The Curse of Insurance

The scenes from "The Big Short," where a few individuals struck it rich by buying CDS during a disaster, might be unforgettable. However, such "insurance-like" derivatives aren't as glamorous as they seem.

For most people, financial market panic means the evaporation of personal wealth and potential crisis. But for some, the sound of the market collapsing is the most beautiful music in the world. John Paulson, known for "The Greatest Trade Ever," is one such individual. His company profited $12 billion during the GFC, surpassing the GDP of many countries, involving an insurance-like financial product—CDS.

Today, we're not discussing CDS but a broader issue: insurance. If you understand insurance, you'll naturally grasp the "curse of insurance."

I believe everyone has encountered a math problem: suppose the probability of you getting into a car accident is 1 in 1,000, and the loss from the accident is 10,000. What should be the "fair" pricing for car accident insurance? In traditional statistical scenarios, the "fair" pricing should be 10. Does this mean people shouldn't buy insurance if the cost is above 10? In reality, insurance costs far exceed 10, with a high premium, yet almost everyone buys insurance. Would we say people's behaviour is irrational and that insurance prices are overestimated?

Most people would probably say no. But if we could short insurance products and had the ability to short a diversified insurance portfolio, such a strategy would indeed be profitable in the long run. By shorting insurance, we become implicit insurance providers, harvesting the insurance premium.

So, is insurance actually overestimated because we lack the ability to short it? I agree that insurance can be overestimated for this reason; assets that can't be shorted are often overvalued, with real estate being a prime example. However, the inability to short doesn't fully explain the massive premiums behind insurance.

Back to whether insurance prices are overestimated and whether insurance pricing is rational. If a financial product can generate returns superior to cash rates in the long term, is it overestimated, and is its pricing irrational?

I believe most people now have an answer. The chart below depicts a long-term profitable strategy similar to insurance. There is stable cash flow during normal times, akin to receiving insurance premiums, but there are significant losses during specific times, akin to insurance company payouts when disasters strike.

Not everyone can bear substantial short-term losses, so they prefer to pay a premium to avoid such situations (refer to "The Art of Knowing Nothing" for analysis). In this case, the premium is divided into a risk premium. The existence of a premium is reasonable, but whether insurance itself is overestimated is a different issue. The insurance premium could be 10% or as high as 80%, indicating a vast difference. So, is insurance "overestimated," and what is a reasonable premium?

Unfortunately, I wish I had an answer. Fischer Black once said prices within a factor of two are fair prices, which many thought was a joke, but he meant it. Low premiums and high premiums give the illusion of market timing, but in almost all cases, market prices are "fair," which is why experts believe market collapses are unpredictable and market timing is unadvisable. The recommended approach is to diversify risks (sell different insurances) and focus on returns from long-term premiums.

I hope the above discussion hasn't confused you about the simple concept of insurance. For this article, the value lies in highlighting that insurance pricing is above the statistically "correct" pricing due to system flaws causing high valuations (inability to short), risk premiums, bubbles, etc.

Although insurance pricing is often difficult to determine whether it's "overestimated," we can identify irrational elements in insurance prices at specific times. In 2005, Hurricane Katrina swept across the US, causing $108 billion in property damage and over 1,833 deaths. Beyond the tragedy, let's look at the insurance industry: after Katrina, disaster insurance premiums rose by 50%. While defining the "correct price" of insurance is challenging, raising risk premiums post-disaster is often irrational, as the objective risk of hurricanes hasn't changed.

One might argue that natural disasters, unlike financial markets, aren't subject to human will. This argument is particularly good; financial markets are indeed different from nature. In the future, I'll write an article based on Soros' reflexivity and investor behaviour in financial markets. However, in this context, it's similar. During crises, market insurance (most commonly options) presents extremely high risk premiums, represented by high VIX levels. Buying put options before the GFC was like buying insurance before a disaster, and high VIX is equivalent to increased insurance premiums post-disaster.

If someone had the foresight to buy insurance (put options) before a disaster, it's easy to imagine they'd profit significantly during the disaster. But if they continue buying insurance, the high insurance premiums during the disaster would quickly erode their gains, possibly within months.

Unsurprisingly, the long-term returns from buying insurance are negative, as you constantly pay a premium above the "correct pricing." There might be short-term, significant gains during disasters, but they can't prevent the long-term negative returns from insurance-type investments.

If insurance premiums increase post-disaster, does it mean buying insurance during calm markets won't yield negative long-term returns? In fact, it doesn't.

Regardless of market risk, the returns from buying insurance are negative. This is the "curse of insurance."

Adding insurance-like assets to a portfolio for hedging purposes doesn't improve the risk-adjusted returns of the overall portfolio, as shown below.

So, what's the conclusion? Surprisingly, the conclusion is: never hold insurance-like assets in an investment context, assuming investment managers lack market timing skills (almost no one reliably does).

References:

• Asvanunt, A., Nielsen, L.N., & Villalon, D. (2015). Working Your Tail Off: Active Strategies Versus Direct Hedging. The Journal of Investing, 24(2), pp.134-145.

• Ilmanen, A. (2011). Expected returns: An investor's guide to harvesting market rewards. John Wiley & Sons.

• Israelov, R., & Nielsen, L.N. (2015). Still Not Cheap: Portfolio Protection in Calm Markets. The Journal of Portfolio Management, 41(4), pp.108-120.

• Mehrling, P., & Brown, A. (2011). Fischer Black and the revolutionary idea of finance. John Wiley & Sons.

• Shiller, R.J. (2015). Irrational exuberance. Princeton University Press.

Disclaimer: The data and information mentioned are from third-party sources, and accuracy is not guaranteed. This article shares information and views, not professional investment advice. Consult professional advice before making investment decisions.

This article was originally written in Chinese and posted on my WeChat platform in 2016. The Chinese link can be found here