risk, insurance, & real estate

By reading this, you are going to understand something about real estate prices that most people do not. You are going to understand how real estate prices can gradually climb for long periods of time, like a balloon slowly rising up in to the sky, and then suddenly collapse, like a balloon with a hole in it.

First, let’s get clear on a major issue in popular methods of accounting. Let’s imagine that I spend $1000 on $1 lottery tickets. I record in my ledger that I have spent $1000 and now I own $1000 of lottery tickets. Why do I say that the lottery tickets are worth $1000? Because that is what I paid for them.

Now, let’s say that I bought $500 of tickets for two different lotteries that happen at two different times. After the first lottery ends, my tickets are still recorded as worth $1000, but soon I can update my accounting and cash in on any winners amongst the first set of tickets.

I find that of the first $500 that I spent, 498 of the tickets were losers and two of the tickets were each worth $300, totaling $600. So, I update my accounting to show that I now have two tickets worth $300 each ($600 total) and another 500 tickets for which I spent $1 each, and so I record each of them as worth $1, totaling $500. So I have two winning tickets totaling $600 and 500 tickets of unknown eventual value on which I spent $500. I record in my accounting books that I now have $1100 of tickets.

There are many ways I could complicate the situation here. I might sell some of my remaining 500 tickets- perhaps for $1 each. That would reduce my risk but also reduce my opportunity. Maybe another government will buy them from me. Or, I might be able to convince someone to lend me $1100 (or more) against my tickets accounted as worth $1100. Why might someone lend me $1100 against my lottery tickets? Because they notice the trend that my tickets are rising in accounted value! (It could also be a factor that I might have other assets that a lender could legally take from me in the event that the set of lottery tickets decline in total value after the second lottery drawing.)

To keep things easy, let’s say that of the 500 remaining tickets, they all lose. So, when the second lottery ends, I still have a value of $1100 in lottery tickets written down in my accounting ledger. Once I review the results and update my accounting, I have only two tickets worth anything: the two worth $300 each from the first drawing. So, my 1000 lottery tickets have been accounted as worth $1000, $1100, and finally $600. Which accounting was the right one?

All of the accountings were accurate! The last one may be the most relevant, but there is nothing inaccurate about any of the other accountings.

Now, let’s consider an insurance company. They sell 1000 policies each for a premium of $1. They write down in their accounting ledger that they have $1000 of cash and that they owe “approximately” $1000 for the insurance claims on which they are now liable.

The first week, no one files a claim against them and they “depreciate” the amount they owe on the policies they have sold. To make it simple, let’s say that their policies were all for 2 weeks in length, so that after the first week, the accountants at the insurance company presume that half of the risk is gone, because half of the length of time has passed. So, after one week, the insurance company still has $1000 of cash, but now records that they are liable for “approximately” $500 in possible future insurance claims.

By the way, no, this is not exactly how insurance companies do their accounting, but the point I am making with this example is quite applicable. The insurance companies, like the purchaser of the lottery tickets in the first example, really do not know the value of their contracts until the end of the contract period. Note that a lottery ticket is a legal contract, as in a legally-enforceable financial instrument- just as much as an insurance policy.

So, after one week, the insurance company spends $500 of it’s cash revenues (possibly to buy lottery tickets or real estate or maybe just to pay their employees or investors). The company still owes “approximately” $500 on it’s policies, but it keeps in reserve $500 of cash to “cover” any claims against those policies.

Well, unfortunately for the future of the insurance company, they soon receive two claims for $300 each. They investigate the claims and try to reject them (since they cannot afford to pay them). However, they end up paying each of the two policy-holders $250 (splitting the $500 of assets that they have in reserve to cover any claims) and then go bankrupt. The two policy-holders who expected $300 are also disappointed to receive only $250. They want the government to pay them the rest (and raise the funds from state lotteries or taxes). The government says “we promise we will.” However, the government does not keep it’s promise. All the two policy-holders get is $250 each.

Or, it could be worse for the policy-holders. If the insurance company realizes it has $600 in liabilities and $500 in cash, it might file for bankruptcy protection in court. In that case, it might pay $200 for the court filing fees, then $200 to a legal specialist. Since it had $500 cash and just spent $400 to file bankruptcy, that leaves $100. The two parties who each own tickets or claims worth up to $300 may be given a total of $100 in the bankruptcy process. So, they may each get $50. The court and the legal staff get the rest.

Now, I want to make a brief point here. Spreading risk does not reduce risk. Did you get that?

Let’s say that an insurance company sells 100 policies with a $1,000,000 limit to the claims. That totals $100,000,000 in possible claims.

Or, we could spread that same amount of risk among more cases, like 1000 cases with a $100,000 limit to the claims. That still totals $100,000,000 in possible claims. Having more cases of smaller risk may not change the total risk, right? Further, having 1000 policies instead of only 100 actually increases the statistical likelihood of at least a few big claims. The more policies sold, the more likely that at least one will result in a claim.

Similarly, the more lottery tickets someone buys, the more likely that at least one of the tickets will win something. However, more tickets or more policies does not alter the underlying risk of the situation. For instance, if the insurance contract is for health care costs, how much does the health of the purchaser change when they buy the policy? None, right? What if the insurance policy is for a home in New Orleans? Does buying the contract alter the risk that the home will be washed away in a flood?

Spreading the risk does not alter the amount of risk. Concentrating the risk also does not alter the amount of risk.

However, concentrating risk can lead to an incentive. For instance, if a particular insurance company sells house insurance policies only in New Orleans, then that huge concentration of risk means that the company has an incentive to do things like invest in the integrity of the levies protecting New Orleans from floods. They may or may not do that and it may or may not go well, but, in certain cases, the company would have an obvious incentive to actually reduce the risk of a claim.

But when an insurance company “purchases risk” from someone (buys a financial liability), that does not protect anyone from anything. Today, I saw a huge vehicle with the words “Allstate protects Arizona.” Allstate is an insurance company, by the way. Allstate purchases risk. The total amount of risk is not reduced when the financial risk is transferred between parties, spread out, or concentrated. Buying insurance does not protect anyone from auto accidents or flooded houses or a personal health crisis.
Buying insurance does reduce the incentive though for people to be focused on personal responsibility. Doesn’t an insured person care less about the risk of flooding if they have insurance? Don’t people tend to focus less on their health if they have coverage to pay for various popular medical interventions?

Now, before we get to real estate prices in particular, let’s get totally clear on “playing the odds” in general. Then, we can explore “playing the odds” as it relates to investing or speculating or gambling on real estate.

In a casino, many games may have very specific mathematical probabilities that “favor the house.” Games like roulette, blackjack, and craps are basically predictable in regard to the average earnings for the casino per dollar invested as “risk capital” in those games. The statistical probability that a casino will make money off each dollar risked by gamblers may be totally consistent over time. As long as the rules are the same and the actual equipment used is fair (rather than rigged), then the results of two similar time periods are likely to be very close.

However, the insurance industry has the opposite quality. A company that concentrates on flood insurance in New Orleans cannot expect that the frequencis of claims will be consistent over time. Claims will come in spurts, like 200 claims in week, then nothing for 236 weeks, then 600 claims in a week, then nothing for 84 weeks, then 20,000 claims in a week.

A further complication with insurance companies is that different places will have different rates of claims. Not only will different periods of time have radically different frequencies of claims, but different regions at the same time, and different types of policies may or may not be correlated (like auto collisions may decrease when flood claims rise, but life insurance claims and auto collision claims may tend to generally go up and down together.)

So, the bottom line about insurance companies and casinos is that casinos have much more predictable risk. Insurance companies purchase huge amounts of diverse kinds of risk and while they can be very profitable for very long periods of time, they can collapse into bankruptcy very quickly, which is extremely unlikely for a casino.

To keep the math simple, let’s say that the mathematical odds for a profit are 67% in certain games for a casino. If they run short of cash briefly, a lender can be very confident that in the long run, as long as gamblers keep playing those same games, the casino will earn more than enough to pay off their loans.

However, if an insurance company has previously made a profit on 67% of a certain kind of policy- no matter how long a period of time they have been selling that policy- there is no mathematical barrier to a sharp alteration in that rate of profitability. Hypothetically, an epidemic  could sweep through a certain region and put many health insurance companies out of business. A flood or other disaster (like a wildfire or earthquake or tsunami) could put many insurance companies out of business.

So, if an insurance company is processing claims in the case of some major increase in claims and then realizes that it may run out of money before it can fully pay all of those claims, is it safe to lend them money? The company may want to go out and sell a bunch of new policies to produce a cash flow for them to cover their recent claims. They may want to borrow money from casinos and other businesses that have been more responsible with their finances. They may want to delay updating the accounting on the real estate and second mortgages that they own- because updating the accounting might reduce the perception of creditworthiness.

What can the insurance companies do in a case like that? They might lobby a government to give them a bail-our rescue package so that “taxpayers” buy their risk and liability contracts and over-priced assets from the insurance industry in order to keep the industry from collapsing. Does that actually reduce the risk to the insured parties that their house will be flooded? No, but it does improve the chances of them getting paid in full on a claim- because the taxpayers (governments) are now operating as the insurance company. The governments own part (or all) of the insurance company.

People may even think of governments as big insurance companies. They may think that by spreading risk over a huge number of people, there is an overall reduction in risk. There isn’t.

Governments and insurance companies may “protect” the distributions of wealth in a society by charging an anonymous group of involuntary taxpayers to carry the risk or underwrite the liability on insuring the property value of something like the World Trade Center. The property gets assessed at a certain value. The property itself may be destroyed, whether by accident or design, and then perhaps the taxpayers pay for the insurance company to give a huge sum of money to someone who recently purchased that property on credit.

Let’s say the property was bought for $10 billion with a down payment of $2 billion and a debt of $8 billion. Then the property goes up in assessed value by perhaps $2 billion in a certain period of time. If the building is destroyed, the insurance company could be basically buying the destroyed building for $12 billion. The insured party gets back the entire $2 billion down payment, plus the mortgage lenders get their $8 billion paid in a lump sum, plus the insured party gets the additional $2 billion, which comes from someone somewhere. That $2 billion differential is a taxable event.

Who pays the extra $2 billion? It could be the insurance company- if they have it. It could be the taxpayers… if they bail-out the insurance company. However, it does not come from nowhere. It comes from somewhere. The risk or liability is not reduced in absolute terms when it is transferred from one party to another, like from a real estate speculator to an insurance company or to “the taxpayers.”

To reduce the risk of a flood, build a great levy. To merely redistribute the risk, buy an insurance policy. The government could buy it or a private company or an individual investor/speculator/gambler. However, redistributing the risk does reduce it.

Now, back to the basic issue that gambling is much more predictable (“safe”) than the insurance industry, what exactly happens if the flood insurance company gets slammed by claims? Do they lobby for a change in the laws? Do they go to bankruptcy court and ask for protection there?

Let’s say that they calculated that for every dollar they receive in premiums, they need to keep at least 67% in reserve in case of claims. They estimated this from prior statistics regarding prior claims.

However, perhaps they find that they have valid claims coming in that exceed their reserves. In the absence of enough to cover their immediate liabilities, they have an issue. Maybe they will get enough money from other premiums to cover the deficit. However, what if that is not enough? In that case, there can be a sudden collapse in the whole “ponzi scheme” of promising huge pay-offs to the early participants and funding those pay-offs with the revenues from late arrivals (or those who simply are “unlucky” enough to not have their homes destroyed in a flood yet).

If the company cannot pay all the old claims, then the people who thought that they had secure coverage may be like kids playing a game of musical chairs. When a company is collapsing, people who file first may get full payment on their contracts, and people who file later may get a percentage of the payment, perhaps quite delayed (like in a bankruptcy proceeding). People who were “unlucky” enough to not to have a flood claim will suddenly have worthless policies. If their home is destroyed in a flood while before they find out that their policy is worthless, that could be quite disappointing!

In the absence of sufficient reserves to cover the existing liabilities of an insurance company, the cash value of all other existing policies collapses. In other words, insurance policies have a lot in common with lottery tickets. Most of them cost more than they pay back. In fact, that is how insurance companies stay in business- by paying out less money than they take in from premiums.

However, in the case of insurance companies, they do not even have all the money that they promise to pay out. So, even insurance policies that are “winning tickets” may still “expire worthless” simply because the insurance company collapses. In contrast, state lotteries may actually have all the money they promise to pay to the ones holding the winning numbers.

Now, seriously, none of that is of any great interest to me. I explained all of that simply to set up the following “dominoes” to knock them down. This composition is, again, about the immense risk in real estate markets.

Simply, there must be new buying to maintain prices of real estate. A huge portion of purchases in real estate are financed (paid using borrowed funds).

If the willingness or capacity of real estate buyers to buy drops even slightly, prices move. Further, if the willingness or capacity of borrowers to borrow drops even slightly, prices move as well. If lenders have a decrease in their willingness or capacity to lend for real estate purchases, again, prices move.

At a crucial point, there can be a serious issue with the sustainability of such a system. Now let’s review our “dominoes.”
When a casino is a little short of cash, they are a very good risk for a lender. Their business includes mathematically predictable business strategies and profits. A short-term fluctuation may be trivial in the long run.

When an insurance company is short of cash from a flood of flood claims, they can be very short very fast. There is percentage limit to the amount of claims that can all come in at once. If their policies insure $1234567890 of liability, then hypothetically that entire amount could become due all at once.

Casinos MIGHT have all of their games ALL lose at once, but the statistical probability of that is trivial. With insurance companies whose risk may be focused in particular types of policies and in particular regions, they may be very interested in the legal loopholes in their policies. Can they get out of paying the claims if there is a war? If a flood leads to a huge rocketing of all sorts of claims (damage to homes, damage to cars, health care costs), can the insurance company get bailed out by a government’s seziure of taxpayer assets?

How much will the government distribute the cost away from the owners of the insurance company and toward the taxpayers? Will the investors in the insurance company lose all of their investment or half or it or what? Remember, stock shares are also quite a bit like lottery tickets and insurance policies in that they can suddenly become worthless, like when a company goes bankrupt, collapses, and stops doing business.

But I was talking about real estate. If lenders and borrowers and even cash buyers of real estate all shift in their willingness or capacity to be involved in real estate purchases, what happens to prices? If there is not enough new cash flowing in to the purchase of real estate, prices drop. However, if there is not enough new borrowing to maintain the confidence of investors in the lending market itself, then the lending market can withdraw. After all, there is no law requiring banks to lend money for real estate purchases (or is there)?

What if borrowers simply choose not to borrow more for real estate, but to buy more insurance policies or buy stock in insurance companies or buy lottery tickets or whatever? At a certain point of reduced borrowing, the confidence in the lending market for real estate can shift. Companies that used to be eager to give second mortgages for appreciating real estate may be reserved to give second mortgages 2 or 20 years into a sharp decline in a market. Owners may be very motivated to sell, rather than wanting to get more loans against any remaining equity. What if buyers get scared and start to think in terms of “let’s wait and see when prices stabilize for a while, and maybe then we will buy real estate again?”

If we remove from real estate prices the portion of price derived from the lending market, that might reduce prices by 80-95%. If there is a single flood that destroys a levy and establishes that any buildings in a particular area are not safe from even minor floods, what happens to prices? If there is a law passed which exempts insurance companies from having to pay claims against floods, then that can also effect prices dramatically, right?

So, here is the bottom line. I am about to topple the whole line of dominoes.

Remember the “investor” in lottery tickets who accounted his tickets as worth $1000, then $1100, then $600? Many real estate investors think of the value of their real estate holdings as equivalent to cash. They may think the same of their stock holdings and of their insurance policies- like just because they are holding a policy and have a valid claim on that policy, that they will get paid the full amount due to them.

Insurance companies may own many second mortgages which they would like to account as worth the face value of those contracts, even though they may know that the actual cash value is tiny compared to the face value. They may lobby governments to buy those contracts from the insurance companies and other investors (lenders as investors, too).

So, the insurance company accountant records a second mortgage as worth $100,000 and then a bank lends them money against that legal asset accounted at $100,000 in value and then the insurance company buys some lottery tickets and no real value has been created by all of these transactions. All that has happened is that liabiltiy has been shifted.

If the lottery tickets pay off, then the insurance company can pay back the debt to the lender. However, the money for that has to come from somewhere.

In other words, borrowing money does not create more money. Borrowing money shifts liability.

The last ones in to the ponzi system of insurance companies can be left with worthless policies. The last ones into the ponzi system of real estate lending can also be left with homes priced at about 10- 20% of their purchase price. The credit bubble can deflate very fast- even collapse. However, when real esate prices drop 80 or 90% quickly, most real estate speculators will lose their homes to foreclosure.

So, back to the prior example, if the lottery tickets bought by the insurance company do not pay off, then the insurance company may not be able to pay back the lender. If the lender does not get paid off, then they may also go out of business, too (if enough defaults happen in a short period of time). lots of real estate may be sold all at once, as lenders and insurance companies are selling their properties in bankruptcy proceedings (or trying to raise funds to avoid bankruptcy).

Again, credit markets are not designed to eliminate risk. There is just a transfer of certain risk from the purchaser to the lender. The purchaser might risk only $2 billion to purchase real estate that is valued at $10 billion. So, the lender and the purchaser both have $8 billion of risk. It is not that the lender has all $8 billion of that risk and the borrower/purchaser is only risking $2 billion. The purchaser gets to spread risk by sharing it with the lender. However, the risk is still the same amount.

How much of that $10 billion of value is at risk? All of it. Could the building collapse in a terrorist event or flood? Sure. Could the insurance compmany collapse as well? Sure. Is the insurance policy for $10 billion the same as $10 billion of cash? No. Is the mortgage contract the same as the same amount of cash? No. Is $1000 spent on lottery tickets the same as $1000?

So, is the total risk reduced when a lender is involved? No, though the immediate risk to the borrower is limited to their down payment. However, they are legally liable for the full amount of the loan.

Likewise, if an insurance company borrows $8 billion for real estate purchases, but then the value of the property drops, do they still legally owe the $8 billion in loans? Yep! How do they pay for that? Perhaps they go to the casinos and ask for a loan.

All of the lending activity in real estate markets does not reduce the risk. Prices inflated by “easy” lending policies and laws are not inherently safe. In fact, they are inherently inflated, meaning super-risky.

Accountants can write that some particular chunk of real estate is valued at $1000 or $1100 or $600 (per acre of rural land?), just like they might change the accounted value of lottery tickets over time. There is nothing “illegal” about accounting or estimating the value of real estate like that. Crimes are defined (invented) by legislation. Anything explicitly licensed by a government is probably not going to be prosecuted as a crime by that same government. Ponzi schemes regulated or operated by governments are not criminal. However, investors might do better at casinos.

There is no “easy money” or “sure thing” in investing. The investors who have speculated and gambled in real estate may have believed that they were investing in a “sure thing.” They may think that there is no risk for any number of reasons. They may think that “Allstate protects them” because Allstate shares in the financial liability. They may think that all other lenders and borrowers are always going to cooperate to keep their own unearned gains flowing. They may be investing in complacency and negligence and risk. They may be disappointed with the results!

So, just to be very clear, accounting is just accounting. Writing down that lottery tickets are worth $1000 or $1100 or $600 does not change the inherent value of the tickets. When an insurance policy is valued at $10 billion, but then the policy-holder realizes that the insurance company does not actually have enough money to pay that and the policy actually pays $4 billion, that is not illegal accounting. That is just naive investing. The insurance policy was never really worth $10 billion. An insurance premium purchased for $100 may actually be worth less than that. Concentrating or spreading risk does not change the total amount of risk.

Real estate accounted as worth $1,000,000 or $1,100,000 or $600,000 may be unchanged in real value. The accounting is just being updated. The actual cash value of the property is precisely equalivalent to the actual amount for which it can be sold, and not eventually, but today. There is no other definitive method of accounting but the ultimate transaction price and all the various estimations made between transactions.
The lottery ticket and the insurance policy and the real estate did not change in value. The accounting changed. The value did not change.

Perhaps the risk was under-estimated by certain accountants (or over-estimated). However, the only way to definitively conclude how much risk there is… is this: look at the amount written down by the accountants as the estimated value of an investment or contract. The full amount is always at risk. The liability for that risk may be spread out, but the amount of risk does not change by an act of accounting. The accounting of value is the accounting of the value at risk.

Can the risk be higher than what is accounted? Yes. Can the risk be lower than what is accounted? Yes.

What is the difference between an accounting of value and an accounting of risk? Not much!

So, if someone invests $10,000 in lottery tickets, $10,000 in down payments on financed real estate, $10,000 in insurance policies (accounted as worth up to $1234567890), and $10,000 to play roulette and other games of chance, which investment has the most risk? The real estate is the worst investment from one perspective, since it brings so much more risk than the $10,000 down payment (because of the liability of the mortgage contract). The insurance policy has a very low probability of paying off and is very close to the lottery tickets in terms of the likelihood of a profit to the investor. The investments in roulette, with strictly limited probabilities of risk, may be the best technically or mathematically.

Unlike real estate investing, at least people playing roulette are not taking on liability in excess of the amount of funds that they are providing themselves. It is the fact that real estate investors can take such huge risks with so little of their own money that makes real estate investing so attractive to them. They think they are buying an insurance policy that is sure to profit. They think the lenders have reduced their own risk.

They may only think in terms of the down payment at risk. Relative to a risk of a $10,000 down payment,  a $100,000 real estate property may seem very low risk. The opposite is true. The entire $100,000 is at risk. There is no guarantee of the future price of the real estate. There is no guarantee of the future value of the mortgage contract.

Yes, lenders are sharing risk with borrowers, but borrowers retain full legal liability for the entire amount of the mortgage. Together, lenders and borrowers have formed a credit bubble in which both are grossly underestimating their risk. The real estate lending bubble will fall like dominoes, perhaps deflating like a balloon with a hole in it.

Is any money created by buying lottery tickets? No. By buying insurance policies? No. By borrowing money to buy real estate? No.

All of those are just the transfer of liability. Accountants may have a hard time keeping up with all of that, but the accountants themselves are not the issue either. Complacency regarding risk (and re-calculations of risk and value) are the issue.

How does the complacency resolve? By natural consequences and attention. But can’t governments just hyper-inflate their currencies to pay out money for winning lottery tickets and so on? Perhaps, but that still does nothing to address the fundamental fact that all value is always at risk.

Governments do not protect anyone from economics. Insurance companies do not protect anyone from economics either, nor against floods and breaking levies, except when the insurance companies do take practical steps to protect against floods. However, transfer of liability or risk is not reduction of risk. Protection against floods does not prevent fire. There is no such thing as “a sure bet.”

Gamblers who think they are not actually gamblers but are just savvy real estate investors are simply fantasizing. This trend of fantasizing may be about to be interrupted as in corrected.

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