bigger spread. That said, I’m sure you’ll recall from finance 101 that the yield of a longer term bond is a function of the the shorter term yields. If the short term bond is 0.76%, then the implicit assumption is that the 3-5 year yield is probably 2.5% or 3% if the 5 year is yielding 1.5%, which, though still low and possibly not sufficient for the risk undertaken still may make sense.

You’ll recall from the book that the author bets on events that are very unlikely. Making money in the carry trade will make you short amounts for a long time, but you’ll lose your shirt when the currency makes a big move against you…that’s the significance.

I look forward to a brilliant reply, which I’m sure will confuse my infantile mind though articulated by your superior one into the simplest possible terms.

Stan

[stansd]

Davelj,

I was trying to respond to some of the other posters who possibly haven’t thought about this as much as you have. I may have hit reply to yours.

Lets keep the posts constructive…argue substance all you want, but there’s no need to be condescending.

On your point about the shape of the yield curve: Typically, I’d agree, you wouldn’t want to buy the longer duration maturities without a bigger spread. That said, I’m sure you’ll recall from finance 101 that the yield of a longer term bond is a function of the the shorter term yields. If the short term bond is 0.76%, then the implicit assumption is that the 3-5 year yield is probably 2.5% or 3% if the 5 year is yielding 1.5%, which, though still low and possibly not sufficient for the risk undertaken still may make sense.

You’ll recall from the book that the author bets on events that are very unlikely. Making money in the carry trade will make you short amounts for a long time, but you’ll lose your shirt when the currency makes a big move against you…that’s the significance.

I look forward to a brilliant reply, which I’m sure will confuse my infantile mind though articulated by your superior one into the simplest possible terms.

Stan

[davelj]

Stan, since I was the only poster to use the word “insane” in describing those who would buy a 1.5% 5-year Japanese note, I assumed your post was aimed principally at me. Thus, your exposition on the yen-dollar carry trade came across as condescending (to me) much like an explanation that 3×2=6. So, pardon the confusion and the condescension – perhaps it was misplaced.

Having said that, I found baffling your comment: “I’m sure you’ll recall from finance 101 that the yield of a longer term bond is a function of the the shorter term yields. If the short term bond is 0.76%, then the implicit assumption is that the 3-5 year yield is probably 2.5% or 3% if the 5 year is yielding 1.5%, which, though still low and possibly not sufficient for the risk undertaken still may make sense.”

I’m not sure where to begin, so I’ll start with the current (as of yesterday) term structure of Japanese interest rates:

3 Month 0.70%
6 Month 0.74%
1 Year 0.81%
2 Year 1.05%
3 Year 1.18%
4 Year 1.37%
5 Year 1.51%

As you’ll notice, the yields on the 2-4 year notes are between 1.05% and 1.37%, not the 2.5%-3.0% (I think) you suggested. Perhaps more important, this 2.5%-3.0% is not “implied,” as (I think) you suggest. Correct me if I’m wrong, but I think you’re getting confused about “bootstrapping,” which is the process of calculating the implied rate on a theoretical zero-coupon bond by using the actual yields on the shorter-term (coupon) securities that would comprise it. For example, because we know the 6-month rate (0.74%) and the 2-year rate (1.05%), we can do a little algebra (via the “bootstrapping” process) and calculate that if a 2.5 year zero coupon bond existed it would yield about 1.13%. So, while you’re correct for the most part that “yield of a longer term bond is a function of the the shorter term yields,” you’ll have to explain to me what mathematical process gets us to implied rates of 2.5%-3.0% for the “3-5 year yield.” Although, perhaps I’m not understanding you correctly.

(As a side note, I’m a big fan of Nassim Taleb, but he’s another guy – like Jim Grant and many others – that’s very, very smart whom you’d never want managing your money. It’s more than a little ironic that the hedge fund that Taleb ran for several years is basically on life-support at this point because he ran across his own financial “black swan” – market volatility has been unprecedentedly low for an unprecedented period of time, while his fund was set up to lose small bits of money during periods of low volatility but to make big money once volatility returned to “normal” levels. The high vol periods were so infrequent that the fund just kept bleeding over several years until people gave up on him. In other words, the outlying event was an absence of outliers! Talk about irony. I think his consulting practice still does pretty well, however.)

[davelj]

Stan, since I was the only poster to use the word “insane” in describing those who would buy a 1.5% 5-year Japanese note, I assumed your post was aimed principally at me. Thus, your exposition on the yen-dollar carry trade came across as condescending (to me) much like an explanation that 3×2=6. So, pardon the confusion and the condescension – perhaps it was misplaced.

Having said that, I found baffling your comment: “I’m sure you’ll recall from finance 101 that the yield of a longer term bond is a function of the the shorter term yields. If the short term bond is 0.76%, then the implicit assumption is that the 3-5 year yield is probably 2.5% or 3% if the 5 year is yielding 1.5%, which, though still low and possibly not sufficient for the risk undertaken still may make sense.”

I’m not sure where to begin, so I’ll start with the current (as of yesterday) term structure of Japanese interest rates:

3 Month 0.70%
6 Month 0.74%
1 Year 0.81%
2 Year 1.05%
3 Year 1.18%
4 Year 1.37%
5 Year 1.51%

As you’ll notice, the yields on the 2-4 year notes are between 1.05% and 1.37%, not the 2.5%-3.0% (I think) you suggested. Perhaps more important, this 2.5%-3.0% is not “implied,” as (I think) you suggest. Correct me if I’m wrong, but I think you’re getting confused about “bootstrapping,” which is the process of calculating the implied rate on a theoretical zero-coupon bond by using the actual yields on the shorter-term (coupon) securities that would comprise it. For example, because we know the 6-month rate (0.74%) and the 2-year rate (1.05%), we can do a little algebra (via the “bootstrapping” process) and calculate that if a 2.5 year zero coupon bond existed it would yield about 1.13%. So, while you’re correct for the most part that “yield of a longer term bond is a function of the the shorter term yields,” you’ll have to explain to me what mathematical process gets us to implied rates of 2.5%-3.0% for the “3-5 year yield.” Although, perhaps I’m not understanding you correctly.

(As a side note, I’m a big fan of Nassim Taleb, but he’s another guy – like Jim Grant and many others – that’s very, very smart whom you’d never want managing your money. It’s more than a little ironic that the hedge fund that Taleb ran for several years is basically on life-support at this point because he ran across his own financial “black swan” – market volatility has been unprecedentedly low for an unprecedented period of time, while his fund was set up to lose small bits of money during periods of low volatility but to make big money once volatility returned to “normal” levels. The high vol periods were so infrequent that the fund just kept bleeding over several years until people gave up on him. In other words, the outlying event was an absence of outliers! Talk about irony. I think his consulting practice still does pretty well, however.)

[stansd]

You are correct. I am referring to bootstrapping. The only point I was making is that the implied yield in the outer years is higher than the 1.5%…you obviously understand the process. If the 6 month yield rises to 2% at the end of the 5 year term, you probably would have been better off with the 1.5% over the horizon.

On the Taleb item-I wouldn’t put my own money in that type of fund…it’s true that market irrationality often lasts longer than your own liquidity…my recollection is that even the LTCM bets actually turned out to be right…they were just levered to the point where they couldn’t wait that long.

Back to the irrational housing market.

Stan

[stansd]

You are correct. I am referring to bootstrapping. The only point I was making is that the implied yield in the outer years is higher than the 1.5%…you obviously understand the process. If the 6 month yield rises to 2% at the end of the 5 year term, you probably would have been better off with the 1.5% over the horizon.

On the Taleb item-I wouldn’t put my own money in that type of fund…it’s true that market irrationality often lasts longer than your own liquidity…my recollection is that even the LTCM bets actually turned out to be right…they were just levered to the point where they couldn’t wait that long.

Back to the irrational housing market.

Stan

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