I (Gary Hirst) was not entirely surprised to hear this week that the International Association of Insurance Supervisors (IAIS) will be examining the portfolios of insurance companies to check for systemic risk (1). The asset classes that are potentially on the chopping block are not inappropriate investments: private equity, securities lending and derivatives; however, they are very different products and, as such, will be evaluated independently, as they should be.
Private equity is a varied class including everything from hedge funds to LBO funds to VC funds with straight commodity type deals like timber mixed in. And speaking of those asset classes they are what form the backbone of what is known as the Yale Model; one of the most successful endowments in the world. And what are insurance companies but a form of an endowment with products bought to meet future liabilities?
It is true that the Yale model (2), like almost everything else, took a beating during the credit crisis. But when assets fall in tandem there is little one can do save being in cash or having the foresight to be in John Paulson’s hedge fund; neither of which would have looked entirely smart or acceptable before 2008. With insurance companies and endowments it is really a question of timing, along with having the ability to take a long horizon rather than being harangued by investors daily (the plight of money managers). As such, I find private equity to be an ideal product that should not be tampered with.
Securities lending is controversial lately as two pension funds have sued their banker for overcharging for services. Concisely securities lending is the loaning out of stock to a third party to cover their short position. The issue that the pension funds have is nothing more than determining the split of the proceeds acquired from those transactions. Given that insurers are managing their own money, there should be no damaged party. Therefore if there is a pernicious side to securities lending it should not affect the insurance business, at least until such time as they outlaw short selling.
Derivatives pose a different question and risk. It is safe to say that the CDS’s, which I termed quasi-insurance in a previous piece, are the derivatives that have brought the inquiry in the first place. The blow up at AIG Financial Products Division is the cause for concern; ironically resulting in questions as to whether there are giants in the industry that create systemic risk and thus creating a de facto imprimatur of a safety net for them being “too big to fail.” And this is the very thing that the regulatory body would like not to face as it is creating internal moral hazard both for insurers and insured.
But that is the problem with getting too big in any industry. You cease being what you once were and instead become a global force in a sector. It is no different in technology where Google was once just an unimportant small search engine, but is to the point now where it is essentially in almost every field of technology in order to maintain its size and presence. Apple, while selectively more parochial, faces the same problems as it grows and begins to invade the turf of other tech players. Ironically cross directorships are lost this way.
The problem in banking and insurance is that they are very much the global plumbing for the rest of the world’s products. Additionally since the assets are not tangible it can be hard to differentiate between a brilliant idea and how it will actually work in the marketplace; a problem Apple must mostly solve regularly or they would not be in business today. Banking can solve some of this with the return to Glass Steagall, but insurance has no such prior regulation to fall back on. And, in any event, a bifurcation of the industry would surely make weaker players but ones that were not necessarily safer.
Note (1): The third of the “Three Pillars” of the IAIS mission is Financial Stability, including developing methodologies for the identification of any global systemically important insurers (G-SIIs) – insurers that are “too big to fail.”
Note (2): David Swensen, who has been Chief Investment Officer at Yale University since 1985, developed what has become known as “The Yale Model.” The Yale Model avoids asset classes with low expected returns, such as fixed income, and recognizes that liquidity should be avoided, not pursued, because in a properly diversified portfolio it results in lower overall returns.