“Investors take first steps to possible Manulife class action over annuities.”

The above is the title of a recent Financial Post article.  I wanted to make a couple of points here:

The first is that the laying off of risk from those who cannot bear it to those who can is fine if you are dealing with risk events that are not systematic (i.e. a house burning down, a plane crashing, or even hurricane risks), but that taking on systematic risks that are likely to affect everyone at a given point in time (global financial meltdowns) is not.  

The second is that some organisation somewhere has to be taking on the risk, it cannot be offset forever.  This leads to counterparty risk (amongst other risks) and the impact of counterparty risk on these reinsurance spirals.   If it were not for central bank and government intervention we would have seen a collapse in the derivatives market place in 2008 and 2009.  Counterparty risk in itself is dependent on the distribution and depth of counterparties but, as was and remains, the case, counterparties are highly concentrated in the market place.  Many complex products make supposed “guarantees”, whereas in reality the certainty of the guarantee itself is unknown.

Thirdly, entirely laying off portfolio risks on the one hand transfers risk returns away from investors, while on the other hand, in an outlier risk event there is no certainty that the guarantee will be met. 

I did a considerable amount of modelling on this issue back in 2006/7/8, and my conclusions were that these products would only really pay off in an outlier risk event that exceeded the boundaries of past risk events, and that in such an event the market would likely not be able to meet these liabilities.

There was and remains too much laying off and and reinsuring of risk in the market place, and this remains both a significant moral hazard (central bank intervention etc) and a risk to the financial system.   Indeed, with the large amount of synthetic leverage within the financial system at the moment, the risk that insurance will not pay off and will likely negatively impact the financial system remains extreme.

I have always believed that risk in the market portfolio should be managed at the margin and that organisations that took on wholesale market risks in the interests of flogging product did so with eyes wide open.  

And finally, the industry needs to develop portfolio risk products that manage risk at the margin, that retain sufficient return for the investor and that transfers manageable risk to the financial system.  

Derivatives, The Risks They Pose & Consumer Fundamentals

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