November 12th, 2008

Financial Catastrophes: No Storm, Plenty of Damage

Posted at 1:00 AM ET

Andrew Marcell, CEO of Americas

We live in a world at risk, but sometimes, the threats take new forms. Even as we are coming out of an above-average U.S. storm season, carriers are focused on a new type of disaster. Throughout 2008, every major city in the world felt the reverberations of a “financial catastrophe,” triggered by the collapse of the subprime mortgage market. This event has put severe pressure on both sides of the balance sheet and proved that an economic event can have the power to move the market.

The concept of a financial catastrophe seems new only because they occur infrequently. The depth of financial markets, carrier risk management, and investment discipline usually provides some measure of protection. Economic conditions undoubtedly influence carrier capital management decisions, but the structure of the industry has generally been sufficient to absorb market-induced shocks. Today, though, we are in the midst of a market event that has pushed through traditional industry controls, impairing balance sheets and raising general threats to capital availability and solvency, which could impact carriers writing all lines of business.

The current financial catastrophe began to percolate more than 18 months ago, when the first subprime mortgage lenders began to show signs of trouble. Before the end of 2007, credit markets were effectively frozen … and the contagion continued to spread. (Re)insurer investment gains were decimated, often becoming losses. Equity markets felt the sting, as the precipitous decline in share prices destroyed vast amounts of shareholder wealth. While all hope that the financial catastrophe will exhaust itself soon, the reality stretches far into the future. In fact, a recovery may take 10 to 12 quarters.

As the situation unfolds, the implications by line of business will vary, but the entire industry will be affected. In general, access to capital will be constrained for (re)insurers. The cost of capital is likely to increase across the board, leading to higher risk transfer pricing. Further, the fact that liquidity has been a problem in some cases may cause carriers to purchase more reinsurance, which would lead to a higher reinsurance spend, possibly at a higher cost. These investments in risk transfer, however, are likely to result in more prudent risk and capital management practices, as the benefits of caution have been proved in recent months.

Casualty lines of business have felt the force of the financial catastrophe most directly. In addition to the damage caused to credit default swaps and other mortgage-related securities, an increase in shareholder class action lawsuits is likely to arise, leading to directors and officers (D&O) and errors and omissions (E&O) insurance claims. Heading into the next renewal, reinsurance rating models will be subject to greater focus than previously predicted, as the need for more robust protection intensifies. Property lines may not be immune to the financial catastrophe, and most of the effects would be derived from broader market conditions.

In the event of a mega-catastrophe, of course, the effects of the current financial climate would be exacerbated. Efforts to replenish balance sheets would be impeded by the availability of capital. The cost to acquire cash would increase substantially, and carriers may not have access to all the resources they would need. While we have come to rely on alternative sources of capital (such as hedge funds and private equity funds) to supplement traditional reinsurance, they have been affected by the credit crisis as well and may not be able to allocate as much to insurance-related risks as they have in the past.

As conditions change in the (re)insurance industry, it will be important for carriers to approach balance sheet protection differently. Instead of evaluating and hedging perils separately, the breadth of the financial catastrophe has shown the value in holistic risk and capital management. Threats are interconnected, and events on one side of the balance sheet can bleed into the other. Risk transfer must be considered within the context of overall capital management, and global economic trends must be seen as yet another peril to be included in any risk management strategy.

We are operating in the age of the financial catastrophe. In addition to watching the traditional property and casualty risks that could lead to claims, carriers must be diligent in covering economic risks as well. The credit crisis, which began with default rates on subprime mortgages, has demonstrated that interconnected risks can result in financial devastation.

Published in the November 2008 issue of Reinsurance magazine

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