Monday, February 20, 2012

Insurance. Or not.

If you have ever wanted to see what a scandal looks like before it comes crashing down, check out the budding Russian insurance industry. Standard & Poor's released last week an interview between an Associate Director of their Financial Services Team and a Russia-based Senior Insurance Analyst.

The video clip, entitled Russian Insurance: High Country Risk and Frail Market Framework is instructive. It describes an insurance sector in Russia that is growing rapidlyfaster than GDP growthin a market where insurance penetration is one-tenth the norm in Europe.

But it is the details that are interesting. Russian insurers are facing high country risk is the theme. The industry is not profitable, largely because 40% of premium costs are paid out to agents and brokers. The industry, the analyst goes on, is highly concentrated and therefore there is significant price competitionnote that this is not an inherently logical statement, as high concentration generally offers greater pricing control, but be that as it may.

And at the end of the day, the high up-front costs, coupled with price pressures create an industry that has very low capitalization. And this is a risk for the industry. This is the conclusion of the report.

S&P, along with its brethren bond rating agencies, are struggling to maintain their independence and freedom from federal oversight domestically, even as they areas illustrated by this videoworking diligently to expand their franchises into new, international markets. Their franchise is about independent analysis in the interest of the investing public.

This report has all of the attributes of a dispassionate industry analysis, from which industry participants or investors might glean valuable insights. The report suggests that this might be a good time to become an insurance broker or agent. Or perhaps pursue a roll-up to gain greater price control. Or perhaps simply to short the stocks of Russian insurance companies before some insured event wipes them out.

But somehow, on the heals of a financial disaster in which the rating agencies were implicated for ignoring key risks that would have broad public repercussions, they seem to be falling into the same pattern here. The key conclusion of this report by S&Pthat the industry is undercapitalized and is not taking prudent steps to build capital and set aside risk reserves—is eerily familiar. The collapse of AIG, and indeed the entire credit default swap market, was characterized by the under pricing of risk, while participants took out huge "profits" on the front end.

Yet nowhere do either of the representatives of S&P suggest that the Russian insurance sector shares these attributes. This report seems to missor simply ignore—this salient point that seems to be a valid conclusion of the Russian industry as they describe it: That the sale of insurance without the careful construction of actuarial risk reserve is a business that borders on fraud. And with 40% paid out up front, it might be a lucrative fraud at that.