Monster in your backyard

Warren Buffett is a miracle. His wealth is a miracle. But what fascinates me most is that he made most of his money from insurance. There is a lot of money to be made in insurance. That is why companies are heading in droves to start insurance subsidiaries.

Every business, every project and even people face infinite situations. Many good. Many bad. And many can hurt deeply. In essence, there is risk attached to every human action (or inaction) or corporate action (or inaction). Insurance is the means to offset and reduce the pain when the calamity befalls.

Insurance companies' expertise is taking on the others' risks, bundle similar risks into a package and do its best to protect itself from any calamitous claims.

Almost always they have been safe. Not many bridges are falling apart or many floods at the same time. Companies have been taking money and enjoying "peaceful period on earth" (as Stephen Hawking puts it when talking of comet strike). Undoubtedly, the largest companies in the world are the insurance companies. The true financial behemoths.

It doesn’t happen until it happens. Companies are much aware of it. Any day there could be a mega flood, a mega hurricane, and an unknown tsunami or Richter 9 earthquake. When companies are looking at longer periods of time the measure the risks the odds that something can go wrong increases. So they protect themselves.

They package it in the form of derivatives. Their large earnings are also protected by derivatives. They, become over years, derivative monsters.

Life has a fat tail

Insurance industry is huge. The risks that they manage are huge. The instruments they use to protect are brittle (It aint broken until its broken). They are masters of risk. There are many risks that can be safely brushed under the carpet. They are easy money. There are some stubborn risks that can’t be buried too long under the carpet. And there are those that will raise their ugly heads once in a while. Anything unprecedented goliaths land in soup. Lets hypothesize a bit.

Imagine a nuclear waste management company. Society pays this company enormous sums of money to protect itself from harmful radiation. Company can do its work honestly and hide the waste from reaching the society ever again. Or the company can also silently spread out the wastes in our parks and our backyards and nobody would know. Society would live happily thinking the scum of risk has been safely taken care by the experts at WM Company. Reality would strike hard.

Global derivatives markets are too big. Too monstrous - to fall quietly. The impact will be heard in everyone's backyard. It may be too late then, to learn risk is something that we can’t just parcel out. Perhaps it is just like energy, it changes form but is never destroyed.

We face lot of such confidence risks. Fiat money collapse, derivatives collapse to name two. It would be naive to assume our backyards are uncontaminated. It is sane to prepare for an event than be hit by surprise.

:) Falkor