Risk cannot be eliminated, only transformed at great expense. Therefore, insurers should spin off at least a portion of their hedging activity to shareholders.
Look for the opinion link!
Opinion: Insurer's Risk Transformation
PrefBlog
Canadian Preferred Shares: Data and Discussion
>The parent and subsidiary would no
longer be related companies following
the spin-off<
Would not the 2 companies still be considered related because the majority holders would be the same for some time?
Otherwise great idea! Especially if they have a new issue at the same time as the the spin-off.
Well, I won’t presume to do OSFI’s rule interpretation for them, but as long as management (and the board) is different, and shareholders are not deliberately managing the companies in relationship to each AND there is no way that a loss by the spun-off company can affect the capital of the spinner-out company, I suggest that the companies will not be considered related.
Hi James, I think I must have missed something basic. What is wrong with just hedging the option (statically or dynamically) which sounds like it’s the norm in other countries? Is there something Canadian-specific about the situation which give a reason why a Canadian insurer would not do what is considered normal elsewhere?
mike, glad you’ve joined in!
I think I must have missed something basic. What is wrong with just hedging the option (statically or dynamically) which sounds like it’s the norm in other countries?
No, you haven’t missed anything; this could be done in other countries just as well as in Canada.
All I’m suggesting is that static hedges are expensive; the insurer’s counterparty is doing them a service, sure, but they’re also charging through the nose for it. The insurer will also have counterparty risk, at least to some extent.
If the insurers spun off at least a portion of their hedges – as deferred dividends, if you will – shareholders would capture that piece of the payment that represents the counterparty’s expected profit.
Thanks James. I’ve enjoyed prefblog for a while and finally thought I’d register.
I see the benefits for counterparty risk. And, I guess the fee that some anonymous market participant would normally charge for the put option is kept in the family (effectively split between the parent and subsidiary/shareholders) ?
And, I guess the fee that some anonymous market participant would normally charge for the put option is kept in the family
Bingo!
(effectively split between the parent and subsidiary/shareholders)
That part will depend on the pricing of the option and the value assigned to the spin-out, but split, sure.
[…] my essay on insurers’ risk transformation. Core Principle #6: Banking firms should be subject to a simple, non-risk-based leverage […]