Thursday, April 22, 2010

Insurance

The government's lawsuit against Goldman Sachs has had me thinking about insurance. After all, Goldman's John Paulson was "betting against" bad mortgages, and one means of doing that is taking out insurance against these bad mortgages.

Doesn't this mean insurance is essentially gambling? Let's look at insurance against bad mortgages. The bank offers a mortgage to someone unlikely to pay (a "bad" mortgage). Then an investor (perhaps the bank itself) takes insurance against the mortgage - if the mortgage fails, the investor gets paid. If the mortgage works out, the bank gets paid. So then, we'll sell the obligation of the mortgage to someone else (or chop it into tiny pieces and bury shares of the obligation into funds all over the place with better investments) and also let other people become beneficiaries of the insurance. So the bank makes the money from unloading the mortgage and the insurance policy.

The thing is, there are theoretically opportunities to take out insurance on anything. Now bankers want to project futures markets on not just stocks but how individual films perform, for example.

Hmm. Does this mean I can offer "Detroit Lions insurance" to NFL fans? They can pay me a fee and every time the team loses, they'll get some small return on the loss. But if the team does better than expected they don't get anything (except the satisfaction of the team doing well). Since some people will think the team will do poorly, they'll buy into my insurance program. But others will think the team will do poorly, so I can sell them the insurance obligations. This is just gambling right? I think the team will do poorly so I put money into insurance. Or I think the team will do well so I'll buy out the insurance policies since I'm sure I won't have to pay anything out.

Of course, then we could package teams from different leagues together to decrease the risk. So you could buy a fund mixed of Lions / Nationals / Knicks insurance! I think we can make derivatives out of this too.

Who needs gambling when you have insurance?

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