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Is There Really Anything That Is Financial Insurance?

In our everyday lives, we purchase insurance to hedge against the risks of dying early, losing our potential for income, health, home, automobile, liability, and even for travel.

While hopefully we don’t become obsessive about risk, it is both reasonable and expected, that one insures oneself against the major vagaries of life.

What about ensuring your money against the very monetary system and political system within which you hold your investments in bonds, mortgages, stocks, insurance policies, real property, and even the value of money itself? Is that a risk worth insuring against?

Financial insurance is not easy to define or obtain. Do we mean insurance against default, loss of value, a rapid depreciation of the value of money, confiscation, taxation, and the fair operation of financial markets which allow for proper price discovery and liquidity?  It should mean all those things.

There is such a thing as “portfolio insurance”, but what that normally means is some derivative contract, usually highly leveraged futures or option contracts, which are supposed to go in the opposite direction of our stocks, bonds, or commodities (whatever we are insuring).  It is intended to offset losses in investments should they decline violently in price.  It is usually short term in nature and it cannot insure against much more than adverse price movements. It cannot insure against systemic problems.

Limited though it might be, portfolio insurance doesn’t always work that well.  It may in fact contribute to the conditions that create losses. Older readers might remember the Crash of 1987, where the stock market fell about 35% in two days.  Later investigations pointed the finger at “portfolio insurance” that blew up.

Even defining market risk is troublesome because it can come in gradations. Bear markets come and go, often without creating systemic damage or long-term economic slumps, such as the Panic of 1987. In other cases, there can be general prosperity but a high degree of inflation, as during the 1970’s in the US for example. Neither compare to the inflation in Weimar Germany, the Confederate States of America, or today’s Venezuela, which caused societal collapse.  Because of these wide gradations and varied outcomes, it is hard to know really what risk one is really facing.

Because of this, the markets have not developed, and likely cannot develop, any kind of true insurance to protect investors from a wide variety of financial ills. Even if such an insurance policy was made available, the investments the insurance company would hold, in the event of a claim, would themselves be imperiled.

In a very real sense, one can’t insure against systemic risk, with investments that are subject to the risks we insured against!

True investment insurance, has to be outside of those risks. What one would need, would be an investment that is considered valuable by all nations and cultures, one that is easy to transact, liquid, and above all; an asset that is not someone else’s liability.

Let’s dig down a little on that last concept.  What is meant by an asset being someone else’s liability?

A bank deposit is supposedly your asset, but it is a liability to the bank and the FDIC.

A bond is your asset, but it is a promise to pay, a liability to the issuer and only as good as the entity, government or corporate, on the other side of the contract.

A share of stock, is an asset, a legal claim to the ownership of a corporation.  But it only has value if the corporation is profitably run and there are functioning stock exchanges where you can sell your shares.

A mortgage you might own, or a rental contract, is an asset but it too is only as good as the person paying the mortgage or making the rental payment.

Almost all investments have this counter party risk, that is, the investment will have value ONLY IF the entity on the other side of the contract can fulfill all of their obligations.

Even the concept of “cash” has some counterparty risk.  It is true that government can print all the money it might need to avoid bankruptcy, but if too much is created, then the value of cash itself will fall.  Cash falls a little bit in value every year, the rate of inflation.  Or it can fall drastically, as we see in Venezuela today.

The counter party risk is the government.  It has to manage its affairs properly, or the value of money not only can fall, the currency itself can be repudiated and become worthless.

The US has done a better job than most in managing its affairs, especially prior to about 1964.  Since then, we have had chronic inflation.  What was the price of gasoline in 1964?  It was 22 cents per gallon.  Today as we write, it is over $3.00 per gallon.  Older readers can think of many things from candy bars to postage stamps to make the mental comparison.  Did those items go up in price because they were rare and expensive to produce, or did the value of money fall, and it simply takes more units of “money” to buy the same postage stamp?

So, even “cash” has counterparty risk in terms of its value and acceptability. Besides, most investors don’t hold cash in physical bills, they have accounts in banks deposits and money market mutual funds.  Just as recently as the crisis in 2008, we saw banks and money funds start to fail and required an unprecedented bailout by the government. We came very close to the edge of disaster.

The best portfolio insurance historically has been gold.  It can’t default, there is no other party on the other side of the contract.  There is no credit risk. It is not a contract that needs a functioning legal system to have value. It is an element, a metal, that has had value for thousands of years among completely varied cultures, and it is held today by central banks as a reserve.

Gold trades in a liquid market that ranks as one of the largest in the world, it cannot rot, rust or deteriorate. You can heave gold into the ocean and recover it centuries later, and it still has value.  Sorry, you just can’t say that about Bitcoin.

Gold also tends to go up in value when other things are going down, and in technical portfolio sense, it is non correlated or negatively correlated to other investments.  Not only is it insurance, it is a true diversifier of market risk.  Gold can fluctuate in price, but it cannot default and requires no legal machinery to have value.

Gold is insurance with, usually, a positive return. This is also a unique feature of gold as financial insurance.

Now, it is true that gold’s return varies with the time period being measured but this is also true of every other investment. Over the past 45 years, gold has outperformed stocks and bonds. That is incredible if you think about it.

The best time to buy gold for insurance purposes has historically been when few people want to buy it… like today.  The price reflects this lack of demand and thus will advance upward when risks in the system begin to create losses on other investments and corresponding demand for gold.

In the next few blogs, we will list what the most likely risks to the health and security of the economic system are and discuss why some insurance money in gold is appropriate.

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