Sunday, December 28, 2008

Next - the Insurance Pyramid Scheme?

There have been a number of high profile pyramid schemes exposed in recent weeks. Internationally the Bernard Madoff scam which seems to have cost its investors up to $50bn. At home, the Breffni O’Brien scheme seems to be missing as much as €20m – more modest perhaps but involving a small number of investors who can probably ill-afford the deception.

Pyramid schemes have a long history and a simple attraction for investors – they appeal to people who expect high guaranteed returns with little or no risk. This combination is, unfortunately, not generally available. The schemes promise high returns and actually deliver them to early investors. They rely on this perceived high performance to pull in new investors to keep the cashflow strong. However, what’s actually happening is that the money put in by new investors is being used to pay “dividends” and /or capital to earlier investors. This “return” to investors has little, if anything, to do with actual investment income or capital gain earned by the scheme.

Pyramid schemes are naturally illegal and Messrs. Madoff & O’Brien can expect to do jail time for their financial exploits, though one suspects the US system will deal much more harshly with such frauds than the Irish legal system is likely to.

Insurance companies are, on the other hand, quite legal, but are open to being effectively operated as pyramid schemes unless they are closely supervised and scrutinised.

Insurance companies operate on the basis of collecting insurance premiums today to pay for insured events arising at some time in the future. This gives large insurance companies a huge cash float which they can invest to earn a return in the interim. Assuming the company’s investment strategy is sound, the bulk of the company’s profits are likely to come from this investment income, rather than any actual surplus of premium income over claim payouts.

In the current investment climate, with stock markets & property all showing major losses on a worldwide basis, it’s highly likely that any investment fund with an aggressive approach is currently nursing substantial losses in the past 12-18 months. Funds which invested in bank shares, property companies, building materials etc etc will be very badly hit.

So it could be that some insurance companies are effectively in “negative equity” on their funds set aside to meet future claims. This means that existing outstanding claims will also have to be partially met from the premium incomes being generated from new and existing clients, which are intended to cover future, rather than historic, claims. To keep the ball rolling, so to speak, such an insurance company has to maximise new business inflows and, to do this, will probably have to quote the most competitive rates in the insurance market. Which will, in turn, increase the negative gap between income inflows and future liabilities arising from claims.

Ultimately, unless there’s a dramatic turnaround in investment returns, the wheels will come off and the insurance company will go bust – leaving its policy-holders without cover and legitimate claimants unpaid.

Sounds like a pyramid insurance scheme to me.

So who are the most aggressively priced insurance companies in the Irish market and what have they invested their surplus funds in e.g. if Quinn Insurances, FBD, Hibernian etc have made substantial investments in Irish banks e.g. Anglo?

Internationally, where has Warren Buffet’s Berkshire Hathaway (owner of some of the largest US insurance companies) invested the surplus cashflow thrown off by those companies?

All we need to follow the international banking crisis is a similar collapse in the international insurance market. The complexity of the huge re-insurance side of the business means that, in the event of a loss of confidence, it will be virtually impossible to establish clearly who’s carrying what risk and how reliable any company’s re-insurance contracts are when it comes to settling liabilities.

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