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The Option Trader's Hedge Fund: An Insurance Business Case Study

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This chapter is from the book
This chapter shows you how to create a business of trading options successfully by using the framework of an insurance company.

This is the same framework used at a hedge fund managed by Dennis (the co-author of this book). So, for this book, we create the concept of The One Man Insurance Company (TOMIC). You will need to know how the insurance business works. What is the good, the bad, and the ugly of the insurance business? How does an insurance company make money? How does it lose money? What are the key profit drivers of the business, and what are the key success factors?

Insurance is the equitable transfer of risk from one entity to another in exchange for compensation, called a premium. The insurance companies make money by taking risks from others in exchange for a premium. For example, if you own a vehicle, you probably have car insurance that protects your asset against a big loss like theft or accident. The insurance company collects a premium each year to protect you against the big loss. The insurance company pays you to make you whole. For an insurance company to function, it must know what risks it is willing to insure. It also needs to know how much premium it needs to charge to be able to back the risks and still earn a profit. It will need to know the car-theft statistics and accident statistics for your car’s model and year. Using that information, the company is able to price coverage and charge a premium that allows the company to make a profit on the large pool of car insurance it writes.

Figure 1.1 illustrates a generic value chain of an insurance company.

Figure 1.1

Figure 1.1. Insurance company value chain.

The main functions in an insurance company are these:

  • Underwriting: Defining and selecting risks to insure
  • Pricing: Identifying the insurance premium for the risk taken
  • Reinsurance: Divesting or redistributing unwanted risk
  • Claims processing: Dealing with customers and payout of insurance losses
  • Customer acquisition: Selling insurance policies
  • Investment operations: Earning additional income on reserves (float)

The underwriting function selects risks the insurance company is willing to insure. This function defines characteristics of the risk and analyzes the statistical outcomes of the risk. For example, the underwriting function of a property and casualty insurance company would look at the auto insurance market and decide which segment of the market they would like to insure. The underwriters, through their analysis, may find out that the small-SUV segment driven by married women between the ages of 24 and 36 have only a 1% chance of an accident versus the general average SUV accident rate of 5%. The underwriters may decide that this is a segment they would like to have in their portfolio of insurance policies.

The pricing function determines the amount of premium to charge for the risk being insured. Continuing this example, the insurance company prices the small SUV driven by married women between ages 24 and 36 at a price that generates a positive expected return. They price it at an expectation of a 20% return on premiums written for the year.

The reinsurance operation divests or relocates unwanted risk. The insurance company buys insurance from other insurance companies or reinsurance companies to spread risk among many. In effect, it transfers the unwanted risk to other entities (reinsurance companies) that are willing to bear the unwanted risks in exchange for compensation. An example of this is a property and casualty insurance company (Auto Insurance Co.) with a large base of auto insurance subscribed in the San Francisco Bay Area. The company is not willing to take the risk of an earthquake wiping out all the insured vehicles. Auto Insurance Co. is comfortable insuring the vehicles for normal accidents and theft, but if the Big One (earthquake) happens it will cause damage to all the company’s insured cars. Therefore, the insurance company reinsures earthquake risk by buying earthquake insurance from a reinsurance company (let’s call it Reinsurance Co.) that specializes in catastrophic insurance and is willing to assume the earthquake risk. So, if the Big One hits, Auto Insurance Co. would not lose because Reinsurance Co. would pay the Auto Insurance Co. for the earthquake claims, which in turn uses the funds to pay the individual auto claims. Hence, its risk of an earthquake was undertaken by the reinsurer and not the auto insurance company.

The claims processing function determines the cost of a loss and pays claims to the insured. Going back to the auto insurance company example, the claims processing unit sends out adjusters to an accident to evaluate the loss and to start the claim process. This involves customer service as well as compensation since the adjuster deals with the insured and wants to provide good service in order to keep them as a client.

The customer acquisition function is executed through agents and brokers. They are responsible for selling the insurance policies. The agents may be exclusive agents or outside agents. The channels could be through physical agencies (offices), by phone, or online (using the Internet). This function is also supported by marketing and customer service departments.

The investment operation function is a profit center of an insurance company. There are two types of profits generated in insurance: underwriting profits and investment profits. The underwriting profits are generated directly from writing insurance policies. Underwriting profits are what is left after the premiums are collected and claims are paid. The investment profits are generated from investing the premiums and reserves set up when policies are written. Some people refer to investment profits as income generated from the “float” on the insurance companies. Warren Buffett is a master at investing. The insurance businesses in Berkshire Hathaway (GEICO and General Re, for example) are required to create a set amount of reserves. These reserves are invested by Warren Buffett to generate income. This is the income derived from the investment operations.

How Insurance Companies Make Money

Insurance companies make money from underwriting and from operations. Underwriting profits come from selling insurance and taking on risks. Investment profits are profits in the form of investment returns. TOMIC makes almost all of its money from underwriting operations. TOMIC could make money from investments also, but this topic is not covered in this book.

Here is an example of how an insurance company makes money selling automobile insurance. Each year ABC Auto Insurance Co. insures 10,000 cars with average value of $20,000 per car, and it charges on average $1,000 annual premium for each car. Each year it has on average 1,000 claims where the average cost of a claim is $4,500. Looking at the insurance operations, ABC Auto Insurance Co. earns a profit of $5,500,000.

This is how a gross Profit and Loss summary looks:

Earned Premium =

$10,000,000; 10,000 cars × $1,000 premium

Incurred Loss =

($4,500,000); 1,000 claims × $4,500 cost of claim

Profit =

$5,500,000; Profit from insurance under writing operations

Of course, there will be administrative overhead beyond this gross profit. Also, while ABC is waiting to pay out claims, it makes more profit from investing the money it collects as premiums and earns investment income. So, assuming ABC can earn about 3% on the premiums it collected and it maintained an average float (premium collected and not paid out as claims) of $2,750,000 ($5,500,000/2), it would make another $82,500 in investment income.

ABC Auto Insurance Company makes money by charging sufficient premium to cover the actual losses incurred and leaving a profit for the company. The key to making money for ABC is the expertise in underwriting risk. A 20-year-old single male driving a two-door sports car pays a higher auto insurance premium than a 30-year-old married female driving a minivan. That determination is made by the underwriters at ABC using statistical estimates of the customer and type of vehicle.

So, by now you are probably wondering how an option selling hedge fund works like an insurance company. How is one option trader able to do everything an insurance company does to make money? Keep on reading. We will show you how to trade options exactly like running an insurance company. A side-by-side comparison of the automobile insurance to writing (or selling) a put is shown in Table 1.1.

Table 1.1 shows a side-by-side comparison of auto insurance and option selling. Remember that options are a form of financial insurance. They transfer risks from the option buyer to the option seller. Auto insurance is just like options:

  1. First, there is an asset being insured. In the case of auto insurance, the asset insured is the car. In options the asset being insured is the stock, index, or future.
  2. Every insurance contract is in effect for a specific time period. In auto insurance the policy usually is for 12 months. In options the period varies depending on the options you buy or sell, and it could range from a duration of one week to 30 months. In this example the option expires in 30 days.
  3. For auto insurance there is an amount that is insured, the value of the vehicle. In this example it is a $20,000 car. In options the strike price defines the amount insured. In this case it’s $90; this means that the owner of the put has the right to sell XYZ stock at $90 before the option expires. This is like auto insurance: If the vehicle is worth $20,000 and gets into an accident that causes $4,500 in damages, then the auto insurance company needs to make the policy holder whole and pay for the repairs needed to bring back the value of the vehicle to $20,000.
  4. To pay less for auto insurance, some car owners are willing to take some risk by agreeing to a deductible in the car insurance contract. In this example, the car owner is willing to pay for the first $2,000 of damages in a claim. Hence, if the car gets in an accident and the repairs are $4,500, the insured will have to pay $2,000 and will be reimbursed $2,500 from the insurance company. This is analogous to selling OTM (out-of-the-money) puts. The option buyer, to pay less for the put that’s protecting XYZ stock, is willing to assume 10% of the loss if XYZ stock goes down. So, instead of buying a put with a $100 strike price, he buys a put with a $90 strike price. That means that if XYZ stock’s price falls within $0 to $10, or up to 10%, then the owner of the put will not get anything back from the put if held to expiration. He is willing to absorb the first 10% of the fall in XYZ.
  5. A premium is paid for insurance, the same as for options. In both auto insurance and options the fee paid for the contract is called a premium. In the example, the car owner paid $1,000 to insure the car for 12 months. The option buyer paid $3 to insure 100 stocks of XYZ at a price of $90 for 30 days.
  6. From the ABC Auto Insurance Co. point of view, there is a loss ratio based on actuarial tables expected from selling the auto insurance. In this example ABC expects to have a 10% loss ratio. This means that on average from the auto insurance segment, it expects to have claims on 10% of its policies. From the option seller perspective when writing the put, according to the analytical model used, the XYZ put has a 90% probability of expiring worthless. The underwriting is very important when one is running an insurance business. This topic is addressed in a later chapter.
  7. In auto insurance either the company pays out a claim when there is a loss, or it does not have to pay out anything if the policy holder is claims free. In the latter case, the insurance company would have made money since it keeps the entire premium. It is the same case for the option seller. If the put option sold expires in-the-money (ITM), the option seller will have to buy XYZ stock for $90 from the put option owner. If the put expires out-of-the-money (OTM), meaning that XYZ was above $90 at the time of expiration, then the put seller keeps the premium collected.
  8. Most insurance companies reinsure part of their risk. For example, ABC Insurance Company might buy earthquake and tsunami insurance from a reinsurance company to cover all the automobiles for which ABC has written insurance. This is done to avoid a catastrophic event. If there were a tsunami, most likely there would be closer to 100% loss instead of 10% expected loss. Hence, reinsurance against catastrophic losses is a good idea. The option seller can do the same to protect against a catastrophic event (e.g., 9/11/2001, a financial meltdown, or a presidential assassination) by buying a put at lower strikes (OTM) in XYZ or by buying an OTM put at the market (S&P 500 index). By doing this, the options seller reinsures just like the insurance companies to avoid catastrophic losses.

Table 1.1. Auto Insurance Comparisons to Option Selling

 

Auto Insurance Terminology

 

Option Selling Terminology

 

1

Insured asset

Car

Underlying asset

XYZ stock (trading at $100)

2

Insured period

12 months

Time to option expiration

30 days

3

Value insured

$20,000

Strike price

$90

4

Deductible

$2,000 (10% of insured value)

% OTM (out-of-themoney)

10% (XYZ was trading at $100 when $90 put was sold)

5

Insurance premiums

$1,000

Option premiums

$3

6

Loss ratio

10%

Probability of profit

90%

7

Claims

Yes: Pay out claim

No: Keep premium

Expired

ITM1: Seller has to buy XYZ for $90

OTM2: Optionseller keeps the premium

8

Reinsurance

Buy insurance from another company to protect against catastrophic loss (e.g., a tsunami)

Hedge

Buy XYZ put farther OTM or index puts to protect against large market losses (e.g., 9/11/01 attacks)

The example shows that selling options is very much like running an insurance company. The business of a one-man insurance company is to collect premiums from option buyers in exchange for the risks of losses in the underlying markets of the options and earn profits from the time decay of the options.

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