Mark-to-Market vs Mark-to-Model in the Insurance Industry

How do you turn low-rated mortgages into high-rated bonds? There are basically

two ways: overcollateralization and insurance. The spotlight has been on the

former of late, as people wonder whether the overcollateralization models reflect

the reality of the subprime market over the past year or two. And now the other

shoe is dropping: David Reilly, today, wonders

what the exposure of insurers in general, and AIG in particular, might be to

the subprime meltdown.

AIG, of course, has its own models of how much it stands to lose on insurance

it’s written against subprime losses. But models, as we’ve seen, don’t always

match with market reality.

The company also said it didn’t see problems related to a kind of insurance

contract, or derivative, it has written against financial instruments that

include some subprime debt. AIG based its all-clear signal for those derivatives

on the fact that its internal models show that losses are extremely remote

in the portions of the investment vehicles it’s insuring. No likely losses

means no reason to worry, the company reasoned.

Yet the company’s valuation models seem to ignore the fact that those derivatives

would likely take a haircut if sold in today’s depressed market. "There’s

no way these aren’t showing a loss," says Janet Tavakoli, president of

Tavakoli Structured Finance Inc., a Chicago research firm. That’s simply a

market reality, she adds, that should be showing up in AIG’s results.

This raises an interesting question. Increasingly, there are market-based alternatives

to insurance products: you can issue catastrophe bonds in the market, for instance,

rather than insuring against a catastrophic event. In this case, AIG’s insurance

is pretty much identical to the credit default swaps that are being traded in

the market and which have seen huge price volatility of late.

But when insurance companies have been in their business for decades or longer,

while the open market in such things is very young, does it really make sense

for insurance companies to use market valuations rather than their in-house

models? Yes, models can be wrong – but so can the market, especially,

as now, when there’s a lot of stress and volatility.

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