When Insurance Fails - Reflecting on AIG

This Planet Money episode on homeowners insurance reminded me of when I first learned about insurance market failures in college. Insurance markets tend to fail when at least one of three factors is present:

• Moral hazard The insured takes on more risk or incurs costly activities because the insurer is going to pick up the tab. Phrases that I have heard, half serious and half in jest: "Sure I can go skiing! I have hit my max deductible on my health insurance." "I don't mind if my glasses break. Insurance covers another pair this year anyway." "I need to make sure I get my doctor checkups, eyes checked, and dental cleaning. I don't need it, but I'll pay loads more when I switch plans next month."
• Adverse selection A narrow market emerges because the insured possesses much more information than the insurer. My wife and I learned about this in 2008 while evaluating insurance for pregnancy coverage. When we looked at the cost of coverage we discovered that because of the premiums and caps, on an NPV basis the coverage made sense to purchase only if my wife became pregnant within the next six months. A baby was not in the immediate plan, but the insurers did not know that. While the point of insurance is to transfer the risk for a price, a six month breakeven NPV is far outside the range of most people's risk appetites. This limits the number of people applying for coverage to the truly risk averse and those who plan on getting pregnant in the very near term.
• Correlated risks Large-scale meteor strikes, war, and 1918 Spanish flu-style outbreaks do not have insurance products. Either the event never occurs and the insurer walks away with the money or the event occurs and the insurer must pays off everyone at the same time and the insurer does not have sufficient assets to pay out. Accordingly, neither a rational buyer nor the rational seller should enter into the contract.

As I reflected on the podcast and some long ago college lectures, I couldn't help but see the parallels with this and AIG's Financial Products division. AIG wrote credit default swaps to insure collateralized debt obligations. In layman's terms, if a pool of mortgages started to default above a certain rate, AIG would be forced to pay the losses. Companies would approach AIG and offer to pay premiums if AIG were willing to assume the risk. To some degree I see all three forms:

• Moral hazard Anything that could make it through the AIG filters would be pushed through. If the price is identical, the first CDOs in line for credit default swap are the lowest quality relative to the perceived risk. 
• Adverse selection In late 2006, I spoke with a regional mortgage broker who referred to a section of his loan portfolio as "hot potatoes." All the due diligence boxes were checked, but because he was closer to the market, he was more familiar with the underlying risk than the standard scoring mechanisms would show. He was in a hot market, and he knew that the buyers who purchased, rebundled, and securitized would be none the wiser. One fascinating fact here according to a comprehensive FDIC report is that while it is true that, "the loans small lenders sold into the secondary market had both higher default risk and higher prepayment risk," the same was not true for the larger banks. Fortunately for AIG, the larger banks kept the loans with higher default risk, but lower prepayment risk. The data on adverse selection in the collateralized debt obligation market is a mixed bag and AIG ended up lucking out as it could have been much worse.
• Correlated risks While I recognize that many believed that real estate movements were not correlated on a national level because historically that was not the case in the United States, nationally correlated real estate prices had occurred at different intervals across many countries over the last fifty years. A friend once told me of a financial risk conference he attended in 2006, and while "across the board decline in real estate prices" was on the board of one of the primary presentations, it was listed in the "very low probability" bucket. While hindsight is 20-20, this was considered a known risk, and insuring it on this scale is like betting all-in against a pop star becoming addicted to cocaine. Sure, it hasn't happened yet to this person, but are you ready to bet the company, the largest insurer in the world, on it not happening?

While adverse selection and moral hazard can run losses for a company, if there are no correlated risks and the ramp up in underwriting volume is not large, the losses will start to pile up and corrections will be made before it gets too bad. Correlated risks, however, were the doozy that sank the company.

Leadership - Leading

Continuing on a previous post, there is a difference between management and leadership. Unfortunately, this phrase has been an overused cliché and become a blank canvas to project whatever one wishes into the paradigm. With that enormous caveat, below is a description of my experience of when I have felt that I have been led versus when I have been managed.

When I am led, I feel that the leader and I have the same goal. It isn't a single word like "Vision" or "Passion," Of my own volition, I choose to want the same thing that my leader wants. Since individuals want different things at different points in their life, depending on the situation, leading can be incredibly difficult. Consider some of the potential objectives for each employee or team member:
1) Avoid work
2) Positioning for outside company move
3) Job security
4) Maximize compensation 
5) Positioning for advancement inside company
6) Praise and recognition
7) Feel superior
8) Winning
9) Team survival
10) Creation

When I'm being managed, I feel like my manager is appealing to any of the first seven items in the list. "Hit your target and get your bonus." "If we do this well, senior management will recognize it." "We can outdo the sales of those B-listers in the other division." "This will look good on your résumé."

When I'm being led, I feel like my leader is using one of the last three items in the list. "We are this close to the best customer experience in the industry." "We have come a long way, and if we can see this result come May, the bankers will give us the green light." "Pulling this off will forever change the industry. I believe that you can do this."

Because individuals are unique, and some are more difficult than others to lead, leadership will always be difficult, a unique attribute, and contrary to what many believe, an inconsistent attribute. People and circumstances will always change. However, recognizing that the appeals to the first group as primary motivators does not feel like leadership is a good step at rising above hum-drum management and taking a shot at the next level.

Leadership - Management Frameworks

One of my favorite analogies is the fire triangle. It's simple, familiar, and applies well in a variety of situations.

(Image from the peer reviewed journal, Wikipedia)

Anything with three primary elements that breaks if any one part is missing is fire triangable. Learning? Existing knowledge, transmission, and retention. Body building? Calories, muscle exhaustion, and repetition. Fire triangle created. Since it seems nearly every framework comes in threes, and a large percentages of these frameworks are co-dependent, the fire triangle becomes ubiquitous.

Take one fire triangle for leadership and team management:
Knowledge - What is the plan? Does the employee know what (not know how) they are supposed to do? What are the priorities, KPIs, process, routine?
Ability - Is the employee presently capable of achieving the objective?
Motivation - To what level is the employee committed to achieving the goal? How much oversight and followup is needed to keep the employee on task and giving all of their effort?

When all three are present, I see a functioning team. Everyone knows their place, is capable of doing their job, and is committed to following through to the goal. What I find most interesting, however, are diagnostic failures. I have often talked over plans of what to do with "underperformers" with managers. There are cases in which the environment has no direction or plan, but the manager believes the employee is incapable. At other times the employee simply does not have the skills to perform a function, yet the manager still believes that one more pep talk just might do the trick. Finally there are those employees who "just aren't capable," yet they switch managers and become a rising star. Misidentification is a mistake we all make, but once you recognize it, testing the hypothesis before throwing the employee out can yield surprising results.

Reputations - Expectations and the Wow

I studied at a university that is at the frontier of brand management. Messaging, positioning, maneuvering, strategy, and tactics were drilled into us. A company is its brand. A team is its brand. An individual is its brand. However, once I arrived in the day-to-day operations of a company and customer management I realized that independent of the myriad directions that one could take on a brand strategy, in the long run the reputation and brand of a company, team, or individual follows the history of customer experiences. Brand positioning must be aligned with the customer experience; otherwise, contrary to what the conspiracy theorists may say, customers stop believing the marketing. Watching the success and failure of various brands in a number of countries, I've witnessed brands gravitate to the customer experience, and the customer experience is at its best when 1) customer expectations are met, and 2) the "wow" factor is then thrown in. Below are two examples. The first is one of my favorite stories of customer service, and the other is about me.

Hampton Inn is not the highest-end brand in the hotel segment, but they strive to establish a brand that fulfills customer expectations. However, with the occasional "wow" factor thrown in during downtime, they can push the brand even further. In the "Additional Requests" field on a Hampton Inn online reservation, one guest wrote, "Please place a framed picture of Alfonso Ribeiro on the nightstand." As Hampton says, "We love having you here." Delivered as requested.

I had taken over a new department with about 30 employees. Results were okay, but not great. This was one of the few departments I had taken over that had a somewhat successful manager before my arrival, and I knew that there were misgivings about me. In the country I was working, it was nearly impossible for anyone to read every word of every document that requires a notarized signature from an authorized board member. And it seemed that every document needed a notarized signature. Accordingly, a high volume of paper came across my desk. On my second day in the role, an employee presented a document to sign, and after a five-second glance I pointed out a typo in a single number in the middle of the page. Next, an employee entered asking for help with a problem with his department. I had some familiarity with the problem from previous experiences. After about three minutes and my asking a few of the right questions to guide his thinking and get buy-in, we were able to restructure the work flows, establish KPIs, and create accountability in his team. The two of them left in awe and shared their experience with others, and it helped me immediately build trust with a new group. Now, I'm probably not nearly as smart they think. However, I at least skimmed everything I signed, and I'd seen a lot of different types of problems by this point. By going back to the team, asking how things operate, pointing out new things I learned from them, and offering feedback, I hope I was able to establish and meet expectations. However, the occasional "wow" factor can really help things along.

Disruptive Technologies, Part X - The Left Out

I commented at the beginning of this series on a few areas where I see the largest potential developments:
- Autonomous vehicles
- Energy storage
- Customized electronic education
- Water desalinization
- Terrorism

The first three I've covered in previous posts. Autonomous vehicles have an enormous cross-industry impact, but only once the truly autonomous part is achieved. Energy storage developments would increase efficiencies in the developing world and lead to large productivity and quality of life increases in the developing world. Customized electronic education provides higher quality education to motivated individuals (or parents) all over the world.

Now for the other two that haven't been mentioned up to this point. Because I follow both of these subjects, I'll simply give an overview without excessive links. I imagine I'll be covering these themes periodically in future posts anyway.

How does a technological advance occur in the terrorism space? Generally it's done by weaponizing an existing technology and then applying it in a way to maximize the psychological impact. Drive a plane into building. Grow ricin and put it in the mail. Put a bomb on a train or crowded area. Hack into a server and steal/publish personal and sensitive information. Et cetera. Thankfully, up to this point terrorist attacks have not been very creative. However, these developments in technology are opening up new doors to terrorism. What's been prevented or missing so far is a motivated individual or group, weaponizing the technology, and opportunity to implement. Advancements in technology provide more opportunities to implement, but also more opportunities to control. While I am quite bearish on the mass implementation of wearables in the short- to medium-term, I believe law enforcement will be using them widely within the next five years. Auto facial recognition scans, license plate scans, etc. will likely be allowed under the law in most countries. Combine wearable tech with the big data behind it, and a formidable security apparatus with all of its accompanying concerns is created. It's an arms race among security, terrorism, and liberty.

Developments in water desalinization are important for many reasons. Millions count on desalinization to provide them water. Water is running out in many areas of the world, Yemen being the most obvious example. Precipitation irregularity with an expanding population base will increase demand for additional water sources. Water scarcity is increasing, and there are many tools to help manage that scarcity. Desalinization breakthroughs, whether from Lockheed, universities, or various Middle East-backed projects, will create a price ceiling for water in every area bordering the ocean and prevent massive potential unrest in populated arid regions. On the world's current trajectory, water management needs to be improved significantly. Populists policies tend to fail in water management. One way to avoid this battle over a scarce resource is to improve the supply through technology. Water desalinization is the best bet for expanding the supply of water through technology, and billions of dollars are being spent to develop it. It might take a little luck, but this innovation is significant, especially compared to the status quo trajectory.

Disruptive Technologies, Part IX - Energy

This is my final entry commenting directly on the contents of the Disruptive Technologies MGI paper. I'll have one more entry on where I see some important elements that were either omitted or glossed over.

Returning to the generation, transmission, storage framework mentioned earlier, we'll break down the developments in energy mentioned throughout the paper by the authors.

A few points before diving in. There is an important point highlighted by the authors concerning peak demand. Energy is generally most efficiently produced when there is an even load. However, energy demand is not even for 24 hours per day. There is a big peak in the afternoon to early evening. From page 101, "To meet peak demand (when generation prices are highest), utilities can either build excess generation capacity or purchase electricity from other utilities or from specialized peaker plant suppliers." Accordingly, reductions in peak demand—even if that peak is merely shifted to other parts of the day—can produce huge savings. The paper's authors focus quite a bit on improvements in smaller scale batteries outside of the larger grid. However, from their writing and from my reading elsewhere, it is incredibly difficult to predict both developments and impact in this space.With this in mind, especially for the transmission and storage elements, below I've focused more in developments at the level of the general electric grid, household consumption, and business consumption.

Generation a) Oil and gas improvements - There have been incredible developments in natural gas over the last eight years. Hydraulic fracturing and horizontal drilling are global game changers in the energy industry. However, the cutting-edge advancements have primarily been implemented only in the United States and Canada. As other nations implement similar technology, and the technology progresses further (e.g., well renewal and other methods), the global energy industry will be very different from what we see today. As the authors put it (page 135), "No one can predict the geopolitical implications of such developments; there are simply too many variables in play."

Generation b) Renewables - Solar and wind continue to progress, but still have a ways to go. Solar will always have the upper limit cap on how much energy the sun produces, but there have been fairly constant efficiency gains in both the technology and production techniques. Solar does okay in certain high intensity deserts (no clouds and more hours of sunlight), but outside of them the economics need to change significantly before coming close to par with fossil fuels. Wind power simply does not appear to be viable until an improved energy storage solution comes into play. Wind is actually close to par with existing fossil fuels, but wind power exacerbates the peak load issues, as wind tends to blow more at night than the day and sometimes the wind does not blow at all. This is also true for solar because of intermittent cloud cover. The key to this is in the storage section below. If interested, one of my favorite TED talks is from a physicist on a realistic description of what green energy needs to look like going forward. going forward.

Transmission - This area was highlighted in the chapter on the internet of things. The estimate from MGI was a potential 2-4% reduction in peak demand, lower loads on the grid, and improved energy management techniques from customers. Nothing earth-shattering, but some decent improvements. One area that was not mentioned in detail was improving the regulatory structure to vary prices for customers depending on demand and supply. Consumers, however, would need to stay informed (perhaps through the internet of things) on the going rate of energy. This aspect alone could capture a significant portion of this benefit.

Storage - I've heard that there are many in the venture capital world working with prototypes of improved storage capacities, but very little is publicly available and there is not much information in the MGI report. The MGI authors do admit this is a slightly longer shot than many other points discussed, but the impact would be enormous. Just in energy production on general energy grids, we could see a 5%+ utilization impact of free energy that is currently lost because of frequency stabilization or inefficient storing of power. Wind power would instantly become far more economical. Plants could even out loads, driving efficiencies across the sector. This would also signify large impacts in the developing world, as intermittent energy is a large blow to productivity and quality of life.

There is a lot of potential in the energy industry. Drilling improvements have already been discovered and are very likely to continue and expand to the rest of the world. Storage improvements at the grid level is potentially disruptive with large worldwide benefits, but it is also the longer shot. I'm eagerly looking forward to the information on developments trickling out of the venture capital arena. Many companies should be aware of storage improvements, as the implementation would likely come quickly, and the effects would ripple through industries in both the developed and developing economies.

Side Comment: Driving in the developing world

From my previous post:

"One final note. Unlike some of the other improvements listed in the report, autonomous vehicles will likely have only a marginal impact on the developing world for both safety and infrastructure reasons. Those who have driven in these environments know how complex driving can be (more construction areas, worse road conditions, lower compliance with traffic laws, safety concerns, etc.), and that autonomous vehicles still have a ways to go before being able to navigate even just the urban areas of cities in the developing world."

One of my favorite stories about this is when I was working for a time in an office relatively close to a sketchy neighborhood. I was checking out the streets in street-view mode on Google maps. I clicked forward into the neighborhood. As I and the Google van advanced with each click, a group of shirtless young men in their late teens or early 20's appeared in the distance in the middle of the street. The Google van approached closer each time I clicked. The next picture showed the young men standing across the road in an intimidating fashion, all looking up at the Google van. I clicked forward one more time, but there were no more options to click further for street view into the neighborhood. The Google van had fled.