October 17, 2008
Regulatory Rule #2: Insurance Products Need to be Regulated
Posted by Mike Guttentag

Let’s again consider the scenario in which you are running an agency charged with overseeing financial markets, and you want to prevent a crash similar to the one in October 1987.  What measures should you take? Regulating financial products that mimic insurance is an obvious first step.

Over the centuries, unregulated insurance markets have proven to be prone to failure.  Insurance products require regulation for good reason.  Insurance involves collecting money now in exchange for a promise to provide payments at a later point in time, if certain events occur.  This kind of transaction offers seemingly irresistible temptations to over-collect and under-reserve, and there are often significant limits on the ability of private parties to avoid these risks.  For example, an individual policy holder is unlikely to be able to prevent their insurer from increasing its risk exposure after the insurance policy is purchased.  This is why for over two hundred years insurance products have been regulated.

Recall that the “villain” in the October 1987 crash was a product called portfolio insurance.  Portfolio insurance involved selling equity futures into a declining market to limit losses, and, despite its name, portfolio insurance was a financial strategy, not an insurance product.  Who “sold” the portfolio insurance that ended up bringing down the markets in 1987?  A small company founded by three finance professors. 

But the portfolio insurance trading strategy had the defining attributes of an insurance policy: a promise to shift risks of future declines to another party.  Due to unanticipated market volatility, the cost of getting coverage from portfolio insurance proved to be higher than anyone anticipated.  Would as many institutions have purchased portfolio insurance if they knew how much it would ultimately cost?  Probably not.  Would markets have crashed as dramatically with fewer portfolio insurance holders?  Probably not.  Would a regulatory intervention requiring that the sale of this “insurance” be accompanied with adequate “reserves” have better reflected the actual cost of the insurance? Almost certainly.  Sound familiar?  It should come as no surprise that inadequate insurance regulation is again at the center of a major market downturn.

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