Thursday, 22 July 2010

On the price of insurance and the bull market in tail risk

From the people who bought you such wonderful ideas as CDOs, now comes the bull market in tail risk products. Deutsche are launching a long equity volatilty index, Citi has come up with a crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. The CBOE is planning a new index based on the skew in the S&P500.

In the past I've talked about the need for cheap insurance, and the benefits that this can bring to a portfolio in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand! You should really only want insurance when it is cheap, as this is the time when the no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset...a path to the permanent impairment of captial. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves the dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffet said holding cash is painful, but not as painful as doing something stupid!

78 comments:

amit said...

So true. In fact, I would go so far as to say this may be the right time to sell insurance - going by the long-term option prices on some of the equity indices which may be pricing in far too much volatility

Carter the Examiner said...

Old bank examiner maxi-um:
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- Raise LT debt when you can
- Buy insurance when it's cheap

MelB said...

Unfortunately, and I feel this is an industry wide bias, being in cash too often is viewed as either stupidity, incompetence or both. Talk to to any asset manager and tell them you are 65-70% in cash and they'd look at you as if you have three heads. I get the whole argument that managers don't want to be in cash because they don't get paid by being in cash, but I also think that a lot of them actually genuinely believe that being fully invested is the only way to go. That is troublesome.

Hondo the bondo said...

James, please expand on this concept, from institutional investing to consumer finance.

I assume you think term life insurance, homeowners' property insurance and auto insurance are good ideas to get. Applying your "buy when insurance is cheap," I would think you'd recommend buying term life when one is young, and auto insurance at times far removed from an accident or traffic violation.

What about extended warranties on products like computers, iPhones, or lawn mowers? The insurance is only offered cheaply at time of purchase. Is it "cheap" to buy an extended warranty on a computer at point of sale?

John MacKenzie said...

Some long-side investors have the option of adjusting their cash position, while others don't. They're have to be 100% "in" all the time. For them, tail insurance is important regardless of its price. Over time, they'll be able to buy it cheap, fair and rich. They won't get a bargain on it, but they'll have it just in case.

John MacKenzie said...

If you want to buy insurance only when it's cheap, then it makes sense to monitor the VIX. Here's a picture of the changing "price" of insurance over the past 20 years:

http://www.scribd.com/doc/33528321/VIX-Over-Time

John MacKenzie said...

Sorry. The VIX graph was accidentally deleted. Here is a replacement link:

http://www.scribd.com/doc/34832519/Charting-the-VIX-1990-2010

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I agree that the insurance should be super-expensive! Once, I've been working abroad as a writer at one of custom writing services and my principle told me about an obligation to have an insurance. He suggested me to try a cheap one, as far as I couldn't pay much money. I can say for sure that cheap one I made didn't differ from the expensive ones that my colleagues did.

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