Last October 1, I argued here that the debris of securitization after the current financial crisis would still contain great utility, as at least some of the financial innovations of the last few years are likely to outlive the securitization excesses. I also referred to possible gains to be accrued in Latin America from a sort of “late securitization” process provided that lessons learnt from the pioneers’ experience are applied.
A colleague from the Inter-American Development Bank (IADB), Bernardo Weaver, has recently called my attention to a product with which he has been working and that would constitute a perfect illustration for my upbeat view. He referred to a scheme of securitization of micro-insurance operations that may permit higher scales and lower funding costs in such a market with high impact on the welfare of poor people and, at the same time, unattractive features for traditional financial institutions.
Micro-insurance as a frontier within microfinance
Microfinance – provision of financial services to poor or low-income people who are not “bankable” – is advancing fast throughout the developing world. The advance has been such as to lead Muhammad Yunus, the Nobel laureate pioneer of micro-credit, to warn last week against risks of a bubble-generating entry of big banks into the market (FT, July 29).
Notwithstanding the booming features of microfinance, and micro-credit in particular, in a world where economic integration of poor people has been dynamic in many regions and has started to attract attention of opportunity-stripped traditional financial institutions, micro-insurance is still lagging behind. According to Martin Buehler, from International Finance Corporation (IFC), “Micro-insurance is now where microfinance was about eight to 10 years ago. Microfinance now is a multibillion dollar industry. Micro-insurance is probably not yet in the billion dollar premium area.”
Either to assist the provision of micro-loans or as a stand-alone product, the availability of low-cost micro-insurance to “un-bankable” people has an obvious potential to ameliorate life conditions and welfare. This is not the time and place to address perils and conditions under which microfinance, and micro-insurance in particular, must operate, but one can take for granted that financial exclusion of large population contingents cannot be a good thing. The Chart below (taken from here) shows the wide range of needs that microfinance can help attend.
Micro-insurance displays in stark form those features that make microfinance a challenge: high transaction costs per unit of value, constraints to enforceability of contracts and use of collaterals etc. Furthermore, in order to succeed, micro-insurance needs to face the following requisites:
(i) it has to reach massive market penetration, with contracts sold to vast numbers of people at very low rates and providing coverage against relatively small losses;
(ii) it has to display simple and direct underwriting methods;
(iii) its commercialization methods have to adapt to an environment in which there is no previous accumulated experience with the product by clients; and
(iv) it must be offered with coverage of multiple events, in a combined fashion.
The last feature highlights how different the ethoses of micro-insurance and traditional insurance are. While the latter is all about slicing risks as much as possible, in order to guarantee accuracy and appropriate pricing of underwriting and claims handling, the former has to rely on mass underwriting, and mass claims handling.
No wonder non-profit institutions still mainly permeate the universe of micro-insurance. Let me refer now to how the product outlined to me by Bernardo Weaver may help reduce the mismatch between, on the one hand, the ugly features of single micro-insurance contracts and, on the other, the need of minimum scales to make feasible the operation with the corresponding products.
GILR-Bond: as attractive and sinful as other securities, yet worth it
A Group Insured Loss Ratio Bond (GILR-Bond) is a securitization of bulks of insurance contracts. In essence, through a GILR-Bond, investors in exchange for cash flows assume some pre-defined portions of the contingent liabilities associated with a cluster of micro-insurance contracts. The GILR-Bond would be an insurance-derivative swap, which is a complete or partial ceding treaty reinsurance agreement issued as a bond in the market.
By lump-summing vast numbers of micro-insurance contracts, one is able to slice and dice risk dimensions, what otherwise would be unfeasible to attain. Financial engineering can then decompose and transfer the returns of the bundle of underlying micro-insurance contracts into different fundamental components of risks (credit defaults, maturity mismatch, inflation risks etc.)
Thus, micro-insurers may become able not only to manage better their risk exposures, but also scale-up their funding, freeing themselves from the restriction of only operating with conventional re-insurance. Competition in funding micro-insurance would be enhanced, as outsiders would also be able to accrue portfolio diversification gains by acquiring risk-return positions in fields uncorrelated with their conventional ones.
“There they come with a new sub-prime-like adventure”, the reader might say. Besides the point that sub-prime clients also deserve to be integrated, and that the baby does not have to be thrown out with the water of recent malfunctions, there is some ground to believe that the development of GILR-Bonds and others in “late securitization” processes may avoid most of the pitfalls of the current US mortgage mess.
At the current juncture of the sub-prime crisis, there is already a reasonable outline of what went wrong with financial innovations. Indeed, the originate-to-distribute model revealed much intrinsic vulnerability that had been underestimated. However, not many analysts have rushed to decree a “death of securitization”.
In a recent well-balanced stocktaking, Jenkinson et al. remark that:
(a) With the benefit of hindsight, we realize now how difficult it had become to establish the pay-off distribution for many complex structured products, with high sensitivity to small macroeconomic landscape changes.
(b) Some information is inevitably lost as the distance between originators and end-investors increases, and the information gap thereby generated cannot be simply filled by rating agencies.
(c) Given the extension reached by the full network of exposures as instruments unfolded into successive waves of derivatives, the assessment of counterparty credit risks became not much reliable.
(d) The three previous informational problems sowed the ground for endogenous risk-creating behavior by investors. Incentives for due diligence and monitoring at the origin were diluted. Additionally, investors became prone to herd-like behaving and other “anomalous” reactions.
(e) Information uncertainty and misaligned incentives led to increasing market liquidity risks, which revealed to be very high when a bout of suspicion was sparked.
(f) The predominance of non-standardized products negotiated over-the-counter in broker-dealer relationships rather than through centralized clearing houses, accentuated the shortcomings above listed. Increasing operational risks went unobserved – including the extent to which the expansion of transactions outstripped the ability of back offices to update trading positions.
(g) Information uncertainty, misaligned incentives, and markets with rapidly-vanishing liquidity turned the whole structure of securities liable to amplify adverse shocks coming from primary (“natural”) assets.
Notwithstanding those pitfalls associated with the originate-to-distribute model, one may bet on its resurgence, even if in a more frugal lifestyle: simpler-to-understand and transparent products, standardized and negotiated primarily through clearing houses, with a higher content of risks kept explicitly by originators and issuers, as well as clearer rules governing collaterals. On top of a self-selective market process that will tend to favor such features, it is likely that future financial regulation will give a hand in the same direction. The fact is that the upside aspects of securities are material enough to impede their complete scrapping.
It is worth noticing that the wild party experienced by securities, followed by a heavy hangover, cannot be explained as a self-contained process. Ultimately, the whole edifice – or castle of cards – was built upon a generalized willingness to overlook risks, as caused or manifested by long enduring “razor-thin credit spreads” (Heise). Whether those razor-thin credit spreads were to be explained by lax monetary policies and a “Greenspan-put”, or rather by some sort of Hyman Minsky’s shrinking – or suppressed – “cushions of safety” as an outcome of the “Great Moderation”, it is hard to put the whole blame of the financial crisis on securitization as such.
“Late securitization” processes may benefit from lessons learnt from the boom-bust experience of pioneers. And indeed the former shall have many opportunities to use a post-crisis generation of securities, among other ends to enlarge microfinance and improve life conditions of poor people. A Group Insured Loss Ratio Bond (GILR-Bond) is just an example.