About Bill Coffin

Bill Coffin is the former publisher of Risk Management magazine.
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One Step Forward, Two Steps Back

European Union financial ministers have agreed today to begin what are sure to be long and potentially onerous negotiations regarding tough new rules proposed for any “alternative investment” vehicles that originate outside of the EU, but are sold to EU customers. What this means in plain English is that because of a widespread perception across the EU (particularly in Germany) that unrestrained actions in the hedge fund and equity markets significantly contributed to the global credit crisis of 2008, the EU now wants to make sure that hedge funds and equity funds play by much stricter rules in the future so they cannot create the kind of systemic risk the world’s financial markets are clearly vulnerable to.

The United Kingdom has opposed his move, mainly because the majority of the alternative investment vehicles targeted by the EU are hedge funds and equity funds originating from the London financial market. Any restriction on how these vehicles are created, bought and sold represents a significant risk to London’s multi-billion pound hedge and equity market.

The agreement to negotiate new rules was seen as a setback for the UK’s new Chancellor of the Exchequer, Gordon Osbourne.

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Osbourne came to his post as part of the national shakeup last week, when the Conservative-Liberal Democrat bloc took power. For Osbourne, this was a battle already too far gone, and he has said as much. It says much of an administration that has the wisdom to know when it’s time to make a stand and when it’s time to die on one’s sword.

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One week in against a surging tide of poplar European opinion is probably not the time to die on one’s sword.

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Robert Peston, of the BBC, notes in his blog that the new regulations essentially would require UK hedge funds to either be a whole lot more transparent with how and where they raise their money (since many are, in fact, domiciled in the Cayman Islands), or they can domicile in Europe proper, but be subject to a whole lot more regulation. It is the kind of situation that ultimately comes down to more annoyance than real regulation towards the “hedgies” (I love that term), leaving Peston wondering why the EU is even bothering. Good point.

In the meantime, financial institutions in the United States would do well to observe what is happening in Europe with an eye toward the future. Financial regulatory reform (read: using tomorrow’s laws to fix yesterday’s problems) is by no means a done deal Stateside, and the death of real knowledge on the part of the public and the legislature regarding how the modern financial system works is a recipe for some truly unhelpful lawmaking. Financiers, take heed.

Swan Sighting

This has been a pretty content-rich conference, but today is the day I have been waiting for. Today, Nicholas Nassim Taleb is the RIMS Leadership Luncheon keynote speaker. If you don’t know who Taleb is, you really ought to. He is a veteran trader, professor at New York University’s Polytechnic Institute and is best known for his book, The Black Swan: The Impact of the Highly Improbable, in which he notes that history is largely defined by very low probability, very high impact events, on a scale that suggests such events are so rare as to be unforeseeable, and so severe as to be context altering. It is a book that I have heard more than a few risk managers describe as the risk management manifesto for the 21st century.

Listen up! This man knows risk.

Listen up! This man knows risk.

Black Swan events, as defined by Taleb, have been referenced in over 600 books, according to Taleb’s website, and even Taleb himself is under a self-imposed media blackout until May, when the second edition of The Black Swan is released in May with over 100 pages of new content (On Robustness and Fragility). I cannot wait to get a copy.

If you are attending RIMS 2010 Boston, then run, do not walk, to this event and hear this man speak. He has forgotten more about risk than most experts and consultants will ever know. In the meantime, I’m going to leave you with an article he recently published in the Financial Times, entitled “Ten principles for a Black Swan-proof world.” Good stuff.

See you this afternoon. He’ll be speaking at the luncheon event, which runs from 12:30 to 2:00. Afterwards, he’ll be signing books at the RIMS booth from 2:15 to 3:00.

Be there.

Contingencies, Transparency and Doing the Right Thing

Against a transparent backdrop fashioned as a giant web page, Willis drew the RIMS 2010 Boston press corps to its booth shortly after the Exhibition Floor opened.

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The reason? For Don Baily, CEO, Willis North America, and Joe Plumeri, Chairman and CEO of Willis Group, to reiterate their staunch opposition to contingent commissions. But more importantly, they were launching ClientsBeforeContingents.com, a new website dedicated to hosting a 24/7 global conversation about contingencies.

Bailey noted that contingencies amounted to having a “second master” which led to inherent conflicts of interest. But Plumeri put an even finer point on the topic when he attacked the notion that contingencies needed only transparent disclosure to avoid a conflict of interest. “Just because you’re transparent,” Plumeri said,” does that mean it’s okay for you to do these things?”

Plumeri and Bailey’s position on contingencies has not changed in the five years since this became a hot button issue for risk managers and their insurance industry counterparts. but what today’s announcement does is show that Willis is no longer willing to comment on the issue only when it arises in the media.it intends to make this a nonstop topic of conversation to anybody who is willing to listen. And if Willis has its way, there will be plenty more people listening and thinking about this in the near future.

For RIMS, which also opposes contingencies, Willis’ new websites adds a welcome resource to the body of literature and communication on this issue.

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And as Plumeri has shown, he and Willis is not going to let this topic go away any time soon.

“You have to have principles,” Plumeri said. “And in this particular case, these prinicples are not negotiable.

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Plumeri noted that Willis does charge higher standard commissions to make up for revenue it loses were it to accept contingencies. He went on to say that certain structural problems that lead to possible conflicts of interest — such as the reality that any one insurance company client is likely to be more valued to a broker than any one end consumer of insurance — Plumeri said that so long as the insurance intermediary does its business in a fully transparent way and always does what is in its client’s best interests, those structural problems tend to settle themselves.

Plumeri himself noted that ClientsBeforeContingents.com was unlikely to overturn the New York insurance office’s recent overturning of a ban on contingent fees. Nor was it likely to spur other states to outlaw the practice.

But what he did hope it would do is cut through a widespread public apathy on the topic, fueled by ignorance on how contingences are structured, how they came into being, and what they really mean to the insurance buyer. By providing third party whitepapers, an opportunity for the public to comment, and frequent content updates from Willis itself, Willis is banking on crowdsourcing public opinion on a matter that has failed to find a convincing legislative or regulatory remedy.

“We have a responsibility to do it honestly, fairly and transparently,” Plumeri said of insurance broking. “Because without community there is no insurance, and without insurance there is no community, and I think we have a responsibility to do the right thing.”

You can read more about the website here.

Give AIG a Break

Okay, I said it: perhaps we’re being too harsh on AIG.

Sure, the company has some serious problems, and its liquidity crisis of 2008 will remain one of the worst business disasters of all time. But since then, AIG has somehow morphed from a deeply troubled company into an avatar of all things wrong with the corporate world. And while I won’t suggest we forget (or even forgive) AIG of the policies and actions that nearly tanked the world economy, we must resist the urge to make this company into things that it is not.

Villainization, while it may make us feel good, usually distracts us from the complexities of a situation we must somehow address. It’s easy to say that any given problem came about because somebody — that guy! over there! — was a greedy jerk. It’s far more difficult to see problems in a wider context, to understand how those problems came about, to address those problems on their own terms, and to take meaningful action to try to prevent those problems from arising again. But when we look at the magnitude of the AIG situation, we can take no other course of action. To do otherwise invites disaster to repeat itself. And really, who in their right mind would want to see a stock implosion like this one again in their lifetime?

This brings me to an editorial yesterday called “Kill AIG Now” by Eli Lehrer of the Heartland Institute, over on the Frum Forum. The Frum Forum is a right-leaning political site, and the Heartland Institute is a think tank that describes itself as a think tank for free market solutions to public policy problems, but a cursory look around the site shows that its views on environmentalism, healthcare and other issues aligns it with the remnants of the GOP trying to stake a claim in Obama’s world. On the whole, Lehrer writes some pretty interesting op-eds, but I don’t always agree with his interpretation of the facts, and that is certainly true here.

Before I go one word further, however, a moment of transparency is needed. AIG has been a generous advertiser on this blog’s parent media outlet, Risk Management magazine, and of Risk Management‘s parent, the Risk and Insurance Management Society, a trade association for risk managers — people who often buy very large amounts of insurance from companies such as AIG, and who are among the first to be hurt whenever a major insurer drops to the ground. The P/C wing of AIG, which has been re-branded as Chartis, is also a sponsor and an advertiser.

This next part is sure to draw a few hoots from our more cynical readers, but I’ll say it anyway: I’m not writing this article because we have a relationship with AIG and Chartis. I’m writing it because as I read “Kill AIG Now,” it seemed like another example of using commonly held half-truths about AIG — a firm nobody is in a rush to defend -— to promote agendas that don’t really reflect the reality of the situation.

This may sound like a joke coming from a journalist in this day and age, but I think that the truth is more important than somebody’s agenda. And to that end, I’d like to point out some problems I have with Lehrer’s editorial, because if we succumb to the temptation to cherry pick facts about AIG to support our arguments for other things, then we distort what AIG was, is and will be. And in so doing, we lose our grip on how AIG self-destructed, and we lose sight of how we can keep such a thing from happening again. So it is important to be fair when we talk about AIG. It is more than important. It is critical. And so we begin.

I first began raising my eyebrows over Lehrer’s comments on AIG’s Byzantine structure. There is no denying it, the company is a massive patchwork of subsidiaries that seems like a massive corporate Gordian knot. Given the company’s financial troubles, one might conclude that perhaps its labyrinthine inner workings played a part in that. And indeed, Lehrer makes such a suggestion, but it raises a question far bigger than the one it answers.

Although a number of other companies sold a product line-up similar to it, Greenberg’s AIG developed a uniquely confusing structure largely as a result of its acquisitive ways. When it collapsed in the fall of 2008 due to some terrible bets it made on credit default swaps, AIG consisted of over 1,500 legal entities, 71 America-based operating subsidiaries, and perhaps 50 brands. (State Farm, the insurer that does the most business in the U.S., has 12 U.S.-based operating subsidiaries and one brand.)

Although odd looking on paper, this structure gave AIG a strong competitive advantage and promotes economic instability now. It “worked” for two reasons.

First, the company was—and still is—largely “regulator proof” and able to engage in risky, high-return investments that state regulations mandating conservative financial strategies closed to most of its competitors. Like all other insurers, AIG is regulated separately by each jurisdiction where it operated and small state-level regulatory operations couldn’t always “follow the money” in a behemoth like AIG. The credit default swap trades that famously brought down the company were only one example of its exotic, high-flying investment strategy: the company also backed “rocket scientist” quantitative hedge funds and built ski resorts.

I won’t argue that AIG might be overly complex, structure-wise. However, to suggest that AIG kept such a structure because it allowed it more ability to sidestep state insurance regulators overlooks a larger issue: the structure of U.S. insurance regulation itself.

Not surprisingly, the National Association of Insurance Commissioners opposes the formation of a federal insurance czar, or even the Optional Federal Charter RIMS endorses because — and this is just my opinion here — it would strip them of the power they have enjoyed for so long. Never mind that the 50-regime system we have is loathed by insurers because it creates extra compliance costs and administrative headaches, to have a federal system to streamline things would somehow fail to serve the industry and the consumer, by the NAIC’s reckoning.

One thing is for sure, though, a simplified regulatory landscape indeed would make it much more difficult for another AIG to take advantage of loopholes. But frankly, to blame AIG for working an obviously broken system is a bit like blaming a dog for eating your lunch when you’ve laid it on the floor. First things first: overhaul insurance regulation. Somehow, given the political leanings of Heartland and Frum, i doubt there will be much call for that, however. We’ll see.

Point the second: AIG’s claims history. Hoo boy.

Second, many AIG subsidiaries—particularly those in highly priced competitive businesses—took a very hardnosed attitude towards paying policyholder claims. Although some of the horror stories about the company probably stemmed from resentment of financial success — then New York State Attorney General Elliot Spitzer launched a sometimes demagogic crusade against it — the overall strategy appeared to be the mostly legal although hardly consumer-friendly game plan of always interpreting contract language in ways that maximized corporate profits.

I have covered insurance journalism for about 15 years now, and if I have learned just one thing, it is this: every single insurance company out there either takes a “very hardnosed attitude toward paying policyholder claims” or they are chastising themselves for failing to do so. AIG may have played hardball, but to demonize them for it is ridiculous, given how much this is merely standard industry behavior. As the discipline of underwriting eroded across the board (especially during the 1990s) and as companies no longer could rely on their investment income to keep them going, they routinely turn to claims reduction as the last line of defense. AIG is no different in this.

And if Lehrer has a bunch of consumer testimonials to say that AIG behaved in a bastardly fashion, then guess what? Ask any resident of the Gulf Coast what they think of their insurance company, and you’ll probably get an earful of language that cannot be repeated in front of polite company.

I also like how Lehrer insinuates that AIG was perhaps acting illegally even though it could not be proven as such. This, my friends, is yellow journalism, pure and simple. If AIG’s claims patterns were in fact illegal, then I cannot believe in a legal environment as rapacious as the United States that such rascalism would not have been dragged out into the light and flogged in public. For all of his vigorous prosecution, not even Eliot Spitzer went after AIG for claims, he went after them for dodgy accounting.

Point the third: pricing.

But, there’s no hard evidence that AIG has systematically broken the law through its pricing. (Because insurance consists of a promise to pay at a future time, it’s illegal to sell an insurance policy at a price that doesn’t provide reasonable assurance that the company selling it will be able to pay claims.) Investigations from the National Association of Insurance Commissioners and the Government Accountability Office both found that AIG is not using taxpayer bailout funds to under-price competitors in an illegal fashion. On the other hand, a late November analyst report from Sanford Bernstein sent AIG’s stock tumbling with the suggestion that several parts of the company lacked the resources to pay likely claims. Whatever the case one thing is clear: AIG—buoyed by government support—has continued to compete vigorously on price because the company was built to do so.

First off, again with the insinuation of wrongdoing. If AIG has practiced illegal pricing, then either acuse them of it or don’t. But reading Lehrer, I get the feeling that he’s taking a cheap shot at a firm widely perceived to be up to no good by a public (and a government) that really has no idea how any insurance company works, let alone one as large and as complex as AIG.

But, I digress.

The real point here is that AIG practices scorched earth pricing, ostensibly to force its competition to price at uneconomic levels, forcing them to endure pains that AIG can absorb much more easily. If this is the case, then we certainly aren’t hearing of it at the consumer level, as there has not been a single statewide push for rate rollbacks that made note of how artificially low rates were in the first place.

Plus, I find it strange for Lehrer to ping away on AIG’s pricing when, in other editorials, he excoriates states for not letting the market set its own prices for hurricane coverage. If we want a free market, then we can’t have it halfway, but that is just what seems to be proposed here. Free markets to give the government a pass on covering coastal risk, but not a free enough one to let a company like AIG throw its weight around like any other corporate apex predator might. What gives?

Lehrer even goes so far as to suggest that by competing on price, as it has and as it continues to do, AIG is depressing the entire P/C market, which is in turn hurting the larger economy. This is wildly oversimplistic and ignores the larger dynamics of the P/C pricing cycle. (For more on that, see Morgan O’Rourke’s market overview feature in our upcoming January/February issue if Risk Management)

All of this is diversionary, though. The ultimate point to be made here, is the one I disagree with the least, which brings us to point the fourth: what to do next?

If it wants to solve the problems that AIG poses, the government should put the company out of its misery. Even if the company remains in existence forever, its total debts will never be paid back because they are based on valuations of the company that assumed its strategy would result in long-term growth that never came. The money AIG lost is gone.

I am sure Lehrer isn’t the first to suggest that AIG be dissolved, nor will he be the last. And from a standpoint of getting government money back, perhaps dissolving AIG is indeed the only viable option.

But I wonder . . . is getting the money back really part of the strategy here? I think not.

AIG was saved because its complete downfall was seen as something that would so devastate world financial markets that the federal government had no choice but to step in, throw a king’s ransom (literally) at it and accept the lesser of two evils. When you get right down to it, that’s what national governments are, truly the insurers of last resort.

The big difference now is that the United States actually owns an insurance company because of it. I don’t know what the Obama administration has in mind ultimately, but I do know that saving AIG was a good idea. You know what would be an even better one, though? Fixing our fractured regulatory system so that another AIG can’t happen.

Suggesting that the government is overstaying its welcome into private enterprise after buying up AIG at a time of crisis is short-sighted, plays to the already tired free market mantra that underpins general opposition to the Obama administration and deflects from the real issue of regulatory reform. AIG’s problems stemmed from a variety of sources — an out-of-whack financial services unit, a market environment that rewarded greed over prudence and a leadership that either looked the other way or truly did not know what was happening in its own shop. But these are the ills not just of AIG, but of the entire corporate environment of the last ten years.

If we want to focus on a meaningful solution here, we need to look to regulation, and how badly the U.S. insurance market needs it, and needs it now.