Insurers Face A Seismic Shift Over Bad Debt
November 13, 2008
Copyright 2008 Reed International Books Australia Pty Ltd.All Rights Reserved
Risk Managements
October 2008
Pg. 1
991 words
Insurers face a seismic shift over bad debt
FOR MUCH of the last decade, AIG was the shining star in the insurance industry. In late September this all changed, when a liquidity crisis at the company forced the US Government to intervene. This and other jarring events have produced a significant shift within the insurance industry, creating both challenges and opportunities - while also elevating the importance of developing new risk management strategies.Almost certainly the turmoil will have a long-term effect on insurers' technology strategies, with many likely to increase their investment in risk management and compliance systems in 2009 by far more than they planned in the first half of 2008. "Given the current economic climate, the financial markets may well be considering whether other insurers are at risk. While the only certainty in today's market is uncertainty, I believe AIG was a one-of-a-kind event within the insurance sector," said Datamonitor analyst, Financial Services Technology, Jonathan Steiman.Unlike other insurers operating within the life and non-life market, AIG was heavily involved with credit default swaps (CDS), which are unregulated quasi-insurance products that protect against bond defaults.For years, CDS were a profit centre for AIG. Essentially, it was collecting premiums for covering credit products such as mortgage-backed securities that, at the time, were not defaulting. The size of AIG's CDS exposure reached $US440 billion ($550 billion), which exceeded what the company could pay in claims. Realising that it had excessive exposure to CDS, rating agencies reduced its rating, forcing the insurer to put up greater amounts of collateral. The event triggered the downward spiral which eventually forced the US Federal Government to intervene."While AIG was in a class by itself in terms of CDS, the events of last month are directly and adversely affecting a number of insurers," Steiman said. "Insurance companies are larger consumers of debt and equity."The lower share price of AIG, Lehman Brothers' bankruptcy and the sale of Merrill Lynch to Bank of America is raising concern among insurance portfolio managers. On September 16, MetLife announced that it had $US800 million of investments between AIG and Lehman, and issued a press release stating that it was continuing to assess the recoverability of those investments. The Hartford also has exposure, particularly $US127 million in subordinated Lehman debt."On the positive side, the US government turned proactive. After coming to the aid of AIG, it drafted a plan to buy and gradually unwind the illiquid assets plaguing the balance sheets of financial service institutions. According to Steiman, the $US700 billion plan, which is still being debated, has two potential positive effects.First, he said, the plan, by steadying the banking industry, should boost lending, thereby lowering the cost of capital and keeping the economy chugging along. Second, the plan will allow the government agency to purchase illiquid assets from a number of financial service companies, including insurers. By enabling an orderly sale of assets (as opposed to a fire sale) the plan should mitigate write-downs among insurers.A key concern, however, is the price tag. At $US700 billion, the plan will increase the US national debt to $U$11.3 trillion, although the government should be able to recoup some if not all of the money from the sale of the assets. In reaction to the country's indebtedness, the dollar weakened against the euro in the days after the plan was announced."Although it is too soon to tell, the recent events could mark the beginning of the end of the soft market. For the last three years, premiums of nearly all commercial lines as well as some personal lines have been falling, and this - in combination with withering investment income - has had a crushing effect on the industry's bottom line. This could change, however," Steiman said."Many times after a market shock - for example, 9/11 - the industry gains greater pricing power. Further, a weakened and distracted AIG could cause a supply shock that puts upward pressure on prices. A shaky economy, however, may temper demand, making it difficult to pass on higher premiums," he saidInsurers have a chance to gain market share from AIG. While AIG's insurance units are solvent, the market has another perception. According to a survey of 1000 insurance agents and brokers conducted by Insurance Journal, 44 per cent of AIG policyholders have requested to move their account. Some 62 per cent of the producers said they expect to place less business with AIG. This shift in consumer and agent perception presents competing insurers with a great opportunity."Lastly, these events will have a long-term effect on technology strategies," Steiman predicted. "At present, insurers place great emphasis on risk management. According to a Datamonitor survey of 200 global insurers conducted in the first half of 2008, 61 per cent and 47 per cent of non-life and life insurers, respectively, said they were planning to increase investment in risk management and compliance systems in 2009. While these are healthy figures, in light of recent events I anticipate even greater spending."Vendors must react to this demand by not simply providing more of the same but by designing innovative ways to re-engineer the risk management practices of insurers," Steiman said."The old assumptions simply do not work. 'Safe' bets, like Lehman debt, proved poisonous. What's more, the current tools failed to account for the labyrinth of unregulated and loosely agreed-to credit default swaps. While new regulations should help mitigate these problems, next generation risk management systems must be able to quickly capture and evaluate complex transactions from every corner of the enterprise. In short, vendors have an opportunity to differentiate themselves by grasping the new realities of risk and designing relevant solutions."
AIG fallout continues
November 12, 2008
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