Government and disaster

Ross Gittins, in his column this week talked about how much we seem to distrust the government because we don’t want to pay extra taxes to help flood victims, even though we are very willing to give money voluntarily.

And yet Julie Bishop this week complained that the government isn’t doing enough, because some Australians might not be able to take an Australian government chartered plane out of Cairo, as it is taking too long to get there.

I am sure that Cairo is pretty uncomfortable for anyone there right now. Because nobody much has worked for a week, food and money distribution systems are starting to break down, so it is hard to get food, and cash. If you are staying in a central Cairo hotel, you are likely very close to Tahrir Square, where the main protests are, so it is sensible to try and get out.

But as far as I can tell, all the people killed and injured so far have been protesters, or police. A tourist is probably pretty safe, at least so far. It may descend into serious anarchy, but it hasn’t got anywhere near that yet.

I was in Cairo two weeks ago, so I have been thinking about this a lot. If I were in Cairo right now I would be very grateful for anyone helping to get me out. But should the government have to do it? I don’t think there should be that much political capital available to the opposition because people have to wait a few days for rescue from discomfort.

And as I write this, the people of Cairns and Far North Queensland are in the middle of a category 5 cyclone, with the Queensland government warning that for 24 hours, nobody will be able to come to their aid, because it will be too dangerous for emergency workers.

No government can stop that. But from what I can read from far away, the Queensland government has done everything possible to prepare the population for the inevitable.  To me, that is the role of government. It is doing as much as possible to prepare for disaster, taking the tough decisions of creating and enforcing expensive building codes, and then helping people rebuild afterwards.

It is nice to be a citizen of a rich enough country that we can think that airlifting citizens who have chosen to holiday somewhere less stable when everything goes pear shaped. But in a situation when we are arguing about how paying for rebuilding flooded infrastructure? Rescuing the middle class on holidays is definitely optional.

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The smell of gunpowder

It’s New Year’s Eve in Munich, and we’ve just gone for a stroll in the fading winter light. Everywhere around us was the smell of gunpowder. From the small stash of fireworks we bought at the supermarket that morning, and were attempting, at great risk, to light despite not understanding the German instructions. From the 10 year old boys we walked past who looked slightly askance at the idea of adults watching them light up some bangers. And from the geeky looking guy doing some test firing from just behind his garage.

I remember similar wintry walks growing up (without the snow of course). In Australia, in my childhood, the Queen’s Birthday weekend in June* was known as Cracker night. Everyone bought their own fireworks and let them off in the backyard. Most neighbourhoods had a huge bonfire on the Monday night, with communal fireworks, and all the children competing for who could find the parachutes. But it is illegal for ordinary people to buy fireworks in most of Australia now.

During the 1980s, most states in Australia banned the sale of fireworks except to fireworks professionals (although some keen people managed to buy them by filling out copious forms). Here in Germany, people over the age of 18 can buy them on the last three days of the year only.

It’s yet another example of the difference in views on safety between Australia and continental Europe. The stereotype most Australians have of themselves, and outsiders have of us, is that we are fairly free and easy, laid back people, without a lot of rules and regulations.

In reality, over the last 30 years or so, our legislators have become much more risk averse than average. They’ve been much more willing to legislate so that people can’t take risks, even if they want to. So when we go places where risks are available, we are not quite sure what to do about them.

With the result that with Mr Penguin trying (unsuccessfully) to set off the bungers this afternoon with some snowy matches, and Chatterboy and Hungry Boy poking curiously at the iced over pond nearby, I was ridiculously (but fortunately not obviously) worried about the theoretical risks all three of them were taking.

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*not New Year ‘s Eve or the 5th of November, of course, as two years out of three there was a total fire ban.

 

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Riskiness

A few weeks ago, the Penguin family had a very enjoyable time at Rocket Car Day, in inner-city Sydney. Our car, the Silver Surfer, won its heat, and was a respectable third place in its repechage final (also in the SMH here). The day was very enjoyable. It was entirely frequented by inner-west geeks (or those who were inner-west geeks at heart, like us). Each new rocket car that was unveiled was admired by the spectators, particularly those (like the R2D2 car) which had clearly had some decorative effort put in, or some careful design effort.

The organisers had put on a barbecue, in best Australian tradition, and the lightheartedness of the event was summed up by the visual joke of the trigger mechanism

Acme Rocket Car launcher

Also at the event, all of us, wearing sandals, were about two metres away from the person who had a one centimetre diameter hole burnt in her foot by one of the more streamlined entries. She was wearing an enclosed shoe.

The organiser was quoted in the SMH:

‘Last year we drew some blood, there’s a variety of things that go wrong.”

But despite the dangers of stray projectiles, tempered by the rule ”too light, won’t race”, lots of children are apparently part of the elated crowd.

”I’ve always tried to keep the spirit of it very community-based … and very relaxed,” Mook said.

I imagine that this event will be quite different in a few years time. Despite the very strong disclaimers at the beginning (you are watching at your own risk, please stay out of the path of the cars), someone is bound to sue for injuries after a while. And then there will be fences, an entry fee, compulsory enclosed shoes, and the wonderful community spirit will be diminished.

Here in Australia, we have a mixture of ways of compensating for accidents that cause injury. They start from the legal view that if the accident was someone’s fault other than your own, you should be compensated by the person at fault. But they’ve changed a lot over the years, as that view became too expensive, in some cases.

If there is clearly no-one at fault but yourself – bad luck – no compensation. But that group of injuries is getting smaller and smaller. At rocket car day, I imagine the woman with the hole burnt in her foot would have a reasonable case against the person who made the rocket car that hit her, or against the organisers, despite the disclaimers.

And then there are a variety of possible organisations or persons who could be at fault:

• your employer – in which case there are very defined limits as to how much you get per injury
• the person driving the car that hits you – again very defined limits per injury
• someone who can be sued for negligence (for example a council), which relies on the courts deciding how much you get per injury)
• the doctor who caused your injury (which also relies on the courts)
• Nobody (which is what the organisers were hoping in this case)

And, of course, if your injury comes from illness, then there is no-one to sue.

But in New Zealand, they have an Accident Compensation Commission, which gives you the same amount per permanent injury regardless of who was at fault (even no-one, or yourself). The key to this, is that nobody can be sued for causing personal injury. The laws in New Zealand have been changed to stop that.

This approach does seem to genuinely lead to a different attitude to risk. The ACC is funded through employment, car insurance, and general taxation. Which means that community organisations, councils and other people organising events do not have any financial consequences in the event of an accident.

Here in Australia, some laws (notably workers compensation and motor accident laws) have been changed (in different ways in different states), to take away that right to sue. But not for all injuries.The Productivity Commission has recently set up an inquiry into a national disability care and support scheme. This is looking at, among other things, whether there should be a social insurance scheme for all disabilities. On the face of it, that seems like a great idea – the long term disabled in this country mostly get a raw deal, but a very variable one, depending on whether there is anyone to sue. But substantial legal reform would be needed to make that work – providing the funding to make disability compensation a more level playing field by type of injury.

We do get a benefit we get in this country from the risk avoidance that comes from people being scared of being sued. But we also get a cost in that many moderately risky activities just don’t happen. That rocket car day was probably very close to that boundary, and may not stay on the do-able side for long. I’d rather not lose it. But that is much easier to say if you’ve never suffered one of those catastrophic, possibly preventable injuries that our legal system tries to stop.

I hope the productivity commission comes up with something more like NZ. But I doubt if it will happen. It seems too old-fashioned some how.

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The insurance cycle

The insurance cycle is something that is well known to general insurers (property and casualty, if you are in the US). For many classes of business, the price of insurance fluctuates much more than the underlying cost. The general consensus is that it is about availability of capital. If the insurance market as a whole has suffered substantial losses recently (think 2005 and the nightmare Hurricane year in the US) then all the capital that is generally available for insurance companies will have been used up paying claims. So companies will have to pay much more for capital, reinsurers will charge higher premiums, and the market as a whole will charge much higher premiums for the next few years. This is, of course, completely contrary to the Efficient Market Hypothesis that would suggest that the premium should reflect the best forward looking view of the risk, but it is a well known phenomenom.

But in my view, there is a different (closely related) reason. Insurance cycles generally happen in “long tail” business – that is business where the claims are paid a long time after the premium is received. Think workers compensation insurance, or (for an extreme) asbestos insurance. And this means that the company is deciding on the premium rate to charge a long time before they know what the ultimate claims will be. Of course, they will get it wrong (that is the only certain thing about insurance). If the insurance companies charge too high a premium for that year’s risk, capital will come flooding into the market because there are superprofits to be made.  And the price will come down substantially.  And if they charge a premium that is too low, the opposite occurs. The problem with this approach is that it is happening a long time later. So inevitably there is an overcorrection – hey presto – an insurance cycle where insurance companies make super profits some of the time, and diabolical losses (if they are still in the market) the rest of the time.

If you know what you are doing, the way to make good profits on this kind of business this is to hold your nerve on price. You need to charge the higher prices that the market generally is charging just after a disastrous year, but when the prices start going too low, you need to be able to hold your nerve and refuse to participate. That takes a long term, patient, shareholder, and a company where the pricing power is nowhere near the marketing team (which will have sales targets they are expected to meet). Of course, you won’t know whether you were right until many years later.

A colleague of mine recently described the group life insurance market as a commoditised business – low margin high volume. It would be, if the ultimate cost of the product was known up front. But the insurance cycle (group life claims, particularly for  disability are paid up to 10-15 years after the premium) changes this dynamic. Instead, I think it is a business where the way to make money is through disciplined and very superior pricing. Which is not very common in any financial services business, and may be the reason not much money has been made in this business historically.

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This is the season for industry events, so I’m musing on what I’ve seen on this blog. It feels quite strange to be doing professional blogging here, but that’s why I originally started this blog after all!

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Buying insurance

It’s a truism in the life insurance industry that “life insurance is sold not bought”.  Meaning that you people very rarely go out and seek opportunities to buy a life insurance policy without someone actively trying to sell it to them. Life insurance agents aren’t well liked, because they are trained high pressure sales people.

But life insurance (in my possibly biased view, working for a life insurance company) is a pretty important product to have, at certain stages of your life. Certainly many people in that stage, where their income is needed to pay a mortgage and support dependents, would agree if you asked them that they should have life insurance. So why don’t they?

Convential wisdom is that it is because people don’t like to think about their death or disability. And there is something in that. Life insurance agents are very practiced at telling real death and disaster stories, because it forces their potential targets to think about it. But people by car and house insurance (more car than house, but they buy it). And car accidents and house fires aren’t exactly fun things to think about.

But I think there is something else. Not many people claim on life insurance. In that peak earning high liability period of their lives, not that many people die. Maybe 1 in every 1,000 per annum.  But 15% of people will claim on car insurance in any one year, and 6% of householders. So you will likely know someone who claimed last year on one or the other. You will know of someone who died, too. But it won’t seem as real, and it won’t seem as much like the normal course of life, to make you take out insurance.

For most people pre-retirement, your income (whether in dollar terms, or in the replacement cost if you disappeared if you are not paid for your labour) is by far your most valuable asset. If you die, it disappears. That’s fine, if no-one but you is depending on it. But if anyone else is, make sure you have life insurance that will replace that asset  for as long as its needed. And even if you don’t have dependents, buy disability income insurance, if you value your current standard of living.

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Warning: Actuarial post ahead – mortality statistics

This week, the ABS released the annual mortality statistics – the analysis of all the people who died in Australia in 2008.. Overall, at a population level, the “standardised death rate” (deaths per 1,000 population, adjusting for a standard age structure) was 6.0 per 1,000 people – the same as 2007. But splitting it down to males and females, the standardised death rate for both males and females went up slightly (from 7.2 to 7.3 for males and from 4.9 to 5.0 for females).

The ABS only releases statistics to 1 decimal place, so its hard to tell exactly where the increases were. But they appear to be largely in the older ages for women (all ages above 70 have a slightly higher death rate) and in the middle to older ages for men (40-44 year olds have gone up slightly, as have the over 80s, the early 70s and the early 50s).

It’s particularly interesting that the older age death rates have gone up, because that goes against a trend where mortality rates at older ages have been improving very significantly (much more than at younger ages) for many years.  Looking at the last 10 years, it is the first time that any mortality rate has gone up over the age of 70.

So I had a look at the preliminary cause of death analysis. I was half expecting to see a big increase in pneumonia and flu type deaths (perhaps the swine flu was widespread before our current flu season?) But diseases of the respiratory system dropped from 7.9% of the total to 7.3% (and the number of deaths from that cause actually dropped by 4% during the year). Lots of other causes took their place. But one increase interested me: Deaths from Endocrine, nutritional and metabolic diseases (mainly diabetes) increased by 10% during the year.  The numbers are small, but doctors have been warning for some time that current mortality improvements will come to an end as the proportion of the population that is obese increases. It’s too early to tell, but I’ll be watching the final analysis for this year (due out in March) with interest.

 

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Why is Australia doing so well?

By world standards, the Australian economy is doing very very well. Our unemployment rate was 5.8% in October, up from 4.3% a year ago. No banks have been bailed out.  In May 2009, two Australian banks were in the world’s top 20 by market capitalisation (where Australia has around 1% of world GDP).  While the government has provided a guarantee on deposits, there have been no equity investments from the taxpayer into banks (or any other financial institution). And According to the Reserve Bank (page 72 of their semi annual review), fewer than 1% of households with mortgages have negative equity, compared with 23% in the US, according to this report. So is it just Australia being the lucky country, or is there more to it? I’ve got a few ideas of what we’ve done well, and a few more about our luck.

First, what have we done right?

Loan to valuation ratios – conservative lending

Australian mortgage holders, and mortgage providers have always been pretty conservative on loan to valuation ratios. A normal mortgage has a maximum of 80% of the home valuation. More than that, and you must take out mortgage insurance – which only benefits the bank if you default. That’s a statutory requirement. So while there were people borrowing more than 100% of the valuation, they weren’t that common. So our banks were not as aggressive as banks world wide. They tended to stick to lower risk lending and securitization.

Quite a lot of pundits give credit to for this conservative lending to the four pillars policy – the top four banks cannot be taken over by each other so banks knew they were relatively safe from takeover, so could afford to rest on their laurels and not take enormous risks.

On corporate lending, there was some poor lending. But none that has taken the banks down.

Regulation

The Australian Prudential Regulatory Authority (APRA) has a few things going for it. First, it regulates all retail deposit taking entities (as well as all insurance companies). So it catches, in a single institution, a large proportion of the financial services sector. Second, it had a near death experience in 2001, with the collapse of HIH. HIH was one of Australia’s biggest general insurers, and in Australia’s biggest corporate collapse (at least at the time) it fell apart with a $5 billion shortfall. That was on APRA’s watch.

APRA had been following a path of fairly light touch regulation – setting principles based rules, and enforcing them at a fairly high level. This is what the HIH Royal Commission had to say about their performance:

By 20 September 2000 APRA was on notice that HIH was potentially overstating its statutory solvency position by including pledged assets in the solvency calculation of its licensed insurers. Within weeks APRA had realised that HIH was also overstating its statutory solvency by means of a netting‑off process and incorrect reporting of its related body assets. At around this time APRA also learnt of the serious deterioration in HIH’s UK and US businesses. But, in spite of the mounting evidence of HIH’s problems, APRA did comparatively little in response. It grappled poorly with the information in its possession, either failing to recognise its significance or failing to analyse it thoroughly. It lacked commitment in enforcing in its requests for further information and explanations from HIH. It did not recognise the seriousness of the situation until it was too late for effective intervention.

Early in December 2000 APRA received a copy of the Ernst & Young report that was mentioned earlier. Later in December the officer to whom the report was delivered perused it. He passed it to his superior. That officer did not read it until late February 2001. He immediately recognised its significance but by then it was too late.

APRA paid attention to that report. Not only did they introduce a new supervisory regime for general insurance, but in a move that wasn’t particularly obvious outside APRA and regulated financial institutions, they changed their style of regulation. John Trowbridge, one of the three Members of APRA, has given a number of speeches in which he outlines the APRA approach to supervision, and why it has been very effective. Here is one:

Our prudential standards are built around capital adequacy, effective risk management and good governance. A fundamental plank of our approach is that we hold the boards of regulated institutions accountable for meeting the standards. We normally work through management but we reserve the right to deal directly with the board and we do so whenever we think we need to.

As I see it, our system does work effectively because APRA is a vigilant and effective supervisor. It was not always so, but APRA now has the resources comprising the experience, culture, competence and strategy to operate effectively.

The quality of active supervision of individual institutions is a critical success factor. Prevention is not only better than cure, it is also better than punishment after a failure. Active supervision is a pre-requisite and a sine qua non of an effective prudential regulatory system.

As someone who has been supervised by APRA, there is a lot to that. Their sticks don’t seem that large from a distance, but they can come in to a company at any time and demand any set of documents. If they think that you aren’t doing things properly, they can demand a lot of documents and management time. And if they don’t understand something, they are unlikely to let you do it, if they have any part of their regulatory armoury they can invoke to stop you. Each “visit” will result in a letter with some requirements, recommendations, and suggestions. The Board is expected to see that, and follow up on them. And if you are laggardly, they will keep visiting.

If you’d asked me two years ago, I’d have said they were excessively intrusive. There is definitely a cost to being regulated so intensively. But it does seem that that cost is a reasonable one to pay, given the place of financial institutions in our economy.

Stimulus

In common with everyone else, the government stimulated the economy heavily 9 and 6 months ago with various one-off handouts. In the Australian economy, we had the advantage that the budget wasn’t already in deficit, which means that the stimulus hasn’t damaged government finances to the extent it has in other economies. So while the government could have chosen that approach regardless,  Australia will not have to slash the budget too far in future.

Exports to Asia

Economic success isn’t just about financial institutions, of course. It’s also about the real economy. And Australia has the huge advantage of being the natural resources supplier to the Asian economy, particularly China. While the WA (the resources heavy state) economy took a sharper tumble than the rest of the country six months ago, it’s pretty much back to boom times now. So the real economy is in good shape.

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