Friday, January 30, 2009

Systemic Risk Super Cat Insurance

Let's take a break from splenetic rants about bad government to contemplate the possibility of good government, shall we? Fast forward to 2025: Our economy is chugging along at 5% annual growth. Warren Buffett cloned himself 51 times, then those 51 clones were employed to overcome every state and federal pension deficit. Each has succeeded mightily, avoiding what could have been a catastrophic burden on future development and growth.

Various aggregator banks took over the heaping pile of dog poo that was our national banking system, and they've made it hum again. We've got industrial growth across the board, most notably in the paint-solar energy field. This neat little innovation has allowed us to place solar cells inside common paint products, enabling cars, houses, and hovercrafts to power themselves with their decorative coatings. It's a marvelous development, and it comes in thousands of shades, from mauve to burnt Siena. Everyone's happy, though talk of "Peak Oil" production has been replaced by fearmongers babbling on about "Peak Paint."

Still, the forward-thinking regulators of 2025 are starting to worry. Once again, there are many businesses growing to the size where, if they were to face hard times, their collapse could unhinge the entire financial system. Much like Lehman, AIG, Morgan Stanley, and General Motors in the days of yore, these companies have created systemic risk, even though there's no imminent risk whatsoever. That doesn't matter, though, because our 2025 brethren are wise and forward thinking, and they understand that we need to address this problem BEFORE we are on the brink of systemic failure.

These folks decide what the USA needs is "systemic risk insurance." You heard it here first, folks. These wise souls devise legislation that mandates systemic risk insurance premiums be paid by our nation's most successful companies while they are at their healthiest. The legislation contemplates the creation of a seven-person panel, comprising bankruptcy and insurance experts from across the land, whose job it is to appraise the balance sheets of the largest companies to assess the impact that their liquidation might have on the general economy. Based on this actuarial assessment ((cost of systemic failure*likelihood of failure over 50-year time horizon) + administrative costs of the program), these companies would be levied a tax that would insure the overall economy in the event of their failure. Being "big" doesn't automatically mean you have high payments. McDonald's, for example, would have a low risk of failure and low premiums. If you're levered 20 to 1 or insuring CDS beyond your capital base, your premiums might make you think twice about the way you run your business.

The responsibility to pay out on this "super cat(astrophic)" event could be handled by a well-capitalized private company (along the lines of a Berkshire Hathaway, not an AIG) or by a federal agency.

Right now, we're dealing with the costs of systemic risk at the time we can least afford it. You don't try to buy renters insurance after you burn your apartment complex down. You do so before it happens. I think a similar maxim should apply to systemic risk. That's all I have to say about that.

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