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Reverse Retros

Written by Rudy Whitcomb, dated: April 18, 2010

By now the story of how a formerly prestigious and internationally famous investment bank colluded with investors to package subprime loans and sell them off to banks and small towns in Norway is history. Behind this scheme, the participants may have taken out an insurance policy to pay if the packages failed. A version of this method of risk transfer enjoyed a period of popularity in the insurance business in the mid 1970’s. At that time it was called it a "reverse retro" or "Chinese retro".

A conventional retrospective (retro) rating plan rewards an insured by reducing the premium back if the insured’s loss experience is favorable. For instance, coverage was arranged for a major commercial airline. The standard, going- in premium was $12,000,000 and the maximum premium, if the airline suffered losses could become as much as $18,000,000. Separately insurers were requested to insure against that retro penalty by covering the difference between the minimum and the maximum.

That spread was of course $6,000,000. Insurers put up that limit for a rate of 10% on line, or $600,000. The airline’s board of directors, wishing to "fix" their insurance costs for that year paid the extra $600,000 to guarantee that their total insurance expense would not exceed $12,000,000 plus the "penalty policy", or $12,600,000 rather than take the chance of having losses that caused the retrospective rating to increase the premium to as much as $18,000,000.

Then an instrument that came to be known as a "Chinese retro" was introduced that paid off in the event the loss experience did deteriorate. Some insurers were offered these instruments but declined, feeling that they were against public policy. They had the effect of rewarding bad loss experience. Chinese or reverse retrospective rating plans were reviewed by the State of California Department of Insurance. In 1977 The California DOI ruled these unlawful. Credit Default Swaps written were an insurance instrument. The brokers and bankers utilized an insurer to guarantee the cd’s and did so strictly because of the insurer’s triple A bond rating. The insurer is a New York domiciled insurance company, subject to "triennial" review by the state of New York Department of Insurance.

The state of New York has a guarantee insolvency fund. The insolvency of that insurer would have fallen on the New York insolvency fund. The State of New York Insurance Commissioner took the position that the financial instruments written by that insurer and that caused it’s collapse were not insurance. This moved the responsibility beyond the purview of the New York Insurance Departments triennial review and made the transactions not subject to the State of New York Guarantee insolvency fund.

The insolvency "fund" is created upon the collapse of an admitted insurer. That is, one domiciled in that state. The fund is paid for by assessing other companies admitted to do business in that state. This is accomplished by charging a percentage of the premiums paid by policy holders in that state as an "assessment". Had the New York commissioner’s position that those policies written by that insurer for those banks and brokers weren’t actually “insurance” been set aside, the federal government would have had no call to step in and using taxpayers money bail out the insurer. It would have been a matter for the state of New York and its residents to address.

A technique similar to credit default swaps was utilized to provide a stop loss protection to a well known New York Bank for its book of lease business. Coverage was arranged for $100,000,000 excess lease default cover for the bank’s book of leases. This was to protect in case the book of leases default rate exceeded a certain threshold. However the end result was insurance had significantly reduced if not eliminated the banks lease officers need to carefully underwrite the leases they made. Why should they? If they messed up they had insurance to fall back on. Reflecting on the credit market in general, if the wholesale cost of money is 4% and the interest rate charged on loans is 7% the gross spread is only 3%. Overhead must be factored in. In the insurance business, overhead, exclusive of profit, is 6% plus acquisitions costs (commissions, advertising etc). If the rate on the stop loss insurance is, for instance, 1.5% to 2% on limit, the net to the lending/leasing institution is very thin. Thus once started down this path, lenders were driven to larger and larger transactions.

As respects credit default swaps and loans packaged and sold as “investments”, the red flags at the other end were that homebuyers were encouraged to overextend themselves by buying homes they could in no way afford. For federal regulators and economic advisors and all the others to miss that obvious fact is inconceivable and really demonstrates their complete disconnect with the marketplace.

Of course everyone in the chain was responsible:

For the government to have reacted to the outcome by giving taxpayer money to bail out the very villains that perpetrated this fiasco is as big a mistake as any made by any other participant in this charade. That goes to everyone, from the foolish and too easily dupable homebuyer to the lenders to the regulators. In reality, there are plenty of banks and lending institutions that didn’t go along with this tidal wave of bad practices. Unfortunately they are being painted with the same brush as their competitors who did throw prudence to the wind.

The end result is an erosion of confidence in the system and rules of an economy based on capitalism.