4 ms·

It's not betting (gambling), it's insurance. Is insurance insane?

by erichocean 10y ago

jdmichal 10y ago
How could you call it insurance when you have no interest in the original security? What are you insurance against?
- jkimmel 10y ago
  You don't need to be a direct party in a contract to be affected by it. You can insure against possible negative outcomes of someone else's contracts. e.g.) Party A and Party B sign a contract that Party B will pay Party A $X by some date. Party A has seperately agreed to pay you $0.9X shortly afterward. You are a savvy businessperson and realize that Party A will not have $0.9X to pay you if the Party B fails to make their payment. Party B is on the rocks after a nasty reorg, and you think the probability they fail to pay is significantly greater than 0. You want to protect your business against this event. To do so, you purchase a Credit Default Swap from Party C for $0.05X that ensures the full $0.9X payment. While Michael Barry was "speculating" using CDS's, you could also argue that he was "insuring" his firm against a housing crash, which did tank most investment vehicles.
  - iofj 10y ago
    Why are these parties allowed to make contracts like that without putting up collateral ? I can pay a bum on the street 10 dollars to sign his name on a contract like that (that he'd take over these payments in the case of bankruptcy). He would not pay up if it does happen. Apparently the situation is the same with these banks. Isn't this fraud ? They're signing insurance contracts they know they might not be able to pay up. Why don't we demand that they put the money into a locked account like every landlord on the planet does with tenants ? If you don't have that guarantee on a locked account, not used for anything else, then why is that contract accepted as hedged risk ?
- erichocean 10y ago
  @jkimmel is 100% right: You don't need to be a direct party in a contract to be affected by it. Here's another example: I buy a house at a higher-than-usual price for the area, expecting its value to increase because of some development that is occurring nearby—an automotive manufacturer has recently agreed to build a plant about 10 minutes away, creating around 2000 jobs in the area. However, the deal still needs to be approved by the Feds. If I wait until the approval, the house might cost even more to buy and potentially make my investment unprofitable (or not profitable enough). But if the plant is not approved, my house will likely not gain enough in value and I will have paid too much. To insure against the Feds not approving the plant, I can by a CDS against that risk. I will lose a small amount of profit in my eventual sale of the house to pay for the CDS, but will also prevent a large (profit) loss in the event that the plant is not approved. Note: In this example, I do not have any direct interest in the (future) plant, or the auto manufacturer, and I obviously do not control the actions of Federal regulators. Nevertheless, I am exposed to risks (and benefits!) taken by them as a homeowner in the area, and a CDS can be used to insure against those risks at minimal cost. Admittedly, this is fairly sophisticated for an individual homeowner, but this kind of thing is routine for financial professionals. CDS is a kind of insurance, and it's totally legitimate, even though you are usually not insuring something you have a direct interest in.
  - jdmichal 10y ago
    I see. Thanks for the clarification. I would definitely still consider that insurance -- as you said, you're really insuring your vested interest in the property. If you were doing such and you didn't even have an indirect interest, I would consider that gambling. Of course, this is just my own personal subjective consideration. Not related to the official definitions of these terms at all.
- rlucas 10y ago
  Insurers (eg casualty insurance) have no interest in the underlying. They are pure speculators. Gotta have a counterparty.

It's not betting (gambling), it's insurance. Is insurance insane?

jdmichal 10y ago

How could you call it insurance when you have no interest in the original security? What are you insurance against?

jkimmel 10y ago
You don't need to be a direct party in a contract to be affected by it. You can insure against possible negative outcomes of someone else's contracts. e.g.) Party A and Party B sign a contract that Party B will pay Party A $X by some date. Party A has seperately agreed to pay you $0.9X shortly afterward. You are a savvy businessperson and realize that Party A will not have $0.9X to pay you if the Party B fails to make their payment. Party B is on the rocks after a nasty reorg, and you think the probability they fail to pay is significantly greater than 0. You want to protect your business against this event. To do so, you purchase a Credit Default Swap from Party C for $0.05X that ensures the full $0.9X payment. While Michael Barry was "speculating" using CDS's, you could also argue that he was "insuring" his firm against a housing crash, which did tank most investment vehicles.
- iofj 10y ago
  Why are these parties allowed to make contracts like that without putting up collateral ? I can pay a bum on the street 10 dollars to sign his name on a contract like that (that he'd take over these payments in the case of bankruptcy). He would not pay up if it does happen. Apparently the situation is the same with these banks. Isn't this fraud ? They're signing insurance contracts they know they might not be able to pay up. Why don't we demand that they put the money into a locked account like every landlord on the planet does with tenants ? If you don't have that guarantee on a locked account, not used for anything else, then why is that contract accepted as hedged risk ?
erichocean 10y ago
@jkimmel is 100% right: You don't need to be a direct party in a contract to be affected by it. Here's another example: I buy a house at a higher-than-usual price for the area, expecting its value to increase because of some development that is occurring nearby—an automotive manufacturer has recently agreed to build a plant about 10 minutes away, creating around 2000 jobs in the area. However, the deal still needs to be approved by the Feds. If I wait until the approval, the house might cost even more to buy and potentially make my investment unprofitable (or not profitable enough). But if the plant is not approved, my house will likely not gain enough in value and I will have paid too much. To insure against the Feds not approving the plant, I can by a CDS against that risk. I will lose a small amount of profit in my eventual sale of the house to pay for the CDS, but will also prevent a large (profit) loss in the event that the plant is not approved. Note: In this example, I do not have any direct interest in the (future) plant, or the auto manufacturer, and I obviously do not control the actions of Federal regulators. Nevertheless, I am exposed to risks (and benefits!) taken by them as a homeowner in the area, and a CDS can be used to insure against those risks at minimal cost. Admittedly, this is fairly sophisticated for an individual homeowner, but this kind of thing is routine for financial professionals. CDS is a kind of insurance, and it's totally legitimate, even though you are usually not insuring something you have a direct interest in.
- jdmichal 10y ago
  I see. Thanks for the clarification. I would definitely still consider that insurance -- as you said, you're really insuring your vested interest in the property. If you were doing such and you didn't even have an indirect interest, I would consider that gambling. Of course, this is just my own personal subjective consideration. Not related to the official definitions of these terms at all.
rlucas 10y ago
Insurers (eg casualty insurance) have no interest in the underlying. They are pure speculators. Gotta have a counterparty.