Here’s an example: On December 16, 1811, an unfathomable 7.7 magnitude earthquake struck New Madrid, Missouri. It was the first of four such quakes and thousands of aftershocks that plagued the region that winter, the most famous being the New Madrid Quake on February 7, 1812 which damaged structures in St. Louis. Today, scientists estimate there is a ninety percent chance that this fault will, once again, shift by the year 2040. Few, if any, of the buildings in Missouri are built to withstand an earthquake, let alone one approaching the strength experienced nearly two centuries ago.
If you owned a chain of banks that operated exclusively in the region, you would want to ensure that the homes secured by the bank’s portfolio of mortgages all carried earthquake insurance from a rock-of-Gibraltar-strength company such as AIG or Berkshire Hathaway. Otherwise, your bank was, in effect, acting as a reinsurance company without earning any premium income; accepting a tremendous risk, potentially wiping out your business and personal net worth.
The Bottom Line
Seemingly uncorrelated risks are most often the deadliest. Charlie Munger, a brilliant intellect and investor, has observed that Fannie Mae has, in effect, become a reinsurance company without any of the offsetting premiums due to a scenario such as the one just mentioned. Perhaps a wise mantra to observe would be: “If a wipeout risk exists, just resist.” Walk away. Your pocketbook is likely to thank you and you’ll look downright prescient at some point.
