When I wrote the September 2008 Iconoclast column last year, I made some 2009 predictions. I foretold that the fraud reduction savings in the insurance industry might cause the dollar amount of profit — but not its percentage — to decrease. Wall Street speculators might then sell their insurance stock. Even though I could have never imagined the debacle that actually occurred, as a professional observer of the insurance industry, I should have. Therefore I come, hat in hand, again surveying the dregs left in an empty coffee cup, to see what lies ahead for our property and casualty claim-adjusting industry.
By the time this is published, most Americans will have forgotten, though likely not forgiven, AIG for paying those millions in bonuses to the very gang in London that brought the company down with its boom market in credit default swaps. Until that point, many rightly regarded AIG as one of the best insurers in the world. Now the rest of AIG will suffer because of the stupidity of a few. The late Patrick Magarick, who was a columnist for Claims Magazine for decades, was vice president of claims for American International, traveling the world on AIG's behalf. His textbooks, including Casualty Insurance Claims, began as instruction manuals for AIG. Having known AIG for more than 40 years, I have been to many of its offices across the nation, including the New York headquarters. As a risk manager, I trusted the corporate insurance to several insurers, including National Union and Lexington. AIG companies were strong, trustworthy, and fair, though occasionally more expensive than some that were less strong, less trustworthy, and frequently unfair. Now it is in shambles, partly because nobody knew insurance history or the proper role for the industry.
Importance of History
In the introduction to the June 2009, Supplemental Update to the two volumes of Excess Liability – Rights and Duties of Commercial Risk Insureds and Insurers, 4th Ed., (another of Pat Magarick's original texts), this writer quoted Godfrey Hodgson's book, Lloyd's of London: "The Committee of Lloyd's does not allow underwriters to write financial guarantee insurance. This rule … dates from 1936…. The provision might seem to rule out insurances like those on bank guarantees or computer leasing. In fact, it does not. The language of the Committee's definition of what constitutes an unacceptable financial guarantee insurance is contorted, but still decipherable: 'The test to be applied … in deciding whether an insurance is a violation of the financial guarantee agreement is whether the happening of any one or more of the following events, viz; (a) the financial default or insolvency of any party; (b) the financial failure of any venture; (c) the shortage of receipts, sales, or profits of any venture; or (d) lack of support; will cause a loss to become payable under the insurance, or brings into operation a peril or contingency insured against that will cause a loss recoverable must be a direct result of a specific contingency, which is not precluded.' The last clause," continues Hodgson, "is the operative one. If an insurance makes a condition that any loss recoverable must be the direct result of a specified contingency [such as fire or windstorm], then it escapes the ban on financial guarantee insurance." In short, we can assume that financial guarantee insurance is poison.
AIG's financial boys in London were making millions by guaranteeing a bunch of financial derivatives based on nothing more than the false premise that housing prices in the U.S. would forever inflate. So a "pop" ensues, and down goes AIG.
We should keep in mind that AIG was not alone. How many other U.S. or foreign insurers were also dabbling in the default credit swaps and derivatives market? Even the CEOs of those insurers may not know for sure. When Elliot Spitzer — one-time prosecuting attorney in New York, and then its elected governor until he tried out the services of the Madame of the Mayflower Hotel and got caught — pressed charges against AIG's leader, Maurice Greenberg, it was unclear that Greenberg knew what the boys in London were doing. Apparently nobody knew.
Nothing New Under the Sun
The rating bureaus were attaching AAA+ rates to these derivatives, and the financial industry was gobbling them up like the local squirrels that go after the seed in my birdfeeder. That's why AIG had to pay the London guys their millions in bonuses; they needed them to unravel the tangle of threads that were in default.
Somebody gave this writer a copy of The Snowball – Warren Buffett and the Business of Life for Christmas. The biographer in this case is Alice Schroeder. The book, all 960 pages of it, was published by Bantam in September 2008, just as it all came to a head. For those unfamiliar with the Oracle of Omaha, Buffett bought a couple of shirt companies: Berkshire Fine Spinning and Hathaway. He turned them into the conglomerate Berkshire Hathaway, making him (at least until last September) one of the richest men in the world. We had all better hope that Warren doesn't lose his shirts.
As I trust many readers already know, some of Buffett's major holdings are insurance companies, including that elegant insurer that uses a lizard and some cavemen to promote its economical auto insurance, GEICO. Another insurer he bought was General Reinsurance, which Schroeder termed a "wholesaler." Well, that's not really what a reinsurer is, but wait until you hear her story. According to Schroeder, the purchase, at $22 billion, "dwarfed by multiples his largest deal ever, GEICO. Investors … were shocked when he … announced Berkshire was buying General Re….
"Buffet did not know much about the inner workings of General Re. He had made the decision to buy based on studying the company's results, and he liked its reputation. General Re was sort of the Grace Kelly of the sometimes-shady insurance business. General Re wore the white gloves and historically had acted more ladylike and respectable than the average company. Still … given the pattern of Buffett's purchases of insurers — in almost every case they plunged straight into the ditch shortly after he bought them — and given the size of this deal, the distant rumble of the tow truck's engine warming up could be heard, barely audible, over the next hill."
Yet the purchase caused Berkshire Hathaway stock to hit a high of $80,900 per share. So, what happened?
"General Re coughed up a nasty surprise within days after Berkshire closed the purchase," Schroeder explained. "Ron Ferguson, the CEO, had called to say that the company had been duped out of $275 million in an enormous, elaborately designed fraud called Unicover."
January 2000, found Buffett already bracing himself. General Re had so far brought him nothing but deplorable news. "A year after the company had admitted being duped in the Unicover fraud mere weeks after Berkshire bought it, Ferguson had made a new confession," Schroeder continued. "Movie producers and their lenders had talked General Re into guaranteeing ticket sales on Hollywood films. The company said it would pay if the box office fell short, without knowing what scripts would be filmed or who would star in them. Buffett was incredulous when he found out. Within weeks, lawsuits began to unreel from the film-finance fiasco faster than the failed films' credits unfurled. …. Then Ferguson belabored [Buffett] into a nitpicking match over how to underwrite an Internet lottery called Grab.com that [a GenRe manager] was reinsuring. Buffett now realized that Ferguson had a sharply different philosophy from his."
Buffett was notorious — and ridiculed — for refusing to buy into the high-tech bubble of the late 1990s. As it turned out, not only did that bubble burst in 2000, but the home price derivatives market bubble also burst eight years later, proving that Buffett was a wise conservative. Almost everyone else in the high-tech e-commerce business lost their Hathaway or Berkshire shirts.
Bursting Bubbles
Since the days of Alexander Hamilton, the American economy has been a boom-and-bust business. Speculators inflate the bubbles, only to cry later when they burst. Wall Street's national anthem may very well be the song, "I'm Forever Blowing Bubbles." We discovered the foolishness of Enron cooking the books a few months after the tech bubble burst. Fools had rushed in to invest their 401k plans in Enron, Health South, World Com and others, all based on recommendations of highly praised Wall Street financial advisors, who were all bubble blowers. However, the cycle is evident to anyone who observes. About every 10 to 15 years, there is another banking crisis. The government both creates this crisis with its actions and bails it out after the losses begin to pile up.
Revisiting those 2008 Iconoclast predictions, one may notice that there was a warning that Congress was getting anxious about having the federal government assume regulation of the insurance industry from the states, in effect killing the McCarran-Ferguson Act. As this column is written, that is exactly what is being promoted in Congress by the new Obama administration: the right to regulate insurance as a financial institution.
It all began about 30 years ago when banks were allowed to buy into insurance companies. Iconoclast columns published in the 1980s reported those ventures and also warned of mayhem. I argued that insurance is something far different from the finance industry. It's a different animal entirely. No one seemed to pay much attention when I said that industry gurus were carving false images.
Insurance companies are designed to pay claims, but only within the terms of carefully underwritten policies. It is dangerous when insurers dabble in other financial instruments, such as derivatives or Internet lotteries or movie productions. When they don't understand the risk, they will violate that most ancient of proverbs: "He who is surety for the stranger shall suffer for it." So, down goes AIG. Who is next?
As adjusters, we need to be aware of this sort of financial mayhem in which our employers may be engaging. Perhaps a reader will write in to advise us of some sort of financial guarantee claim that he got stuck adjusting. While adjusting is just a matter of words — the investigation, evaluation and negotiation of coverage, liability, and damages — underwriting also requires caution and foresight as well as investigation and evaluation. Obviously there are financially connected insurance companies out there that don't know that fact.
© Arc, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.