March 25, 2015

Drawing the Line Between Gambling and Finance:
Part V—Hedgers and the Law

Note:  This is the fifth article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article.

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Having looked at some of the more common aleatory contractsinsurance, reinsurance, and derivatives—and found strong parallels between those legally accepted contracts and various forms of gambling, it is time to return to the original question: Why are contracts like insurance and derivatives legal if they are fundamentally identical to gambling?

The short answer is that the law regarding aleatory contracts has long reflected a struggle to resolve the tension between the economic benefits of risk hedging on the one hand, and the moral and economic dangers of unbridled speculation on the other hand. This legal tension has spanned several centuries and been addressed across many cultures. The American legal system has traditionally taken a conservative approach to aleatory contracts, permitting those which show clear economic utility while being slow to permit or enforce contracts which resembled traditional wagers. But, as the American economy has evolved into a leader in the modern sophisticated global financial markets, the American legal system has likewise evolved to accommodate a broader array aleatory contracts.

The Historical Utility of Insurance
"This [New York City] has only been made possible by the insurers. They are the ones who really built this city. With no insurance there would be no skyscrapers. No investor would finance a building that one cigarette butt could burn to the ground."

~ Henry Ford
Insurance is the oldest form of legal aleatory contract, with some forms of economic risk pooling dating back to at least the ancient Babylonian empire; the Code of Hammurabi recognized a form of insurance protecting merchants' goods transported by ship or caravan against loss by storm or theft.

With the rise of the British Empire, insurance became an important and increasingly sophisticated part of international commerce as reflected in the founding of the famed Lloyd's of London underwriting syndicate. Interestingly, the close relationship between insurance and gambling was never far from the surface. As maritime insurance revenues fell, the Lloyd's underwriters turned to other lines of insurance, some of which—death by gin drinking, say—might raise a modern regulatory eyebrow. And the Lloyd's underwriters also turned to other, more traditional forms of aleatory contracts:
"Lloyd’s coffee house soon became notorious as a gambling den. An extract from the London Chronicle of the time [1768] stated: ‘The amazing progress of illicit gambling at Lloyd’s coffee-house is a powerful and very melancholy proof of the degeneracy of the times.’"
American insurance law, as might be expected, derives heavily from English common law. The American insurance industry was slow to develop in colonial times, mostly because the high risks of loss in the New World were deemed uninsurable by established British insurers. But, following the Revolutionary War, numerous American insurance companies were founded. Despite some moral opposition from conservative churches, the American insurance industry was doing robust business by the early 1800s; ironically, one of the first insurance corporations was organized by the Presbyterian Synod of Philadelphia to protect its ministers and their dependents.

The Economic Utility of Risk Hedging

The legal acceptance of insurance contracts is based on their economic utility; insurance is legal because it is economically important. The economic benefits of insuring against catastrophic loss are readily apparent. But insurance offers other, less obvious, economic benefits. For example, two of the largest expenses most people will routinely encounter are purchases of a house or vehicle. Generally, these purchases are made on credit, via a home mortgage or an auto loan or lease. Without insurance to protect their collateral, banks would be reluctant to offer credit on as favorable of terms. Instead, banks would require larger down payments (to limit the extent of possible losses) and would charge higher interest rates (to compensate for their higher risk of loss). In other words, insurance not only protects against large scale losses to homes and vehicles, but in many cases, insurance makes the purchase itself possible.

Similar principles apply in the commercial context. Without insurance, businesses would be reluctant to make large-scale capital investments in, say, buildings or machinery, if those investments were subject to loss because of fire or storm. To the extent businesses face uninsured risks of any kind—whether from fire, storm, theft, cyber-attack, lawsuit, or other cause—prudent financial planning will result in the maintenance of substantial capital reserves to cover those uninsured risks. Insurance, then, is not just a risk mitigation tool, but a method by which businesses can free up capital for investment into business operations.

Insurable Interests and Moral Hazards

Insurance, then, derives its legal status from its obvious economic utility. The ability of individuals and businesses to hedge against catastrophic risks not only protects those purchasing insurance, but also serves to lubricate the general economic machinery. But the law is careful to limit insurance to a hedging function through a concept known as insurable interest.

The insurable interest doctrine requires a party purchasing insurance to possess some legal interest in the object of the insurance policy. For example, an individual can insure his own life, but cannot insure his unrelated neighbor's life. Similarly, a business can insure its warehouse against fire, but cannot insure the warehouse of a competitor. Although the underlying insurance contracts in each case might look the same, the purpose of the contracts is fundamentally different. When insuring a life or property in which a person or business has a direct legal interest, the purpose of the insurance is hedging against risk of loss. When insuring life or property in which a person or business has no direct legal interest, the purpose of the insurance shifts to one of pure speculation. As the U.S. Supreme Court stated:
A contract of insurance upon a life in which the insured has no interest is a pure wager that gives the insured a sinister counter-interest in having the life come to an end. And although that counter-interest always exists, as early was emphasized for England in the famous case of Wainewright (Janus Weathercock), the chance that in some cases it may prove a sufficient motive for crime is greatly enhanced if the whole world of the unscrupulous are free to bet on what life they choose. The very meaning of an insurable interest is an interest in having the life continue, and so one that is opposed to crime. And, what perhaps is more important, the existence of such an interest makes a roughly selected class of persons who, by their general relations with the person whose life is insured, are less likely than criminals at large to attempt to compass his death.

Grigsby v. Russell, 222 U.S. 149, 154-55 (1911) (emphasis added).
In other words, absent an insurable interest, an insurance policy is nothing more than rank gambling, a wager on misfortune befalling a third party. Worse, the lack of an insurable interest creates an acute risk of moral hazard—specifically, the risk that an insured will destroy property or kill a person insured in order to profit from the contract. Regardless of whether a moral hazard actually arises, this type of speculation on the misfortunes of others is generally regarded as morally repugnant. The law, therefore, has long refused to permit speculative insurance contracts, and regards as void any insurance contract in which an insurable interest is lacking.

Gambling With Insurance

Interestingly, the U.S. Supreme Court ultimately ruled in Grigsby that life insurance is a form of property that can be assigned (transferred) to another person, even a person lacking an insurable interest in the underlying policy. In other words, the insurable interest requirement is satisfied by the initial purchaser of the policy, who is then free to sell the policy and its benefits to anyone. This ruling eventually led to the explosion of viatical settlements in the 1980s and 1990s, as individuals with AIDS sought to extract enhanced cash value from their life insurance policies by selling them to speculators who would pay below the policy's death benefit but above the actual cash value of the policy (which might be zero in a term life policy, or relatively small compared to the death benefit in a whole life or universal life policy). The speculator would pay the policy premiums, and would profit if the insured died early enough such that the policy death benefit exceeded the purchase price plus additional premiums. Viatical settlements are also common with other acute diseases with limited treatment options and short life expectancies, such as certain types of neurological diseases and cancers.

Similar to viatical settlements are life settlements, where an individual may sell to a third-party a life insurance policy the individual no longer needs. As with viatical settlements, the purchaser is speculating that the policy will "pay off" with the insured dying early enough that the death benefit exceeds the purchase price plus subsequent premium payments. Life insurance policies purchased via viatical or life settlements are sometimes bundled and securitized as so-called death bonds (essentially turned into an asset-backed security, as discussed in Part IV of this series). Because of the potential for abuse and fraud, most states tightly regulate viatical and life settlements. Nonetheless, viatical and life settlements are the one area where the law permits insurance to be used for speculation—specifically, "gambling" on the life of a stranger.

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Next up, discussion of the law's view of speculation.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management


March 19, 2015

The Usual Brackets:
America's Curious Embrace of Sports Gambling

"The greatest trick the devil ever pulled was convincing the world he did not exist. And like that, poof. He is gone."

~ Roger "Verbal" Kint (Kevin Spacey), in The Usual Suspects (1995)

Today is the beginning of one of the great American sports holidays—the NCAA men's basketball tournament, a/k/a "March Madness", a/k/a "The Big Dance". Tens of millions of Americans who rarely if ever gamble will enter office pools, filling out brackets to pick the winners of 63 basketball games over the next three weeks, hoping to win a piece of prize pools which can range from enough to feed a family off the fast food value menu to thousands of dollars in some higher stakes contests.

My first time winning a bracket contest was my junior year of high school. I was in a pool with a handful of guys on the basketball team, along with our coach (who was also the principal). The stakes? The winner got a free soda (50 cent value in those days) from each of the losers. Keith Smart and "The Shot" kept me in quality caffeine for a week.

It was also my first big gambling win.

In the ensuing couple of decades, I have participated in and/or organized scores of NCAA basketball pools in numerous formats (all scrupulously conducted within the requirements of Iowa's social gaming statute, of course). There have been straight brackets, randomly drawn brackets, and brackets with upset bonuses (add the difference in seed to the points for each win). There have been "against the spread" brackets where players draft teams which play through the bracket with the Final Four teams getting the prize money; the catch is that the "winner" which advances is the team that beats the spread. There have been Calcuttas, where teams are auctioned off to the highest bidder, with a percentage of the overall pool awarded for each win. For years I operated a Sweet Sixteen second-chance "confidence pool" which required participants to rank the remaining teams in the tournament, with weighted points awarded for wins.

One of my favorite pools was one operated by a friend and (now former) law partner. His pool had five games; your standings in the overall pool were determined by your agregated standings from the individual games:
  • Game 1:  Standard straight bracket.
  • Game 2:  Rank the top ten potential champs. Winner is the person with the eventual champ ranked highest (first tiebreaker was highest ranked runner-up). A "go for broke" strategy would be to eliminate one team from your picks which is a popular championship pick among the rest of the participants (say, Duke, to pull an example from thin air). If that team doesn't win, you likely have a major edge in where you've ranked the actual champion. 
  • Game 3:  Pick all first round games against the spread. Picking all the dogs was usually a winning strategy. 
  • Game 4:  Pick one team from each seed level (i.e., pick one of the four 1-seeds, one of the four 2-seeds, etc. all the way to one of the four 16-seeds). Points are scored for each win, with points doubling each round. 
  • Game 5:  Pick any five teams. For each win, you get points worth the picked team's seed divided by the seed of the team they beat (i.e., if a 5-seed beats a 12-seed, you get 5/12 = .417 points, while a 12-seed beating a 5-seed would get 12/5 = 2.4 points). So, a 1-seed or 2-seed doesn't score many points until the late rounds, but is likely to go deeper, while a lower seed might score big points early, then fall out of the tourney. A good strategy was to pick seeds 2-6 likely to make deep runs, with maybe one flyer on a 10-12 seed likely to win a couple of games.
The best part of the pool was that participants and their guests would watch the championship game together in a sports bar. The kicker was that while the top 40% of participants split the prize pool, the bottom 40% had to split the tab for the party. You could always spot the locked-in winners—they were the ones drinking the top shelf booze. And with numerous tiebreakers in play, many participants were rooting for strange outcomes in order to make the money or miss the bar tab: "You need North Carolina to win by more than six in regulation, or you need two overtimes and total points scored under 166."

Regardless of structure, all NCAA pools are gambling, assuming there is an entry fee. Frankly, NCAA pools are nothing more than the bastard love child of sports betting and keno (though Wall Street could probably sell them as "sports derivatives"). Whether these pools are illegal depends on applicable state gambling laws; many states carve out small-stakes social gaming from their criminal gambling and bookmaking statutes. Of course, even where NCAA pools are technically illegal, law enforcement rarely pursues them unless they are high-stakes or there are complaints of cheating or theft.

Despite being blatant gambling, NCAA pools occupy something of a moral and legal blind spot in American culture. President Obama can broadcast his bracket picks every year without any criticism that he is promoting gambling. Celebrities like Kevin Jonas and Kati Couric can participate in "celebrity bracket challenges" without fear of damaging their wholesome public images. Sitting down to help their young children fill out brackets is part and parcel of being an All-American Dad these days; none of these parents would dream of playing casino-style games with their kids. In Congress, fifteen Representatives have signed on as co-sponsors of an expansion of the federal Wire Act which prohibits electronic transmission of sports betting information; if I were a betting man—and I am—I would wager most of those Representatives have staff, friends, and family using one of the mainstream online sites (CBS Sports, ESPN, Yahoo) to manage their brackets. Opponents of online gambling legalization often dramatically tout the dangers in "making every cell phone a casino"; how many of them have a bracket tracking app on their own cell phones or tablets?

Americans' embrace of NCAA pools is directly at odds with their general hostility toward gambling. Recent Iowa polls, for example, show strong majorities opposed to legalization of online gaming (71% opposed) and daily fantasy sports contests (63% opposed). So why do NCAA pools get a free pass from America's otherwise judgmental gaze?

Our collective cognitive dissonance on the status of our brackets undoubtedly arises from the wild popularity of college sports in general and March Madness in particular. Even the most casual of sports fan is drawn to the drama of the tournament, rooting for their favorite team(s) and cheering for David-versus-Goliath upsets. Filling out brackets augments the enjoyment of the experience by giving fans something to root for in every one of the 63 tournament games, and something to talk about with friends and co-workers.

NCAA pools are just an old-school version of social gaming, the sports equivalent of Farmville or Candy Crush. Sure, they might cost a few bucks, but filling out brackets for a fun contest with friends or coworkers is nothing like calling a bookie or going to a casino. So, with a wink and nod, Americans have collectively convinced themselves NCAA pools are entertainment, not gambling. Fiction though it may be, that's our story and we're sticking to it.

March 11, 2015

Drawing the Line Between Gambling and Finance:
Part IV—Derivatives and Daily Fantasy Sports

Note:  This is the fourth article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article (when available).

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Overview of Derivatives

Moving from the world of insurance into the world of finance, another important set of aleatory contracts are the derivative contracts ("derivatives" in common shorthand). Although derivatives come in a myriad of variations, they all share one important feature—the contract derives its value by reference to an underlying value. As we will see, that underlying reference value can be something as simple as a stock price or interest rate, or something as complicated as a portfolio of mortgages, a stock index, or even the temperature in a particular city.

Some of the more common kinds of derivatives include:

Forwards and Futures: Forward contracts and futures contracts are related types of derivatives in which one party agrees to sell a set amount of an asset for a fixed price at a designated point in the future. The most significant difference between forwards and futures is that futures are standardized contracts while forwards are non-standard and can be tailored to the specific needs of the parties; thus, futures are generally “exchange traded” while forwards are sold “over the counter”. A classic example of this type of derivative are commodity futures which are used to trade a wide variety of commodities such as agricultural products (e.g., grain, pork bellies, coffee, and sugar), metals, and oil. The current price is reported using both the price and the date; “September Corn is at $4.04” means that a contract for standard-grade corn to be delivered in September carries a price of $4.04 per bushel. The plot of the classic comedy movie Trading Places starring Eddie Murphy and Dan Aykroyd revolved around an attempt to corner the market on frozen orange juice futures.

Options: Options contracts give one party (the buyer) the right, but not the obligation, to buy or sell an asset (typically shares of stock) at a set price on or before a specific future date in exchange for an up-front premium paid to the seller. An option to buy is referred to as a “call option”, while an option to sell is referred to as a “put option”. If the buyer exercises his option, the seller is obligated to sell or buy the asset at the agreed price, even if the market price is substantially higher or lower. If the buyer does not exercise his option, the contract expires. In either case, the seller keeps the premium.

Swaps: Swaps are contracts in which the parties exchange the cash flows of two financial instruments. Common versions of swaps include interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. Swaps permit parties to gain the benefits of the underlying alternative financial instrument without incurring the potential legal, tax, and other downsides of an actual transfer of ownership.

For example, one common swap—the interest rate swap—permits two parties who each have loans with different interest rates to swap or exchange the interest payments on the loans. For example, assume two companies have issued corporate bonds, one party at a fixed rate, the other party at a floating rate (e.g., a rate tied to LIBOR or U.S. treasury rates). The party whose bonds have a floating interest rate might want to be able to lock in a fixed rate on the assumption that rates will rise. The counterparty might like to move to a floating interest rate loan, on the assumption rates would fall. By using a swap, the parties gain the benefit of a different interest rate without needing to redeem and reissue their bonds, a process that would be both expensive and difficult. Also, note that individuals holding these companies’ bonds could also enter into an interest rate swap, although their expectations would be the opposite of the expectations of the underlying companies—i.e., a bondholder with a fixed rate bond would swap with a floating rate bondholder expecting interest rates to rise, not fall.

Interest Rate Caps, Floors, and Collars:  Closely related to interest rate swaps are interest rate caps, floors, and collars. These derivatives are contracts in which the buyer pays a commission in exchange for a guarantee of payment if interest rates rise or fall below a predetermined point. These derivatives are commonly used as a form of insurance on bonds or other debts which have a floating interest rate. These derivatives are also useful for companies which have a business model highly sensitive to changes in interest rates, even if the interest rate derivative is not purchased to hedge a particular debt instrument.

Asset Backed Securities and Collateralized Debt Obligations: Asset backed securities (ABS) and collateralized debt obligations (CDO) are derivatives which are created by pooling underlying assets, typically various loan and debt obligations, then paying the loan proceeds (interest and principal) to the contract holders as they become due. ABS/CDO can be created from a wide range of underlying debt obligations, including mortgages, student loans, credit card debt, and auto loans. A CDO differs from a vanilla ABS in that the debt proceeds are divided into slices ("tranches") which prioritize the order of repayment. This process allows the earlier tranches to be given higher credit ratings as they are much less likely to suffer a loss in the event of unexpected default rates in the portfolio of loans underlying the CDO. The 2008 recession was precipitated in large part by a real estate bubble market created in part by the packaging of subprime residential mortgages into mortgage-backed securities (MBS) and real estate CDOs which then experienced unexpectedly high default rates (partially due to shoddy or fraudulent mortgage underwriting practices).

Credit Default Swaps: Another derivative, credit default swaps (CDS), also played a key role in precipitating the 2008 recession and stock market crash. Although nominally a swap contract, CDS function as insurance against default on a debt obligation (e.g., bond or ABS). For example, a CDS buyer might hold a large number of corporate bonds issued by one company, or a block of similar ABS (say a portfolio of RMBS), thereby exposing the buyer to risk if the issuing company or the underlying industry sector suffer adverse financial results. For a fee or commission, the CDS seller agrees to pay off the underlying debt instrument in the event of a default or other negative credit event. In 2008, insurance giant AIG became insolvent as the result of collateral calls on billions of dollars of CDS it issued in connection with RMBS, as those RMBS became financially impaired in the wake of the real estate market bubble collapse. With many institutional investors exposed to financial risk if AIG collapsed, the federal government stepped in with an $85 billion bailout.

Derivatives: More Than Financial Risk Insurance

Because derivatives are aleatory contracts, they necessarily contain an element of risk (or chance, if you prefer). Thus, like insurance and reinsurance, derivatives are an excellent tool for financial risk and volatility management. In a sense, derivatives can be understood as a form of financial insurance. Investors can hedge the risk of a falling stock market through options. Futures allow producers of raw materials to hedge against falling market prices, while manufacturers can hedge the risk of rising raw material costs. Many businesses and investors can be adversely affected by fluctuations in interest rates; derivatives can offer protection against these fluctuations tailored to the purchaser's specific need. As with insurance, there is always a premium, commission, or fee associated with the derivative contract, but the purchaser deems that cost acceptable in exchange for reduction in financial risk and volatility.

Derivatives, however, go beyond acting as financial insurance in two respects. First, derivatives such as CDO and ABS also provide the benefit of transforming a relatively illiquid assete.g., a bundle of mortgages or credit card accountsinto a security which can offer a less risky stream of income payments than the individual underlying loans. In essence, the process of securitization spreads the risk of any one individual loan defaulting across the full pool of loans aggregated for the CDO or ABS. So, CDO and ABS offer banks and other debt writers a way to market their debt-based assets, while investors have a method of participating in the debt market via less risky and more liquid securities.

Derivatives also go beyond the financial insurance function by creating ways to monetize non-financial risks. A classic example are so-called weather derivatives, which base payment on how much temperatures or precipitation levels fall above or below certain points over a set period of time. So, a business adversely affected by unusually hot or cold weather, or by unusually high or low precipitation levels, can purchase protection against this type of risk, and receive a monetary payoff if extreme weather conditions occur. And, unlike insurance, the weather derivative pays off without any need for the purchaser to quantify any weather-related losses.

Taking matters yet another step, reinsurers have entered the weather derivative market with insurance-linked securities (ILS), which essentially are derivatives based off an underlying reinsurance pool. For example, a reinsurer with a large block of property insurance policies on the books in an area at high risk for hurricanes, tornadoes, or earthquakes might issue catastrophe bonds (or "cat bonds") in which outside investors pay a premium in exchange for a payment of money if a defined catastrophic weather event does not occur, or based on the value of an index of natural catastrophe events.

Fantasy Sports League Or Sports Derivative Investment Fund?

Which brings us to fantasy sports. Fantasy sports started out as an effort by hardcore baseball fans to essentially play general manager and put together a better team than their opponentsusually friends or work colleagues—in a friendly league. Because these fantasy teams obviously do not exist in real life, they cannot play actual games. Instead, the players on each fantasy team roster are awarded points tied to the performance of the players in real life games.

Over the past two decades, participation in fantasy sports has exploded. Much of this growth is tied to the rise of online sites which take care of much of the tedious record keeping and scoring functions, leaving players free to focus on evaluating players to draft or trade. More recently, fantasy sports have experienced another boom with the advent of daily fantasy sports (DFS) sites in which contests run not for a full season, but for only a day.

Although DFS is legal in most statesand legislative efforts are underway to clarify the legality of DFS in the other handful of statesthere has been a growing debate as to whether DFS has gone too far and approaches being a form of gambling. Although whether DFS is "gambling" requires something of a value judgment, there is little question DFS is an aleatory contract, and more specifically, a type of derivativea sports derivative, if you will.

DFS contests clearly involve an element of risk or chancespecifically, the uncertain nature of any player's performance on a given day. There is a fee associated with the contests. The financial results of DFS contests derive from the performance of all of the players drafted in their underlying real life games, much like derivatives can be tied to the performance of outside stock or commodity prices, securities indexes, interest rates, or even weather events. And, much like weather derivatives, DFS contests act as sports derivatives by awarding financial payoffs based on a non-financial performance.

The DFS industry assiduously eschews any connection to gambling, instead marketing DFS as a "skill game". Top DFS players tout their analytical chops in winning hundreds of thousands of dollars a year, enough to even lure some to quit their Wall Street trading jobs for a regular DFS grind. Yet, there is a fairly strong public sentiment that DFS at least borders on being gambling. In New Jersey's ongoing legal battle to legalize traditional sports gambling, the state has asserted that DFS is akin to sports betting. And as prominent sports bettor Haralobos Voulgaris tweeted, "Newsflash to the NBA—DFS is actually gambling."

The question then becomes: Why is the legal system—and for that matter, the general public—comfortable that stock options, commodity futures, and even weather derivatives are not gambling, but concerned that a DFS contest—a de facto sports derivativemight be gambling? As we will see, the answer to that question is complicated.


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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management


March 09, 2015

Drawing the Line Between Gambling and Finance:
Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Note:  This is the third article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article (when available).

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Purpose of Reinsurance

In the last article in this series, we looked at insurance contracts and how they function. Although insurance companies are in the business of assessing and accepting risks, there are situations where insurers look to limit their risk exposure. The primary tool for insurance risk management is through reinsurance. Reinsurance treaties (as such contracts are traditionally denominated) are complex and high-dollar business arrangements by which insurance companies achieve certain financial goals—risk reduction, volatility reduction, and capital management.

With respect to risk reduction, an insurance company might review its block of business and note that it is vulnerable to a particular risk. For example, a property insurer might note that it has a high volume of insured properties in areas at risk for hurricanes or tornadoes. Or perhaps an insurer notes it has insured multiple office buildings in a single block or fire station district, making it vulnerable to heavy losses in a large-scale fire. In many cases, an insurer might want to write policies with large benefits (e.g., a $5 million life insurance policy or a $2 million dollar homeowners policy), but be uncomfortable being at risk for the full policy amount, particularly where the insurer writes a decent volume of such policies. And sometimes an insurer will write a special endorsement or surplus lines policy to accommodate an insured's special risk needs, but the insurer will be uncertain it has properly underwritten the risk. In each of these situations, an insurer would seek out reinsurance in order to reduce its risk profile by laying off some portion of the excess risk.

Reinsurance assists insurance companies with volatility reduction by smoothing over differences in year-to-year loss experience. Reinsurance treaties tend to involve long-term, multi-year relationships between insurer and reinsurer. In a given decade, an insurer might have three years with massive underwriting losses which are offset by the other seven years of moderate to significant underwriting gains. Yet the years with large losses might interfere with the insurer’s long-term business plans. By sharing the risk with a reinsurance partner, the insurer is able to achieve smoother, more predictable cash flows, enabling it to maintain a longer term business perspective (e.g., holding premium levels steady rather than raising premiums—and losing market share—in an attempt to immediately recoup losses).

Finally, reinsurance is a key tool for capital management by insurance companies. Insurance companies are subject to strict regulations meant to ensure they will be able to meet their obligations to policyholders. The cornerstone of these solvency regulations is statutory accounting, which places greater emphasis on the balance sheet and liquidity than do the generally accepted accounting principles (GAAP) commonly used in most other industries. An insurance company can only write more new policies if it has sufficient surplus (positive working capital) to support the policy. Yet, under statutory accounting, when a new insurance policy is written, the full amount of the actuarial reserves and policy acquisition costs (e.g., commissions, expenses, and other overhead) must be immediately posted to the balance sheet as liabilities, rather than amortized over time. So, writing new business quickly erodes surplus, leading to surplus strain. In such a situation, an insurance company can find new capital, stop writing new business, or find surplus relief by laying off part of the policies (and their attendant reserves) on its books through reinsurance.

Reinsurance Structures

Reinsurance can be structured in a number of ways, but the basic forms are facultative and obligatory (a/k/a treaty) reinsurance (see SwissRe's "Essential Guide to Reinsurance", pp. 22-24). Facultative reinsurance is where a large individual risk or policy is ceded to the reinsurer; e.g., a multimillion dollar property policy on a commercial building or a multimillion dollar life insurance policy on a company’s CEO. Obligatory reinsurance, by contrast, allows a block (portfolio) of similar risks or policies to be ceded as a unit; e.g., a block of all automobile liability policies written by a company during 2014.

Risk allocation under a reinsurance treaty can also be structured in several ways (see SwissRe's "Essential Guide to Reinsurance", pp. 25-30). In quota share reinsurance, the insurer and reinsurer(s) each receive a proportional amount of the premiums and pay proportional amounts of losses, with the primary insurer being paid a commission by the reinsurer for the costs of selling and administering the policies. For example, a primary insurer might keep 25% of the premium (plus its administrative commission) and cede the remaining 75% to one or more reinsurers (it is common for multiple reinsurers to take from 5% to 50% stakes in the ceded risk). When losses become payable, the insurer pays the claims and then is reimbursed by each reinsurer for their share of the losses.

Other kinds of reinsurance risk allocation methods operate by permitting the primary insurer to retain the first full layer of risk and associated premiums (the retention) with all risk and premiums/losses above that amount allocated in various fashions to one or more reinsurers (again, the primary insurer is paid a commission by the reinsurer for the costs of selling and administering the policies). Such arrangements include surplus share, excess of loss, and stop loss agreements which are tied to particular blocks of policies, as well as catastrophe and aggregate agreements which are tied to losses caused by a single large-exposure event (e.g., a hurricane, thunderstorm cell, or large fire) or by a series of large-exposure events (e.g., multiple hurricanes or storms), respectively. For example, a reinsurance treaty might provide that the primary insurer will retain the first $500,000 of risk per policy, and reinsurers will assume and share responsibility for losses above $500,000 per policy. Or, a primary insurer with high storm loss exposure could enter into a combined “catastrophe aggregate” reinsurance treaty in which the primary insurer would retain the risk for losses of $10 million per storm and $100 million per year, with reinsurers sharing losses above those retentions.

Reinsurance v. Bookmaking

Despite its complexity, reinsurance shares some traits in common with simpler and more common gambling world concepts. Consider, for example, a typical local or retail sports book operator. The bookmaker’s business model is essentially a specialized form of insurance—attempt to take roughly even bets on each side of a given game or wager, pay the winners with the wagers of the losers, and keep his commission (“vig”).

However, the bookmaker faces two financial risks. First, betting may fall unusually heavily on one side of a wager; if that side wins, the bookmaker will need to pay the winners out of his own pocket. Second, a bookmaker might face an unexpectedly large individual wager or a high volume of wagers (perhaps on the NCAA tournament or the Super Bowl). Here, the bookmaker faces a financial risk if there is a notable default rate by losing bettors. The solution? In both cases, the bookmaker retains the amount of wagers he is comfortable with keeping in light of his risk appetite and working capital. The bookmaker then passes along (“lays off”) those wagers he is not willing to risk—along with the accompanying risks and profits—to a larger bookmaker, online sports book, or even a legitimate sports book. In other words, the bookmaker is limiting his risk exposure through use of what are essentially stop loss, catastrophe, and aggregate reinsurance principles.

Reinsurance v. Poker Staking

Reinsurance also bears strong resemblance to the practice of poker staking. In general, poker staking is an arrangement where a poker player receives some percentage of the buy-in to an individual or series of tournaments or cash game sessions in exchange for a roughly commensurate share of any profits. The staking agreement can have one or more backers, and each backer may have a different share in the agreement. Typically, the player will retain a piece of the action, and will be paid a premium (“markup”) in compensation for the investment opportunity and the player’s efforts in actually playing in the tournaments or cash game sessions. Essentially, poker staking is analogous to a specialized version of quota share reinsurance—facultative if only for certain high-stakes tournaments or cash games, obligatory if for a set series of tournaments or period of time, with markup playing the role of the commission paid by the reinsurer to the insurer for administrative costs.

Poker players seek staking arrangements for the same three reasons insurers seek out reinsurance—bankroll (capital) management, risk reduction, and volatility reduction. Bankroll management is essentially a working capital issue. A poker player might have a positive expected value advantage in, say, the World Series of Poker or a cash game session with some wealthy whales in Bobby’s Room at Bellagio. But the player might not have enough money to buy in to the tournaments or cash games without putting too large a percentage of their liquid working capital at risk. Staking gives the player the ability to take advantage of these potentially profitable games while maintaining prudent bankroll reserves. Similarly, even if a player can comfortably afford to buy in to the tournaments or cash games, poker results can show high volatility, creating a financial risk for even the best player. A staking arrangement, particularly for a single high cost tournament (e.g., the WSOP Main Event or a high roller event) or an expensive series of tournaments (e.g., the full WSOP tournament slate), can both reduce financial risk and smooth out the inherent volatility of poker results. This reduction in risk and volatility, of course, comes at the price of reduced profits from successful tournaments and cash game sessions subject to the staking arrangement.

Even more interesting is the alignment in interests between reinsurers and those who stake poker players. Reinsurers are seeking out high rates of return from specialized investments; so are poker stakers. Reinsurers want to be able to participate in an insurance market without the hassle and expense of getting licensed and dealing with regulators, not to mention designing, selling, and administering a block of insurance policies. Likewise, poker stakers want to participate in the opportunity to make money in poker tournaments or cash games, but without the hassle of actually playing. Reinsurers tend to bring highly sophisticated risk analysis to bear in evaluating potential deals; though this skill is not necessary for successful poker staking, the best poker stakers demonstrate a keen evaluation of poker playing skill when choosing players to stake.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management

Drawing the Line Between Gambling and Finance:
Part II—Insurance: Gambling on Catastrophe

Note:  This is the second article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to subsequent articles can be found at the conclusion of this article (when available).

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Types of Insurance

Insurance is probably the most familiar and ubiquitous of the aleatory contracts. People face a variety of significant financial risks, such as house fires, car accidents, injuries and illnesses, or even the loss of income from the death of a family member. People can protect against these large, even catastrophic, financial losses by purchasing property insurance, casualty insurance, health and disability insurance, and life insurance, respectively.

Just about any risk can be insured, for a price. Most individuals rarely need anything more than “off the shelf” personal lines of insurance (e.g., homeowners’/renters’ insurance and auto insurance), along with health and life insurance. Businesses tend to carry “off the shelf” commercial lines of insurance, usually including at least a basic group of insurance coverages for commercial property, automobile, general liability, and workers’ compensation. Businesses also will take out additional insurance tailored to their particular business needs. Common commercial insurance coverages include aircraft, product liability, fidelity and surety, professional liability (a/k/a malpractice insurance), directors and officers, and inland marine policies (which ironically usually have nothing to do with either the ocean or soldiers).

Individuals or businesses having special risks not covered by a standard policy can obtain insurance by use of an endorsement or rider which expands coverage under a standard policy; this generally requires special underwriting review, additional premium, and special conditions or limitations on coverage. Particularly large or unusual risks often need to be insured via a special policy specifically written for the risk, often referred to as surplus lines insurance. Lloyd’s of London is famous for this type of specialty underwriting, often insuring singers’ voices or athletes’ bodies, as well as movie productions and rare art and jewelry. Insurers will write policies for events as silly as a hole-in-one at golf, or as difficult to predict as weather. For those individuals who are at risk (mostly teens in bad movies), there is even insurance available in the event the insured is abducted by aliens or turned into a vampire or werewolf.

Insurance as Wagering

An insurance contract essentially operates like a wager. The person purchasing insurance is betting a small amount of money (the “premium”) that a particular event will occur (e.g., his house burns down), in which case the insurance company will pay him the policy “benefit” (here, the value of his house. Given the asymmetrical financial arrangement—small premium, large potential benefit—how does the insurance company make money?

Insurance companies rely on two concepts to set the correct premium for a given insurance policy—underwriting and risk pooling. Underwriting looks at a variety of factors—e.g., geography, age, gender, type of business—which have been found to statistically correlate with the particular risk being insured, charging a greater premium for insuring more risky insureds. For example, a college-aged single male with multiple moving violations on his driving record is more risky to insure than a middle-aged married woman. Conversely, a middle-aged female smoker with diabetes would pay a higher life insurance premium than a healthy college-aged male. And some geographical regions will have a greater or lesser overall risk of car accidents or mortality.

In some respects, underwriting is analogous to a sports book operator setting a wagering line on a proposition ("prop") bet. Unlike traditional sports wagers on the winner of a game, the point spread, or point totals (over/under bets), prop bets are one-off wagers on individual occurrences in a game. For the recent Super Bowl, gamblers could bet on props such as the length of the national anthem, which player would score first, and which player would be named MVP. The research the sports books put into setting those odds at a level which would attract action while still giving the house a profit is essentially the process of underwriting.

Insurance Company as Casino

Still, even with underwriting, it is impossible to predict whether any particular individual risk will occur. In other words, while we know young men are more likely to be in car accidents and older smokers are more likely to die, we can’t predict which specific individuals will be in a car accident or die. Even if an insurer properly underwrites a particular risk, random chance may strike and require the insurer to pay off the policy benefit at a large loss.

Insurance companies avoid this risk by implementing risk pooling. Risk pooling harnesses the law of large numbers, which essentially states that over a large number of trials, a probabilistic outcome will approach its expected value. By writing thousands of similar insurance policies, an insurer can spread the risk of losses over the entire block of policies, and hope to experience losses commensurate with its underwriting assumptions.

In risk pooling, insurance companies operate in a fashion analogous to both pari-mutuel wagering books and standard casinos. In pari-mutuel betting, all wagers are pooled together and the house commission (a/k/a “vig”) is taken out. The remaining pooled funds are paid to winning bettors in a proportional manner. Insurance companies similarly pool premiums and pay off “winners” (those who have insurance claims due to an insured loss) with premiums from "losers" (ironically, those who did not suffer a insured loss). The insurance company keeps the remaining funds—known as “underwriting gain”—to cover expenses and for profit. [FN1]

The pari-mutuel wagering analogy breaks down to a degree, however, because a pari-mutuel book will never take a loss paying off winning wagers. An insurance company, by contrast, can have instances in which, for a particular policy year or for a particular block of policies, the paid claims exceed the premiums charged. This type of “underwriting loss” situation is actually rather common in the property insurance field, where one or several large-scale events—hurricanes on the Southern or Eastern coasts, tornadoes in the Midwest, fires or mudslides in California—cause both widespread and high-dollar losses. Insurance companies deal with short-term underwriting losses in several ways: viewing underwriting gain/loss over time (i.e., a block of policies may be unprofitable in individual years yet profitable over ten or twenty years), raising renewal and new issue premiums to recoup losses, and entering into reinsurance arrangements (discussed in Part III of this series).

Given the potential for underwriting loss over the short-term, the use of risk pooling in insurance has a stronger analogue in casino operations. On any given individual wager, the casino knows it has only a small statistical edge. The casino can’t predict which individual wagers will win or lose, or which individual gamblers will walk out with a profit or a loss. Further, casinos can experience short-term losses when a large single bet pays off (e.g., a slot jackpot), or when the casino experiences significant negative variance on wagers by high rollers (Vegas casino gaming revenues are notorious for significant swings from the performance of its high-stakes baccarat tables). But the casino does know that the more wagers it takes, the closer its profits will reflect its weighted average expectation for the built-in house advantage.

Like a casino, an insurance company is indifferent to whether any particular policyholder “wins” or “loses”. In fact, no insurer can predict which of its insureds will “win”—i.e., suffer a loss and be entitled to benefits in excess of the premium paid. The insurer operates by assuming that it has properly underwritten and priced the block of policies such that in the aggregate the total premiums charged will, over time, exceed the total benefits paid. The larger the risk pool, the closer the insurance company’s experience for the block of policies will track with its actuarial projections.

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[FN1] An insurer also makes money on its investment portfolio. The funds ("reserves") held by the company to back its in-force insurance policies and expected claims are invested, predominately in high-grade bonds, along with some other types of permitted securities and assets (state insurance regulators monitor these investments closely for both risk and liquidity). The return on the investment portfolio is included in the setting of premium and expense charges for policies, keeping premiums and expense charges lower than would otherwise occur in a strict risk pooling arrangement. Income from the investment portfolio, rather than underwriting gain, has become the primary driver of profits in modern insurance.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management