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Receivables
Feb. 19th, 2009 07:47 amThere's a quirky little accounting device in the insurance industry called "receivables", but it struck me just now that, in the land of Stanford & Madoff, we are all in the land of receivables; we just hadn't realized it.
Insurance companies only have so much capital to hand (indeed -- many have a lot less to hand than they did). This means, to avoid falling foul of lots of laws in all the countries of the world, that if they have a potential liability above their own capital's capability to pay, they have to reinsure it with another company. So take, for example, UK floods. An insurer might want to write business with a potential liability of £5bn, but only has capital to cope with £3bn of losses. Actuarially speaking, it only expects a loss of more than £3bn once every 50 years or so. It therefore seems a bit of a waste to raise extra capital just to cover that rather unlikely loss.
However, in the land of insurance (unlike, say, investment banking) you can't really say "let's just hope it doesn't happen". What you do is pay a company like Swiss Re about £100m a year in premiums to protect against any losses above £3bn.
Now, suppose there's a huge flood. It's definitely cost more than £3bn, but, as is the way with this kind of thing, it can take a long time to establish the exact levels of loss. What happens now is that the insurer puts onto its book an estimated loss of (say) £4.8bn, of which it has already paid £4.2bn, but it will get £1.8bn of this back from Swiss Re. This goes onto the book as a receivable.
In the old days, £1.8bn was £1.8bn, and no-one batted an eyelid. But in these more exciting modern times, you have something called credit risk. This has always existed for dodgier reinsurance companies. In simple terms, the attitude now is that, unless that £1.8bn is under the mattress, there's a small, but finite, chance, that it isn't worth £1.8bn at all.
In a way, we are all functioning in this fashion. If you have £2,000 in the bank, it isn't really £2,000, because there is a finite chance that you won't be able to get it if you want it. It appears that Stanford made just this mistake. America's rich have so much become a cashless society, he forgot to follow the Robert Mugabe School of Financial Management. He tried to book a private jet out of Houston, and then attempted to pay by credit card -- a processing that was, understandably, denied.
This Stanford matter struck me because, on hearing the news, I wondered to myself which of my poker sites was registered in Antigua (answer, I think, is none) and whether there are any poker sites with money tied up in the Bank of Antigua (answer, I suspect, a few). I've got just north of $20k in various poker sites and Neteller -- none of which money is protected in any way, shape or form. That doesn't mean I should be panicking. The chance of the cash disappearing is small, but finite. What it does mean is that I should not "value" the money at 100%. Estimating the likelihood of loss (and, of course, any loss would be either zero or significant, rather than the "expected loss" of 1% or so) is up to me.
The ordinary financial solutions to this (the ones you read in the press) aren't really solutions at all. It's actually better EV to accept the risk and to spread the money about in a hope that any loss at one site will not be 100% correlated with loss at another. In a sense, leaving it in the (slightly higher risk) sites and neteller is better than bringing it all back home, because the latter focuses my risk more singly in the UK.
Most people, of course, don't have much choice in that matter. All their money is in one bank and that one bank is in the UK. In that sense I am extremely lucky. However, the downside is that the likelihood of a small "total loss" from one institution is somewhat greater. On the upside is that any such "total loss" won't really matter that much in the grand scheme of things.
_________________
Insurance companies only have so much capital to hand (indeed -- many have a lot less to hand than they did). This means, to avoid falling foul of lots of laws in all the countries of the world, that if they have a potential liability above their own capital's capability to pay, they have to reinsure it with another company. So take, for example, UK floods. An insurer might want to write business with a potential liability of £5bn, but only has capital to cope with £3bn of losses. Actuarially speaking, it only expects a loss of more than £3bn once every 50 years or so. It therefore seems a bit of a waste to raise extra capital just to cover that rather unlikely loss.
However, in the land of insurance (unlike, say, investment banking) you can't really say "let's just hope it doesn't happen". What you do is pay a company like Swiss Re about £100m a year in premiums to protect against any losses above £3bn.
Now, suppose there's a huge flood. It's definitely cost more than £3bn, but, as is the way with this kind of thing, it can take a long time to establish the exact levels of loss. What happens now is that the insurer puts onto its book an estimated loss of (say) £4.8bn, of which it has already paid £4.2bn, but it will get £1.8bn of this back from Swiss Re. This goes onto the book as a receivable.
In the old days, £1.8bn was £1.8bn, and no-one batted an eyelid. But in these more exciting modern times, you have something called credit risk. This has always existed for dodgier reinsurance companies. In simple terms, the attitude now is that, unless that £1.8bn is under the mattress, there's a small, but finite, chance, that it isn't worth £1.8bn at all.
In a way, we are all functioning in this fashion. If you have £2,000 in the bank, it isn't really £2,000, because there is a finite chance that you won't be able to get it if you want it. It appears that Stanford made just this mistake. America's rich have so much become a cashless society, he forgot to follow the Robert Mugabe School of Financial Management. He tried to book a private jet out of Houston, and then attempted to pay by credit card -- a processing that was, understandably, denied.
This Stanford matter struck me because, on hearing the news, I wondered to myself which of my poker sites was registered in Antigua (answer, I think, is none) and whether there are any poker sites with money tied up in the Bank of Antigua (answer, I suspect, a few). I've got just north of $20k in various poker sites and Neteller -- none of which money is protected in any way, shape or form. That doesn't mean I should be panicking. The chance of the cash disappearing is small, but finite. What it does mean is that I should not "value" the money at 100%. Estimating the likelihood of loss (and, of course, any loss would be either zero or significant, rather than the "expected loss" of 1% or so) is up to me.
The ordinary financial solutions to this (the ones you read in the press) aren't really solutions at all. It's actually better EV to accept the risk and to spread the money about in a hope that any loss at one site will not be 100% correlated with loss at another. In a sense, leaving it in the (slightly higher risk) sites and neteller is better than bringing it all back home, because the latter focuses my risk more singly in the UK.
Most people, of course, don't have much choice in that matter. All their money is in one bank and that one bank is in the UK. In that sense I am extremely lucky. However, the downside is that the likelihood of a small "total loss" from one institution is somewhat greater. On the upside is that any such "total loss" won't really matter that much in the grand scheme of things.
_________________
