Do we need Insurance if we can
bottle Certainty like Coca Cola?

by
William Krehm

These days the excessively entrepreneurial are as busy on the dimension of time as Einstein was a century ago. Einstein, however, had a better idea of what he was up to.

Take this front-page story of The Wall Street Journal (3/06, “In Echo of Sept. 11, a Bitter Spat Roils Aviation Insurance” by Mark Maremont):

“Burlington, N.C. – Not long after the Sept. 11 attacks, a small army of auditors showed up at a non-descript brick building in this sleepy textile town. Hauling in nine photocopiers, they began sifting the records of Fortress Re Inc., an insurance firm. Though little known in its hometown, Fortress was a bold player in the high-risk world of aviation reinsurance. As an agent for three large Japanese reinsurers, Fortress was a leading seller of policies that covered big chunks of the losses in many aviation catastrophes. For 24 consecutive years, Fortress reported to the Japanese insurers that the business it oversaw was profitable.

“But when 3,000 lives, four jumbo jets and the twin towers of the WTC were lost on 9/11 alarms went off in Tokyo. Concerned about their exposure two of the insurers sent in their own auditors to look at Fortress’s books.

“One insurer, Nissan Fire & Marine Insurance Co., contends it has uncovered a massive fraud in which Fortress hid some losses by, in effect, borrowing the money to cover the claims. While the Japanese insurers were incurring a giant bill, a Nissan Fire lawyer alleged in a hearing in federal court in Greensboro, N.C., Fortress’s owners were ‘skimming off’ hundreds of millions of dollars in part via a Bermuda firm they owned.

“Fortress’s general counsel, Glenn Drew, denies any fraud or other wrongdoing and says the suit is just an effort by a big insurer to avoid paying losses from risks it knowingly incurred. The insurer profited for years, he says, but ‘after 9/11, all of a sudden they didn’t like the deal they cut.’

“In Japan Taisei Fire & Marine Insurance Co., one of the three big insurers that worked with Fortress, has become only the second casualty insurer to file for bankruptcy since World War II.

“The events have roiled the global reinsurance market – essentially, insurance for insurance companies, which buy policies from others to lay off part of their own risk. Some who bought policies from Fortress wonder if they’ll be able to collect. At the same time, Fortress’s sudden absence from the market has exacerbated a post-9/11 surge in the cost of aviation insurance.

“Nissan Fire’s suit against Fortress is on hold while the parties pursue arbitration, in which Fortress has filed breach-of-contract and other counterclaims.

“Maurice D. Sabbah, 73, founded Fortress 30 years ago, and was soon joined by Kenneth H. Kornfeld, 55. Despite the “Re” in its name, it wasn’t an insurer. Instead it managed a reinsurance business for the Japanese insurers – committing them to policies that Fortress sold, and taking a share of the profits. Aviation eventually became the main focus.

“Say an airline takes out a policy from a group of primary insurers for up to $1.5 billion per crash. The primary insurers, not wanting to keep so much risk, decide to retain only the first $100 million of it. They unload the rest to reinsurers by buying several policies from them. One might cover the layer of losses from $100 million to $400 million. Another might cover the losses from $400 million to $700 million and so on. These reinsurers, in turn, often seek to minimize their own risks by buying reinsurance themselves, from still other companies.

“If there’s a plane crash, every insurer that that has covered a layer of risk has to pay its part. It’s a big global industry that includes such prominent companies as Swiss Re Group, General Electric Co., Berkshire Hathway Inc., and the Lloyd’s of London syndicates.

“As an agent, Fortress sold reinsurance policies on behalf of the three Japanese insurers. They gave Fortress broad authority to commit them to policies. Some of these entailed hundreds of millions of dollars of exposure, but their deal with Fortress called for it to obtain reinsurance that cut their exposure to just $49,000 per policy.

“The business model: Fortress would collect premiums on the insurance it sold, then attempt to buy reinsurance for a lower premium. The difference – minus fees and claims – was profit, to be shared between the Japanese insurers and Fortress. Such ‘managing general agency’ setups have been used for decades, but are relatively uncommon in the reinsurance end of the business.

More recently Fortress dominated an estimated 40 to 60% of the aviation insurance niche – that covering losses between $50 or $100 million and $400 million of crash claims. In any major disaster claims are likely to be made within these ranges. It is thus amongst the riskiest portion of the business. And their prices were surprisingly low. Many insurers stepped back from taking advantage of the seeming bargains because they felt that sooner or later Fortress was bound to get into trouble.

Nevertheless, from 1998 to 2000 Fortress reported to its Japanese clients that it had achieved for them – before its commission – $275 million.

From there it was all downhill for Fortress. Nissan Fire requested permission to examine Fortress’s records, but the request was fended off. They retained lawyers. Sept. 11 made it clear that huge losses must have been incurred. At that point Nissan Fire was allowed to have PricewaterhouseCoopers examine the books on their behalf.

It is one of the charms of the contemporary business world, that for every big problem there is a seeming solution, that in fact is not really what it appears to be. “In place of traditional reinsurance that transfers risk to others, Nissan’s suit says, Fortress made extensive use of a much-less-costly product known as ‘financial reinsurance.’ Instead of transferring risk, this is like a line of credit from a bank. If there is a claim, financial insurance pays off – but by making what is essentially a loan, which has to be paid back in future years through higher premiums.

And thus the law suits trundle on.
However, this tale raises the question how much risk management and insurance are feasible in our deregulated, globalized world where mobile interest rates are singled out as the one stabilizer and a highly unstable one at that. In such a setting many of our crucial reckonings are based on the fiction that we can foretell future profits sufficiently well to book them as current earnings, and, moreover capitalize them on the assumption that they will continue to expand in the future at the rate at which a questionable accountancy has presented them as having expanded in the past.

To make matters worse, the one remaining financial nexus between the present and the future is interest rates. Beset with all these uncertainties, the further question arises: with so much verging on the make-believe in the economy, why should insurers feel obliged to cling to more rigorous standards? That is the big question that is gnawing at the guts of our society. It must be answered.