Econ 101

"What's an insurance company?" I asked Mike on our walk this morning. I'd heard the term now and then through a constant white noise in our house that I believe is called cable TV news.

M knows the answers to lots of questions about business because he spent nearly half his life teaching in a university business school. (When people find out he was a college professor, they often want to know what he taught, and he tells them morons and idiots. But I think he's just jerking their choke-chains. His actual field was economics and his main focus was corporate finance.)

"An insurance company," he informed me, "is a firm that sells you peace of mind by guaranteeing to take a particular kind of risk off of your shoulders for a price."

I gave him my best "Why The Fudge?" face, which told him he needed to simplify. (He says he used to get that look from his students, too.)

"Every so often," he explained, "say every month or three months or year, you pay the company some money. Those payments are called premiums and what they do is buy you a policy. As long as you pay the premiums, you own the policy--unless of course the company decides to cancel it."

"They can do that? They can stop your policy even if you keep giving them your money, right on schedule?"

"Does a stray dog poop in the woods?"

M told me about the time a few years ago when my Cousin Ginger was visiting from Kentucky and crazy old Willis scratched her eye. It took a veterinary ophthalmologist many stitches and cost about $1,400 to repair the damage. When M filed a claim with his homeowners insurance company, they paid a not-very-mind-boggling $500 and a few months later told him his policy would not be renewed.

"But let's not get into that right now," he said. "Let's at least start positive. So the company invests your premiums in a portfolio of stocks, bonds, and other things. Then if something bad happens to you and it's covered in your policy--say you die or get sick or your house burns down or you wreck your motorcycle or maybe you're a doctor and you accidentally amputate the wrong leg and then get your pants sued off--the insurance company, because you are a valued policyholder, is obliged to cover your losses. With some exceptions like Cousin Ginger, this usually amounts to a lot more than the premiums have cost you up to that point--and certainly more than you can afford to pay out of your own pocket. Are we okay so far?" So much for simplifying.

"But that doesn't make sense," I sputtered. "How can the insurance company afford to promise you more than you pay them?"

"Well, they tell you it's because you're pooling your risk with lots of other customers who have the same kind of risk but who don't have losses at the same time as you."

"What if lots of customers do have losses at the same time?" Something in the white TV noise about an oil leak in the Gulf of Mexico and some old storm called Katrina told me this was a distinct possibility.

"A good point. For starters, you can always count on the company to deny as many claims as possible," he said. "In fact, that's the big gun in their arsenal. It's their favorite part of the whole insurance business model. While we're on that topic--which is one of my pet peeves--here's a word to the wise: Don't ever confuse having health insurance with having health care. Insurance companies don't make money by paying claims!"

I chewed on that for a moment. "So these companies can get your money and never pay it back, even though they've said they will if the bad thing in the policy happens to you?"

"Not if they can help it."

"Cool," I said, and he sort of scowled at me. "Tell me," I continued, "about this portfolio thingy that they invest your premiums in."

"Back in the old days it was made up mainly of the stocks and bonds of other companies in lots of different industries. That's called diversification and it's used to reduce risk. Stocks and bonds are your two basic kinds of corporate securities. Their owners--the insurance company in this case--would collect dividends on the stocks and interest on the bonds and sometimes they were also able to buy the securities for a low price and sell them later at a higher price. That gave them a special kind of profit called a capital gain. So they had investment income from these three different sources. Plus a regular income called commissions that are part--sometimes a very large part--of your premiums."

"Suh-WEET!"

"Sweet for a while. But then the financial wizards got greedy. Over the years they invented things called derivatives that let speculators--that means investors who have more money than brains--try for huge profits by putting up very little of their own capital. Eventually, fed by something called a housing bubble, this speculation reached a fever pitch. The profit potential was enormous. It made the traditional insurance company's dividend and interest income look like chump change."

"Wait--let me guess," I said. "So then the insurance companies wanted to do derivatives, too?"

"Smart doggie!" M replied, patting my head. "And one of their favorite new toys was a little thing called a CDS or credit default swap."

"How does a CDS work?" I begged, wagging my tail in anticipation. The secret of a prosperous life was about to be revealed.

"It seems nobody knows for sure. Not the insurance and other financial moguls who had their traders buying and selling them by the bazillions of dollars. Not the government watchdogs--some of whom used to be the same big financial CEOs who gave them the green light in the first place. Probably not even the MBA whiz kids who invented them. One thing is certain, though: They didn't work the way the market thought they would.

"They were supposed to allow a bondholder to get rid of his default risk by paying a speculator to assume it. Modern financial markets are all about passing risk along to somebody else--like a hot potato. The trouble is, deep in their souls no one really wants to be the ultimate holder of someone else's risk. And they have no real intention of doing so. They intend, instead, to cover their positions while things are still relatively rosy. But if the regular stock and bond markets hit the skids for any big unforeseen reason, the derivative markets can dry up fast. If you're among the last to own some, you might not be able to unload them. You can't even tell what they're worth, because there's no one bidding for them."

"So what happens then?"

"If you're a small player--tough noogies. But while your Roth IRA and 401(k) are going down the financial tubes, the big insurance companies and the mega-banks and brokerage firms get to enjoy another special kind of income called a government bailout."

Necessity, it turns out, is the mother of intervention! My head was spinning. I knew it was going to take me a while to process all this.

"And who came up with these little beauties--these credit default swaps?" I asked M when I found my voice again. "Did I understand you to say it was some enterprising MBAs?"

"I did."

"And--uh--did you ever teach MBA finance students?"

"Yes--but I never taught them to be greedy. I was Dr. Squeaky-Clean Balance Sheet. My whole approach to finance was safe and boring and old-fashioned."

"Still, you must be very proud."

"Don't be a moron!" he said as he gave my choke-chain a sharp tug.