The Digest #22

Published on May 20, 2020

In Today’s Issue:

  • Pandemic Insurance Proposals 
  • Where Are the Customers’ Yachts?
  • CFA Institute Virtual Conference
  • Fragile Investment Strategies

To read last week’s newsletter please click here.

Pandemic Insurance Proposals

The insurance industry is based on the concept of risk pooling. For risks that are relatively uncorrelated, insurers can set premiums knowing that it is very unlikely that a single event would trigger insured losses for a large number of customers. For example, an auto insurer knows that most customers who pay premiums during a given year will not file claims. Drivers who suffer losses can be compensated with the pool of funds collected from all insured parties. A well run insurer knows how to set rates sufficient to cover expected losses as well as to provide an adequate profit margin.

As many businesses have discovered recently, most insurance policies for business interruption in the United States contain pandemic exclusions. As we discussed last month, there have been attempts to get insurance companies to pay COVID-19 claims despite policy exclusions. While litigation is likely to go on for years, it is unlikely that contractual language will be changed retroactively to provide coverage. 

More recently, policy-makers have turned their attention to putting in place pandemic coverage for future risks. Since pandemic related shut-downs represent a highly correlated risk, private insurers are unlikely to offer coverage at rates that businesses can afford to pay. For this reason, industry groups and politicians have been discussing the possibility of introducing a federal government loss fund.

Jimi Grande, senior vice president of government relations for the National Association of Mutual Insurance Companies, does not believe that a risk-based underwriting approach works in the case of coverage for pandemics:

“The pandemic risk is fundamentally different from a terrorist attack,” Grande said. “Terrorist attacks, as awful as they are, do have limits in geography. They have limits in scope and frequency. This pandemic would be like having 9/11 every day for 60 days or 90 days.”

Insurers don’t think that the risk-based approach to insurance underwriting works for pandemics. While the risk-based approach provides valuable price signals in most markets, including the market for terrorism, there is “a misalignment of goals, in our opinion,” when talking about a public health response.

COVID-19 will be seared into the memories of business owners for years and decades to come and many will seek to mitigate pandemic risks. Whether the private insurance industry can come up with a business model and pricing that is considered “acceptable” remains to be determined. Based on what industry groups are saying, insurers appear to want to “punt” on pandemic coverage entirely leaving the government to be the insurer of last resort due to the highly correlated nature of the risk.

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Where Are the Customers’ Yachts? 

Financial markets have certainly changed a great deal since 1940 when Fred Schwed published Where Are the Customers’ Yachts. Schwed wrote at a time when investors were skeptical regarding the stock market. The 1929 crash took place a decade earlier and stock prices were still far from the record highs. The Second World War was underway with Nazi Germany on the rise. Surely, a book regarding Wall Street written at that time would be a relic of a bygone age, one that has little relevance to us today? Yet, that is not the case at all.

Anyone who spends a few hours reading this book today will, between bouts of laughter, recognize that very little has changed in terms of human behavior. As Michael Lewis writes in the introduction to the book, “What Schwed has done is capture fully — in deceptively simple language — the lunacy at the heart of the investment business: the widely held belief that there is someone out there who can tell you how to turn a little money into a lot, quickly.”

Click here to read The Rational Walk’s full review of the book

CFA Institute Virtual Conference

Due to the COVID-19 pandemic, the CFA Institute’s annual conference was forced to switch to a virtual online-only event this year. There is no cost to attend although registration is required. Once you have access, you can view any of the recorded sessions that have already taken place and you can attend any of today’s sessions live.

On Monday, Howard Marks was interviewed by John Authers, formerly a reporter with The Financial Times and now a Bloomberg columnist. Howard Marks has been very visible in recent weeks as the COVID-19 pandemic roils financial markets and his message of acting prudently and cautiously has resonated with many investors.

On May 11, Marks published a memo entitled Uncertainty in which he emphasizes the enormously complex set of “thousands of factors” that make the current investment problem enormously multi-variate. Marks was also interviewed on May 11 on the Tim Ferris show.

Aswath Damodaran will present a session entitled The Value of Everything in an Unstable Environment at 11:00 am ET this morning.  Damodaran is Professor of Finance at NYU’s Stern School of Business and the author of the Musings on Markets blog, a consistent source of articles popular with investors.

Fragile Investment Strategies

In a bull market, all sorts of unsound investment strategies can work out as rising tides often lift all boats. During times of financial stress, however, fragility is often quickly exposed and can lead to broken portfolios.

Jason Zweig’s latest Wall Street Journal column discussed a product offered by UBS which is referred to as a “yield enhancement strategy”, shortened to the acronym of YES.  The YES strategy borrows against a client’s holdings and purchases option contracts. Promoted as a product uncorrelated with the market or a single stock position, YES was intended to deliver “consistent income at minimal risk”.

Zweig reports that the YES strategy was based on an options technique known as an “iron condor“. It can post positive returns if stocks do not lurch up and down too much – in other words, the strategy can work in calm markets with limited volatility. Of course, markets have been anything but calm this year and YES was down 15.5 percent for the year through April 17.  

These types of strategies resemble the idea of picking up nickels in front of a steamroller. It is precisely the type of approach prone to blowing up during periods of volatility that Nassim Nicholas Taleb warned us about in Antifragile.

One aspect of the strategy is not fragile, however.  The UBS annual fee for YES is 1.75 percent, which seems quite robust.

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The Digest #22