The economics of bluffing

WILL Greece default on its debts and leave the euro? Will Britain decide to leave the European Union? Politicians in the two countries have threatened, implicitly or explicitly, to take these drastic steps if their European colleagues do not offer them inducements to stay.

Many people regard these threats as a bluff. They think that Greece does not really want to leave the euro, and that David Cameron, Britain’s prime minister, does not want his country to exit the EU. When push comes to shove, Greece will do a deal (see article) and Mr Cameron will persuade British voters to stay in the EU in his planned referendum. But there are risks that neither outcome will turn out as planned. In both cases, political leaders are making a risky bet.

The financial analogy is with writing (selling) an option. In the markets, an option is the right to buy (a call) or sell (a put) an asset at a given price; say shares of Apple at $130. In return for granting the buyer of the option this right, the writer receives a payment called a premium, rather like an insurance company receives a premium for protecting a homeowner against fire or theft. But if Apple shares do rise above $130, the buyer of a call option is likely to exercise it, to the writer’s cost; if they fall below it, the holder of a put option is likely to cash in.

Political leaders in Greece and Britain have in effect written an option on exit. The premium they receive is political popularity—for opposing the demands of international creditors, in the case of Greece, or for asserting Britain’s sovereignty, in Mr Cameron’s.

But in the financial markets, option-writing is a very risky strategy, unless the position is properly hedged. A lot of small profits can be earned from the option premia, only for all the gains to be wiped out when an option is exercised at an unfavourable time. Of course, the buyer of an option is most likely to exercise it when the cost to the writer is greatest.

For the political leaders of Greece and Britain, the difficulty is that they do not get to decide whether the option gets exercised. The other nations within the euro zone and the EU may decide to call Greece or Britain’s bluff. In Britain, the electorate also has the right to exercise the option of exit—which they might use in the referendum to protest against government policies in general rather than voting on the merits of EU membership in particular.

This leads to some complex calculations. Unlike Apple’s shares, the price of Grexit or Brexit at any moment is highly uncertain; political leaders cannot be sure what the costs and benefits will be. So this is rather like an option on one of the complex securities that proliferated before 2007—a collateralised debt obligation based on subprime mortgages, for example. The uncertainty makes it less likely that Europe will exercise the option and risk the departure of Britain or Greece.

If that gives the bluffing states an advantage, they also face a difficult trade-off. The more intransigent their demands, the more they may please their electorates (ie, the greater the “option premium”). However, such intransigence may make it more likely that the option will be exercised. European leaders may feel that making too many concessions to Greece or Britain will simply encourage other countries to make similar demands, and thus destroy the European project. In Britain, there may be a huge gap between the expectations fostered during the negotiating process and the reforms that emerge. This may create the impression that the government has failed, making the public more inclined to vote for exit.

This discrepancy between the high-flying nature of political promises and the mundane reality of policy outcomes lies at the heart of recent voter discontent. Promises may result in short-term electoral success but at the cost of increasing disillusionment in the long term. The most significant short-term influences on growth—the oil price, Federal Reserve policy, China’s success in managing its economic growth—are outside the control of European politicians. National leaders are, in effect, bluffing when they say their own policies can make much difference.

Europe’s failure to generate much in the way of economic or wage growth over the past decade means that voters are not just turning against the parties in power—they have lost faith with the mainstream opposition as well. The effect can be seen everywhere, from the rise of Marine Le Pen in France to the emergence of brand new parties like the Five Star Movement in Italy and Podemos in Spain. Years of short-term gains for the mainstream parties have resulted in a long-term loss.

Source: http://www.economist.com/news/finance-and-economics/21652362-when-political-leaders-turn-option-writers-economics-bluffing

Chinese insurer emulates ‘Buffett model’ with Waldorf purchase

The previously obscure Chinese insurance company whose global shopping spree has raised eyebrows in the investment world is pursuing a Warren Buffett-like strategy in which investment returns drive growth and insurance plays only a minor role.

This month alone, Beijing-based Anbang Insurance Group announced the purchase of Manhattan’s Waldorf Astoria hotel for $1.95bn and Belgian insurer Fidea for an undisclosed price. South Korean media have also reported that Anbang is considering acquiring a controlling stake in state-run Woori Bank.

Such ambitious investment may seem strange for a company that ranks eighth among Chinese life assurers with only a 3.6 per cent market share, far below leaders China Life and Ping An, which control 25 and 14 per cent, respectively. 

Yet a look at Anbang’s business model suggests the company is more like a private equity fund with a side business in insurance. Rather than profiting from the excess of premiums over claims, analysts say Anbang aims to generate earnings through investment returns.

Chinese entrepreneurs have expressed admiration for the “Warren Buffett model” in which insurance premiums provide cheap funding for far-flung equity investments.

Fosun founder Guo Guangchang has frequently cited the example of Mr Buffett in outlining intentions to transform his industrial conglomerate into a strategic investment group.

In China, however, the strategy of using insurance as a platform for unrelated investments is riskier, since the core insurance business is less profitable than in the west.

Roughly 70 per cent of “life assurance” products in China are more akin to certificates of deposit. The customer pays a premium only once, and the insurer guarantees the return of principal plus interest after five to 15 years.

Insurers earn razor-thin margins on such products, which are sold mainly through banks and must compete for funds with lenders’ own high-yielding wealth management products.

Protection-type products, which only pay out in the event of an accident, illness or untimely death, deliver higher margins because the insurer doesn’t pay out on every policy, but still comprise only a small fraction of China’s overall insurance market.

Privately held Anbang collected Rmb33bn ($5.4bn) in life assurance premiums in the first eight months of 2014 versus only Rmb3.4bn in property and casualty fees, government data show.
Its profitability has been further compromised by its rapid growth strategy. Premiums have grown from Rmb1bn in 2005, the year after Anbang’s founding, to Rmb36bn so far this year. That has required big spending on hiring sales agents and paying commissions to banks that champion their policies.

“I can’t see how they’re making a profit, with all the reserves they have to put away and all the acquisition costs. I would be stunned,” says Sam Radwan, co-founder of Enhance, a management consultancy that advises China’s insurance industry.

Premiums at Anbang’s life assurance unit amounted to only 8 per cent of assets by end the of 2013, compared to 16 per cent at China Life. That suggests Anbang is using equity capital, rather than premiums, to finance its purchases.

China Life and Ping An have both ventured into foreign real estate over the past year, following regulations enacted in 2012 permitting such investments by insurers. But their core businesses are more diverse and profitable than Anbang, meaning investment returns are icing on the insurance cake.

Still, in other respects Anbang seems well-suited to the Buffett model given the proven ability of founder and chairman Wu Xiaohui, son-in-law of late paramount leader Deng Xiaoping, to raise funds from China’s elite state-owned companies. 

Anbang raised its registered capital to Rmb30bn in April this year, up from Rmb12bn in 2011 and more than the Rmb28bn in registered capital at rival China Life.

A complete shareholder list is not publicly available, but the company has wooed investors including state-owned oil refiner Sinopec and SAIC Motor, China’s largest carmaker, according to state media. Anbang could not be reached for comment.

If it succeeds in efforts to emulate Mr Buffett, the danger is that Anbang ends up resigning itself to unprofitability in its core business and basing its strategy solely on high-risk investments.

“If you’re playing the asset game and pushing your yield, you can get yourself into a lot of trouble,” says Mr Radwan.

Source: http://www.ft.com/intl/cms/s/0/9b6f1036-5424-11e4-80db-00144feab7de.html