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The insurance industry made a big fuss a few months ago about " fronting up" - the trick whereby parents reduce the cost of motor insurance for a 17-year-old son.
Instead of insuring the youth as they should as the main driver of his vehicle, the parents pretend it is their car and take out the policy in their own name with the high-risk youth listed as an additional driver.
The insurance company thinks its primary risk is to the mature stable drivers who have not had an accident for years, and charges accordingly. The reality is that its risk is the 17-year-old who drives the car most of the time.
Inevitably, that leads to more accidents than the insurer had expected and priced for. As a result, it loses a pile of money, which is why the industry now says this is fraud because the nature of the risk is misrepresented to them.
In economic terms, what these parents have done is sell their credit rating to their son, so that he in effect reaps the benefit of their no claim bonus.
Interestingly, though motor insurers now no longer allow it, this is precisely the business of themonoline insurers - the companies that threaten to be the most dangerous casualties yet of the credit crunch. These predominantly US insurance companies have triple A credit ratings, and their business is guaranteeing the creditworthiness of lesser-quality bonds.
In effect, they lend their credit rating to the weaker business in return for a fee. Once a poor-quality credit - say a triple B - buys insurance against default from the monoline, its credit becomes as good as the insurance company that has agreed to cover any default. It appears to become triple A.
But the reality is that the risk has not gone away. It has simply been obscured, just as it is with the parent fronting for the son. This sleight of hand does nothing to reduce the rate of accidents.
Greed blinded the banking community to this, and the accidents have begun to happen. The disaster threatening to engulf the financial system is that the cost of the defaults on these insured bonds could overwhelm the insurers, exhaust their capital and force them to default. We are not there yet - at least among the big boys - but it is a high enough probability for rating agencies to warn they may have to cut the insurers' triple A rating in anticipation of such problems, and unless they get a lot of additional capital from somewhere very quickly.
This is serious because if the insurers' rating is cut, it will pull the rug out from under every bond that has passed through their hands. It will cut the rating of all the tens of thousands of bonds they have insured - those of respectable local authorities and municipalities will be downgraded along with the toxic credit derivatives. Low-rated bonds have a lower face value and require a higher rate of interest. A rate cut on such a huge scale would trigger hundreds of billions of losses across the entire financial system. No pension, insurance policy or money fund would escape unscathed.
Interesting that this should be the result of the insurance industry adopting a business model it banned when the public tried it. Interesting, too, how reminiscent this is of the causes of the disaster that almost sank Lloyd's of London 20 years ago. A major problem then was that underwriters took on toxic risks knowing that they were poor quality and wrongly priced.
They did this because they also knew they could pass on - or reinsure - the risk with another, less alert, insurer and simply keep the commission. It went pear-shaped when there were widespread defaults among the insurers to which they had sold the risk, at which point all the risk transfer and protection was found to be a charade.
Finance is human nature, and it never changes. Bankers these days call such activity the "originate and distribute" model. It is a different label but it is crippling them just as it crippled Lloyd's.
CHRISTOPHER Flowers, the activist US investor, is reported to have built up a 3% stake in Friends Provident, the insurance group that has been at something of a loose end since it tried and failed to merge with Resolution Life last year.
Inevitably this has sparked off suggestions that Friends will sell off its 55% stake in the separately listed Foreign & Colonial fund management group. Therein madness lies. One can easily argue that the fund management group would be better off on its own, but only an idiot would think this was a sensible time to sell.
Fund management valuations have plunged since last summer - New Star, for example, is a fifth of what it was then. These financial professionals are supposed to know about market timing - why would they sell at the bottom?
