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Key Topics
- Requirement
- Solution
- Introduction
- Credit Default Swaps (CDS) – A build up to the crisis
- Impact on specific insurance sector segments and companies
- a.US mortgage insurance companies:
- b.Life Insurance companies:
- c.Financial guarantee insurance companies:
- d.Insurance-Dominated financial groups
- Learnings from the after-effects
- Conclusion
- References
Requirement
Financial Crisis - An Insurance Sector Perspective
Solution
Introduction
The financial crisis seems to have had a minimal impact on the insurance sector vis-s-vis the banking sector whose solvency was endangered. However, insurance sector has been affected in adverse ways. This essay discusses the build-up of the financial crisis with a specific financial instrument at the core of it in Section II, its impact on the specific insurance segments and companies in the US in section III, some lessons learnt from this crisis in section IV. Section V concludes.
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Credit Default Swaps (CDS) – A build up to the crisis
Experts have presented a diverse view on the role of the insurance sector in the financial crisis with some backing the insurance sector to cushion the volatility as against few experts blaming the insurance product (CDS) as the root cause for the crisis. This is per views expressed by Chief Executive of Allstate (an US insurance company) as below:
“It was, after all, an insurance product that contributed to the risk that almost brought down the global economy. It should be no surprise that a big insurer like AIG would be a major issuer of credit default swap.
What is surprising is the claim that insurance did not contribute to the recent market failures, and therefore insurers don’t need to consider how to prevent them from happening again. ”
At the epicenter of the crisis is the fundamental shift in the bank’s business model from their core of tendering loans and holding them until maturity to distributing credit risks. These were conceptualized through innovative financial instruments viz. Credit default Swaps (CDS). A CDS is a bilateral agreement designed explicitly to shift credit risk between two parties. In a CDS, one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default or similar credit event by a reference entity . It is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. The buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract. In return, the seller agrees that, in the event that the debt issuer defaults or experiences another credit event, the seller will pay the buyer the security’s premium as well all interest payments that would have been paid between that time and the security’s maturity date .
A covered CDS is wherein the protection buyer owns instruments issued by the reference entity. Thus it helps the owner of the asset / instrument to manage the risk associated with the investment which is similar to the insurance contract. In case the protection buyer does not own particular reference obligation, the covered CDS engulfs the shape and form of a ‘naked’ CDS thus divulging from the motive of insurance onto speculation . If an insurer acts as a protection seller, then it is exposed to a negative impact due to an increase in credit risk. Huge CDS losses are inevitable against a fall in the value of a portfolio of mortgage-backed securities. Following the subprime crisis, AIG’s credit portfolio depreciated by USD 11 billion in Q4 2008 with a loss of USD 5.3 billion . Numerous U.S. insurers have already begun to set up reserves for potential claims following the financial crisis.
Impact on specific insurance sector segments and companies
a.US mortgage insurance companies:
The crisis began with the US residential mortgage market and these entities survival hinged on mortgages retaining or increasing in value. Thus the US mortgage insurance companies witnessed the brunt of the financial crisis, 2007. These insurance companies insure relatively high-risk or non-standard loans. Consequently, deteriorating mortgage market since 2006 has caused substantial losses to these mortgage insurance companies with an effect of wiping off capital buffers, originally, in place to cover any unprecedented losses. New Century Financial Corporation, a leading US subprime mortgage lender, filed for bankruptcy in 2007 with largest US mortgage insurers (MGIC Investment, PMI group, Radian) incurring significant losses. Thus the prices for protection against default of these companies rose vis-à-vis fall in share prices of these companies. Refer figure 1 below:
b.Life Insurance companies:
Life insurance companies have lower exposure to lesser rated mortgage backed securities. They generally invest in equity and corporate bond markets. The financial crisis led to lower valuations of these equities and corporate bonds. Thus a lower bond interests implies a significant increase in actuarial liability levels.
Life insurance companies have annuities contracts and guarantees to fulfill couples with deteriorating bond interest rates stretched the credit risk exposure of these companies along with asset-liability management challenges. Further, hedging positions turned costly owing to heightened market volatility. However, the only continuing boon for life insurance companies is that they continue to face lower liquidity risk as compared with banks and financial institutions. They would be prone to ratings downgrades thus increasing their appetite for higher liquidity. The financial stress at these life insurance companies would reflect in lower confidence of policy-holders’ in these companies resulting in annulment of contract from their end even though such action will entail termination fees and investment losses.
c.Financial guarantee insurance companies:
Financial guarantee insurance companies lost their AAA ratings status, which was their core of business model. These companies tend to be highly leveraged institutions and their business model revolves around lending their high rating to lower rated debt issuers and guaranteeing interest and principal repayment obligations. With their own ratings downgraded, their share prices plummeted with a rise in premium to cover credit default of such financial guarantee insurance companies. The difficulties experienced by these entities would adversely affect the financial markets through different channels. The insurance regulation in the US resides with the respective states. The New York State insurance regulator has been closing the written contract with the counterparts of the financial guarantors with an aim to provide financial restructure assistance to these guarantors’ insurance companies.
d.Insurance-Dominated financial groups
Though experts believed AIG to be the world largest insurance company, it was a major seller of CDS through its Financial Product’s unit. The gradual improvement and upgrades in the risk management models were in place in 2006. The only problem with this was that AIG, by such time, had built up most of its exposure to derivatives . It witnessed massive losses five straight quarters, with USDD 60 billion loss in Q1 2009, the highest quarterly loss a US corporation has ever reported. AIG’s credit ratings were downgraded in September 2008. This triggered massive collateral calls, forcing US government into action resulting in USD 150 billion aid to AIG till November of 2008. Refer figure 2 below depicting financial market indicators for AIG.
Source: Thomson Reuters DataStream
AIG was a significant counter party to systemically important banks. (The likes of Goldman Sachs, Societe Generale, Deutsche Bank, BoA, Barclays and so on). Thus AIG itself was being considered systemically important. Thus there was a focus-shift of government aid in terms of liquidity infusion measures from banking companies and financial institutions to insurance companies.
Learnings from the after-effects
Insurance companies are financial institutions which operate with a longer term liabilities than commercial and investment banks. Hence, they have the capacity to adopt investment strategies with longer-term horizons. This in effect is a stabilizing catalyst in the financial system. Moreover, since they cover a variety of hazards, they have the ability to reinvest the proceeds in financial assets.
The crisis has highlighted issues related to valuation of securities in a low liquid market scenario. With liquidity evaporating from the markets, valuations methodologies observes a shift from observable inputs to unobservable inputs. Thus market participants failed to correctly value the financial health of institutions. Questions are being raised on the efficacy of the accounting rules in ensuring transparent valuation of assets of all types of financial institutions.
Despite insurance companies have relatively stable flow of income through premium collection; they are not completely immune to liquidity risks. During crisis, insurance companies face rating downgrades leading to collateral calls and subsequently demand for liquid money. With credit lines drying up from the already stressed banking sector, owing to crisis, central banks would have to intervene to provide liquidity support. This was witnessed with AIG which was the first financial conglomerate to received US government aid.
Problems for large conglomerate arise from the financial product’s unit that operates in capital markets providing credit protection. Losses for AIG mounted at its financial product’s unit were so massive that it camouflaged its diversified revenue sources. Thus there is a need for a well-functioning internal controls system, corporate governance and risk management in these companies and regulatory and supervisory framework at a macro level.
A way ahead for large conglomerates would be to re-analyze the benefits of insurance companies expanding their business into banking or commercial or investment activities. AIG’s federal support involved a planned break-up into separate divisions.
The crisis has called for a lesser complex financial instruments and institutional structures. A large conglomerate, with various divisions, operates out of one common capital base. This capital base is raised by all the various divisions combined, but a particular division may have access to capital raised by a less risky division leading to cross-subsidization of risk exposure at the divisional level. Thus a regulatory framework needs to be in place to segregate capital for different type of uses. A simple financial instrument would be easily valued leading to transparent valuations of financial institutions. This will assist in reducing uncertainties in the valuation of banks themselves.
The crisis calls for an intra organizational supervision, governance and information sharing leading to close scrutiny of the activities. This needs to be gradually expanded at inter organizational, national and international level as well.
Conclusion
The financial crisis was seen more as the one impacting the banking and financial sectors. However, it has reflected a more visible effect on the insurance sector. Even though the trigger of the crisis lay at US mortgage market and subsequent failure of CDS arrangements, the far reaching effects on the market volatility and investment portfolios have rendered adverse effect on insurance companies.
The position for underwriting is uncertain, but not all negative as the crisis have changed the behaviors and demand for specific types of financial products. This is a positive for life insurance companies.
The crisis has shown that insurance companies, which were once expected to be immune to liquidity risks, may have to witness liquidity crisis more than what their risk management models have factored. Thus liquidity risk is becoming more of an issue for some insurance companies. Further, it has surfaces the ideology that one unit may endanger the survival of the entire organization. Hence there is a need for a simpler structure which enables insurance companies to focus on their core business models and enabling investors to judge the risk exposure for an insurer.
It is imperative to note that the insurance, excluding certain insurance segments, overall the insurance sector have played a role of a shock-absorber during financial crisis. With lower liquidity and lower leveraged positions, insurance companies didn’t require to force-sell their investments. Moreover, steady flow of premium from the market participants to the insurance companies implied that these were re-invested in financial assets helping them to support their prices.
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Anon, 2008, Faulty computer models helped sink giant AIG, [Online], Available at http://www.jstic.com/Newsgroup/WSJE/2008/WSJEWJ_November_3nd.pdf, [Accessed date 10th December 2015]
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Anon, N.D., Credit Default Swap – CDS, [Online], Available at http://www.investopedia.com/terms/c/creditdefaultswap.asp, [Accessed date 10th December 2015]
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Eric Dinallo, New York State Insurance Department Circular Letter No. 19, [Online], Available at http://www.dfs.ny.gov/insurance/circltr/2008/cl08_19.htm, [Accessed date 10th December 2015]
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Papadopoulus , PP, 2010. Credit Default Swaps - Pricing, Valuation and Investment Applications, 1.
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Tom Wilson, 2009, Regulate Me, Please, [Online}, Available at http://www.nytimes.com/2009/04/16/opinion/16wilson.html?_r=0, [Access date 10th Dec 2015]
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William K. Sjostrum, Jr.,2009, The AIG Bailout, 66 Wash. & Lee L. Rev. 943, Available at http://scholarlycommons.law.wlu.edu/wlulr/vol66/iss3/2., [Accessed date 10th December 2015]
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