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Insurance Is Where the Money Is

One basic weird thing about the financial industry is that it consists of a lot of big pots of money that you can buy for less money than is in the pot. Occasionally there are stories about how a pharmaceutical or tech company is trading for below the value of its cash and marketable securities, and how weird and shocking that is, but it is absolutely the norm in the banking and insurance industries. JPMorgan Chase & Co. has a stock-market valuation of about $342 billion, but it has something like $600 billion of cash and cash-like investments and another $675 billion of trading assets and investment securities. 1 American International Group has a stock-market valuation of about $37.6 billion, but it owns something like $240 billion of bonds. 2 If you could buy all the stock of JPMorgan or AIG, you’d immediately control a much larger pool of money than you spent for the stock.

This is not a magical free lunch or a scam; it is just another way of saying that the financial industry, compared to more normal industries, tends to operate with a lot of leverage. Banks have a lot of money, much of it invested in relatively liquid financial assets, but most of that money is borrowed (from depositors, etc.) and will eventually have to be paid back. Insurance companies have a lot of money, much of it invested in relatively liquid financial assets, but most of that money comes from insurance policyholders and will eventually have to be paid back. The banks and insurance companies are just holding all that money in trust for someone else. That’s what a financial institution is; it’s a business that holds money for other people.

But the “pots of money that you can buy for less money than is in the pot” framework can be useful. For instance, if you need $100 million for some project, but you only have $10 million, you can go to a bank and ask to borrow the rest, but they will ask you tedious questions like “what is this for” and “how do we know you will pay us back.” But if you go find an insurance company with $10 million of equity value and $90 million of “float” (money from insurance premiums that will eventually need to be paid out in claims) that owns $100 million of bonds, you can buy that company for $10 million, and now you’re in charge of a pot of $100 million. You control the company, you can make yourself the boss, you can sell the bonds for cash and invest the $100 million in your project. 3 If your project is good, then you will pay back the insurance company’s investment with interest, and the value of your equity investment in the insurer will grow. If your project is bad, then you won’t be able to pay back the insurance company, you’ll lose your $10 million equity investment, and policyholders’ money will also be at risk. If your project is “I will buy a $100 million yacht and sail far away,” then the policyholders will lose everything, and you will have gotten a $100 million yacht for $10 million.

This is mostly not a magical free lunch or a scam, but not for some deep structural reason or anything. It’s just that this is all pretty well-known stuff, so a big focus of banking and insurance regulation is making sure that the people who control banks and insurers don’t just loot them for their own personal projects. But, you know, sometimes! …[ ]

What do you think?

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Posted by charlie21

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